Commercial Mortgage-Backed Security (CMBS) Loans: A Guide
If you’re involved in buying and selling real estate, then you’ve probably heard of commercial mortgage-backed securities (CMBS). A CMBS loan is a fixed-income investment backed by commercial mortgage real estate properties.
CMBS loans offer many advantages for both the borrowers and the investors involved in this process. As a borrower, you could earn low fixed-rate terms and gain access to high-leverage financing that you may not be able to find otherwise.
But how do you take out a CMBS loan? And what are the advantages and disadvantages of choosing one over a traditional commercial loan? Those are exactly the questions this article will set out to answer. It’s important to note that Rocket Mortgage® does not offer CMBS loans.
What Is A CMBS Loan?
Commercial mortgage-backed securities (CMBS) are a bundle of commercial real estate loans sold as a series of bonds by the lender. CMBS loans, also called conduit loans, are often used to buy commercial real estate properties such as apartment complexes, multi-family homes, retail buildings or office centers.
CMBS Market Vs. MBS Market
The CMBS market is sometimes confused with residential mortgage-backed securities (MBS), but they are not the same thing. Residential MBS are backed by residential mortgages, most often single-family homes. In comparison, a CMBS is backed by income-producing real estate.
When a lender issues a CMBS loan, they pool it with a number of similar loans. These CMBS loans are then divided into tranches, depending on the level of risk involved.
The highest-rated tranches have the least amount of risk, so these loans will be paid in full first. Low-rated tranches come with higher credit risk, so they are the first to absorb any losses when a borrower defaults on the loan.
What Is Securitization?
The process of bundling CMBS loans together and selling them to investors is known as securitization. Most lenders perform between three to eight securitizations a year, depending on the lender’s size and the loans being issued.
How Do CMBS Loans Work?
When a borrower closes on a property, the mortgage is initially funded by the financial institution issuing the loan. Multiple CMBS loans are then packaged in the form of bonds and are typically held within a trust.
The loans are diversified by the loan terms, amount and property type. The bonds are also rated based on the average loan amount, debt-to-income ratio (DTI), and how many loans are in the pool.
After the bonds have been rated, they’re sold to investors based on that rating. Once the CMBS loan is sold, the original lender is repaid. This gives the bank more liquidity to continue issuing loans.
Overall, the securitization process benefits both the lender and the investors involved. It makes it possible for banks to issue more loans and gives investors early access to commercial real estate.
Pros Of CMBS Loans
If you’ve been looking into purchasing an investment property, then CMBS loans are not a bad place to start. Let’s look at some of the advantages of choosing a CMBS loan.
Fixed Interest Rates
These loans tend to come with better interest rates than what you’d find with a traditional commercial loan. And CMBS loans typically come with fixed interest rates, which means the rates won’t fluctuate throughout the life of the loan.
These types of loans tend to be a better bet for both the borrowers and the investors. Borrowers get to take advantage of consistent monthly payments, and these types of loans have a lower risk of default than variable rate loans.
CMBS loans tend to come with high leverage financing but don’t have the same high requirements for a borrower’s credit or net worth. Most properties come with a 75% maximum loan-to-value (LTV) ratio.
CMBS loans are also considered nonrecourse loans. This means that if the borrower fails to repay the debt, the lender can’t pursue legal action to hold the borrower accountable for the loan's full amount.
This is an obvious win for borrowers, but there are a few caveats. Most CMBS loans have fine print that outlines specific conditions under which the loan would become full recourse.
For instance, most loan terms state that if a borrower commits fraud or misrepresents their financial situation during the application process, the loan becomes full recourse. And you’d also be held liable if it was determined that you caused intentional damage to the property.
Most CMBS loans are assumable, though a small fee may be required. This means that if you decide you want to sell the commercial real estate and another borrower is willing to take on the loan, you can essentially hand it off to them.
That borrower will then be bound to the same terms of the original loan agreement. An assumable loan is a significant advantage for borrowers, especially since most CMBS loans don’t allow for prepayments.
Cons Of CMBS Loans
While there are quite a few upsides to CMBS loans, there are certain disadvantages to this decision. Let’s look at some of the biggest pitfalls of CMBS loans.
CMBS loans come with prepayment penalties, which means borrowers can be penalized for paying off the loan early. These penalties are set up to allow investors to earn the same type of profit they would have gotten had the loan been paid off in the agreed-upon time frame.
There are two different types of prepayment penalties associated with CMBS loans: yield maintenance and defeasance. In the event of a yield maintenance penalty, the borrower must pay a fee between 1% – 3% of the entire loan amount.
We’ll look at the defeasance requirements more closely in the next section.
Some CMBS loans are required to go through a process called defeasance (a condition or clause that can render a contract or deed null and void) before they can be prepaid. This involves a borrower purchasing alternative securities to replace the collateral and interest the lender will lose out on.
Defeasance can be a complex process, and the terms should be outlined in the original loan agreement. Borrowers will likely need to work with an experienced financial advisor to ensure the process is carried out correctly.
One of the biggest disadvantages of taking out a CMBS loan is that there is very little flexibility in negotiating the loan terms. The interests of the investors always come first, so borrowers have little say about the terms involved. And once the loan documents have been signed, there are even fewer opportunities to make changes.
How To Take Out A CMBS Loan
CMBS loans are offered by conduit lenders as well as many banks. Let’s walk through the process of taking out a CMBS loan.
Meet CMBS Loan Requirements
To qualify for a CMBS loan, most lenders require that you have a net worth equal to at least 25% of the total loan amount. And at least 5% of the total loan amount must be available in liquid assets.
Decide On The Loan Term
The terms on a CMBS loan are typically available in 5, 7 or 10 years with an amortization of 25 – 30 years. Since the terms don’t match the amortization schedule, the loan balloons at the end of the term. At that point, the remaining amount must either be paid in full or refinanced.
Work With A Master Servicer
One important thing to understand about CMBS loans is that once you’ve gone through closing, you won’t be dealing with your initial lender any longer. Instead, you’ll begin working with a master servicer.
A master servicer is a company that specializes in administering conduit loans. The master servicer will collect your payments, inspect the property and take care of other administrative tasks related to the loan.
Because the loan is sold off and pooled with a group of other loans, some borrowers find it challenging to contact their servicer. This can become a problem if you run into financial hardship and struggle to make your monthly payments.
If you default on your loan, you’ll work with a special servicer who will be responsible for adjusting the terms of the loan. It’s important to understand that this servicer is going to work to find a solution that benefits the investors, not the borrower.
The Bottom Line
A CMBS loan is a bond that’s made up of a group of underlying commercial mortgages. These bonds pay investors a return based on the principal and interest payments made by borrowers.
If you’re considering investing in commercial real estate, then a CMBS loan could be a good option for you. But just like any other type of financing, you should make sure that you consider all of your options first.
For many people, CMBS loans may not offer the most favorable terms and rates. And even if you do find favorable rates, the servicer will ultimately structure the loan in a way that benefits the investors.
While Rocket Mortgage doesn’t offer CMBS loans, we do provide mortgage options that could help you finance a residential investment property. If you’re thinking about buying an investment property, start the mortgage process today.