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Commercial Mortgage-Backed Securities (CMBS)

Step-by-Step Guide to Understanding Commercial Mortgage-Backed Securities (CMBS Loans)

Last Updated February 20, 2024

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Commercial Mortgage-Backed Securities (CMBS)

How Does CMBS Work?

CMBS loans are fixed-rate bonds collateralized by a portfolio of commercial mortgages across a range of commercial properties.

CMBS stands for “Commercial Mortgage-Backed Securities”, and refers to a form of collateralized financing secured by a pool of commercial real estate mortgage loans.

CMBS loans are classified as asset-backed securities (ABS), since the financing is secured by a pool of commercial loans that serve as the pledged collateral.

The securitization and issuance of CMBS loans are designed to construct separate bonds based on the respective risk profile of each instrument.

The structure of commercial mortgage-backed securities – in which the CMBS loan is split into separate tranches on the basis of their credit risk – caters to a broader range of potential investors, given the wide-ranging appetite for risk and preferences on returns (i.e. capital preservation or yield-oriented).

A CMBS loan is secured by income-generating properties, most often commercial office buildings, shopping centers, industrial facilities, or hospitality properties, such as hotels or resorts.

The income generated by the underlying commercial properties is used to service the periodic interest expense obligations.

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What are CMBS Tranches?

The riskier, junior CMBS tranches offer the highest yields to investors, while the less risky senior tranches offer lower yields.

Each CMBS tranche in the loan structure provides a different risk-return profile, allowing the offering to appeal to a wider range of potential investors in the market.

  • Senior CMBS Tranches → Lower Yield and Less Risky (with a Higher Recovery Rate in Event of Default)
  • Junior CMBS Tranches → Higher Yield and More Risk (with a Lower Recovery Rate in Event of Default)

Since the collateralized debt issuance is split into different tranches, investors are presented with more optionality to participate in the financing based on their unique investment criteria, effectively expanding the scope of potential investors.

The junior tranches are prone to absorb the most losses in the event of default (and retrieve the lowest recovery rate), while the senior tranches are more likely to recoup their original contribution (and receive higher recovery rates).

Therefore, the most upside potential in yield must be offered to the junior tranches to compensate for the higher risk with a higher potential return (and vice versa for senior tranches).

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What is the CMBS Market?

CMBS loans are a common source of financing to fund the acquisitions of commercial real estate (CRE) properties, such as office buildings, shopping centers, hospitality properties (e.g. hotels), and industrial properties – or in other scenarios, to refinance or recapitalize existing properties.

CMBS loans are an integral part of the commercial real estate (CRE) market because the higher purchase prices of commercial properties often create the necessity to raise external capital.

Why? The reliance on leverage is an inherent part of commercial real estate (CRE) investing and is one of the core drivers of returns.

Since the equity contribution of CRE investors decreases from an increased reliance on leverage, there is then more discretionary capital on hand to expand their portfolios and allocate funds elsewhere, such as to improve existing investment properties via capital improvements (i.e. value-add strategies).

Therefore, a commercial property investment (CRE) meeting its minimum rate of return might not be viable in the absence of relatively cheap, readily available debt in the credit markets.

Combined with the fact that a lower initial equity investment on the date of acquisition coincides with a higher return, a CMBS loan is a favorable form of financing for commercial borrowers – not to mention, CMBS loans are a critical source of liquidity in the commercial real estate (CRE) market.

The size of the CMBS loans pertaining to the U.S. commercial real estate (CRE) market with scheduled maturities in 2023 and 2024 amount to an approximate combined value of $900 billion.

The considerable volume of loan maturities is untimely, given the increase in the cost of borrowing, reduction in property values, and the Fed’s interest rate hikes to mitigate the risk of inflation post-COVID – especially since CMBS loans account for more than one-third of the outstanding commercial loan balance.

The CMBS loan market is therefore expected to continue facing headwinds, with reduced refinancing reserved for only borrowers possessing strong credit profiles (and with a spike in defaults for those unable to refinance).

CMBS Delinquency Rates by Property (October 2023)

CMBS Delinquency Rates by Property in October 2023 (Source: Trepp Market Research)

2024 CMBS Loan Market Outlook (with Predictions)

The sentiment at present among commercial investors and lenders with 2024 on the horizon appears to be that the current upward trajectory in delinquencies and weak demand is likely to continue.

The CRE market has faced headwinds since the onset of the pandemic with minimal recovery in sight. The interest rate hikes by the Fed in 2023 certainly did no favors for CRE investors or lenders.

In October 2024, the delinquency rate in the CMBS market reached 4.63%, per research conducted by Trepp.

The all-time high delinquency percentage registered was 10.3% in July 2012, while the highest rate around the COVID-19 era was 10.3% in June 2020.

The commercial office segment, in particular, has underperformed and has been the area of most concern for investors, as delinquencies continue to outpace other segments in the market – nearly 5.6% in October 2023.

The credit impairments and monetary losses, however, are expected to be concentrated among the lower-rated CMBS tranches, while higher-rated tranches will fare better.

One notable trend has been commercial borrowers trying to extend their existing loans (i.e. “amend and extend”) rather than try to refinance at current rates.

CMBS Market Data by Segment October 2024

CMBS Loan Market Delinquency Rate Data by Property Type (Source: Trepp CMBS October 2023 Report)

What are the CMBS Loan Characteristics?

The standard characteristics of CMBS loans are described in the following table.

Characteristics Description
Minimum Loan Size
  • The minimum loan size for a CMBS loan is $2 million.
Maturity (Borrowing Term)
  • The standard maturities of CMBS loans range between five and ten years, with periodic monthly interest payments and principal amortization.
Amortization Schedule
  • The amortization schedule of most CMBS loans comprises partial amortization, followed by a lump sum at maturity (“balloon payment”).
  • CMBS loans are ordinarily amortized across 25 to 30 years with partial amortization.
Fixed-Rate Pricing
  • Most CMBS loans are priced at a fixed-rate rather than at a floating-rate. Therefore, the interest remains constant and does not fluctuate based on changes in the current economic conditions.
Borrowing Entity
  • In CMBS financing, a special purpose vehicle (SPV) is created solely for the intent to hold and manage the commercial properties.
  • The entity is independent from the borrower and is bankruptcy-remote, i.e. the borrower is not personally liable, so personal assets (non-collateral) are protected from creditors in the event of default.
Non-Recourse
  • CMBS loans are a form of non-recourse financing – therefore, if the borrower defaults on a loan, the lender is unable to recover their losses via obtaining the borrower’s personal assets.
  • Said differently, the borrower is not personally liable in the event of default, and only the pledged collateral (e.g. the property) can be seized in a foreclosure.
CMBS Loan Risk Profile
  • The CMBS tranches are organized based on their respective credit risk (and likelihood of default).
  • The senior tranches constitute lower risk and coincide with properties of stronger credit profiles.
  • The junior tranches are on the riskier side, and investors must absorb a higher percentage of the losses in the event of default.
Assumable
  • CMBS loans are assumable, meaning that if the borrower sells the commercial property, the existing loan (and terms) transfer to the new buyer.
  • The borrower might incur a minor fee from the conduit lender, who oversees and manages the “hand-off” transaction.

What are the CMBS Loan Requirements?

The standard underwriting parameters established by commercial lenders for borrowers to obtain a CMBS loan are as follows:

  • Maximum 75% (or 80%) Loan to Value Ratio (LTV)
  • Minimum 1.25x Debt Service Coverage Ratio (DCSR)  DSCR
  • Minimum 8.5% to 10.0% Debt Yield (DY)
  • Minimum Net Worth Requirement of 25.0% of the Loan
  • Post-Closing Liquidity of 5.0% of Loan

The loan to value ratio (LTV) and debt service coverage ratio (DSCR) are particularly important to commercial lenders.

The loan to value (LTV) ratio compares the size of a loan to the property value at present, expressed as a percentage. The proportion of the requested loan relative to the current market value of the commercial property provides insights to determine the right size of the loan, where the credit risk is manageable.

The formula to calculate the loan to value (LTV) ratio consists of dividing the requested loan amount by the current market value of the commercial property.

Loan to Value (LTV) Ratio = Loan Amount ÷ Property Value

The other credit metric, the debt service coverage ratio (DSCR), compares the net operating income (NOI) of a commercial property to its annual debt service obligation.

The DSCR measures the estimated capacity of a commercial property to generate enough income to cover its annual debt service, inclusive of interest obligations and principal amortization.

The formula to calculate the debt service coverage ratio (DSCR) consists of dividing the commercial property’s net operating income (NOI) by its annual debt service.

Debt Service Coverage Ratio (DSCR) = Net Operating Income (NOI) ÷ Annual Debt Service

What is the CMBS Loan Origination Process?

The origination process of commercial mortgage-backed securities (CMBS) is conducted by a financial institution – termed the “conduit lender” – such as a full-service investment bank with a commercial lending function and capital market divisions (ECM and DCM).

The centerpiece of the origination process of CMBS loans, particularly in the underwriting stage, is the commercial properties, rather than the borrower.

The process of issuing a commercial mortgage-backed security (CMBS) loan consists of the following steps:

Origination Process Description
Step 1. CMBS Loan Application
  • The borrower submits an application to the conduit lender to request a CMBS loan.
  • The loan proposal contains the requested financing amount among other information and documentation of relevance to the lender, including the context of the request for funding, leases on commercial properties, independent property appraisal reports, and historical performance data.
Step 2. CMBS Pre-Approval Underwriting
  • The financial institution (or conduit lender) analyzes the commercial loan application submitted by the borrower to determine if the request for financing meets their lending criteria.
  • The risk underwriting process is the most time-consuming stage, as the lender must mitigate risk and verify the loans are secured by quality assets.
  • The factors reviewed in the due diligence phase include the property types, classifications, locations, and income potential (i.e. historical and projected cash flows of the properties to estimate debt capacity) to size the loan appropriately based on the creditworthiness of the borrower.
Step 3. CMBS Post-Approval Underwriting
  • If the transaction is of interest, the underwriters analyze the credit risk connected to the financing (and the risk of default) to set the terms of the lending agreement, such as the interest rate(s).
Step 4. CMBS Origination (Marketing)
  • Once the terms are negotiated and agreed upon by both parties – the lender and borrower – the origination team starts to market the loan (or more specifically, the components) to potential institutional investors in pitch meetings.
Step 5. CMBS Loan Issuance (Distribution)
  • If enough loans have been originated, a special purpose vehicle (SPV) – formally termed a real estate mortgage investment conduit (REMIC) – is formed to hold the securitized commercial mortgage loans and facilitate the issuance of the bonds.
  • The REMIC is treated as a bankruptcy-remote entity, segmented into distinct tranches based on the risk profile of each.
Step 6. CMBS Post-Issuance Borrowing Term
  • The interest payments distributed to the bondholders stem from the income generated by the commercial properties securing the loan over the borrowing term stated in the lending agreement.
  • Therefore, the income generated by the commercial properties securing the CMBS financing collectively serviced the pooled commercial mortgages, which were securitized into separate bonds sold to investors.
  • The interest is paid by the income generated by the properties, and collected by a loan servicer – an intermediary between the borrowers and the bondholders – designated with the role of distributing income to bondholders as interest.

Who are the Lenders in the CMBS Loan Market?

So, who are the active participants in the CMBS market?

  • CMBS Market Originators → CMBS loans are offered by financial institutions – termed conduit lenders – such as full-service investment banks with a lending function and capital market divisions, traditional commercial banks, and non-bank alternative lenders.
  • CMBS Market Borrowers → The borrowers who request CMBS loans are predominately real estate investment firms, including real estate private equity (REPE) firms and property developers.
  • CMBS Market Investors → Once the tranches of the CMBS loan are established, the bonds are sold to institutional investors, such as pension funds, insurance companies, and hedge funds (e.g. credit or debt funds), and real estate investment trusts (REITs).

Contrary to a common misconception, banks are not the only lenders in the CMBS market, as illustrated by the below graph on lender composition by CBRE in Q2-2023.

CRE Lender Composition – CMBS Loans

Q2 2023 Lender Composition (Source: CBRE)

What are the Pros and Cons of CMBS Loans?

Commercial mortgage-backed securities (CMBS) offer investors several distinct advantages.

Advantages Description
Portfolio Diversification
  • Commercial mortgage-backed securities (CMBS) offer investors the opportunity to gain exposure to rental income from a diverse portfolio of commercial properties while benefiting from credit protection through the securitization process.
  • The pooling of multiple commercial mortgages “spreads” the risk attributable to a single property across the entire portfolio, reducing the impact of individual property defaults (or other unanticipated, negative events).
Higher Loan to Value Ratio (LTV)
  • The percentage of leverage is relatively high, with a 75% LTV ratio representing the standard for most commercial properties (and can even reach 80%+ in certain cases).
Convenience Factor
  • By participating in a CMBS issuance, the investor obtains exposure to commercial real estate (CRE) – an asset class that has historically exhibited a lower correlation with the broader market – without the need for direct, “hand-on” property management.
Collateral Protection
  • CMBS loans distribute rental income from a diversified pool of commercial real estate loans.
  • The underlying properties serve as collateral for downside protection, where in the event of default, the proceeds of the properties post-liquidation can be sufficient for full recoveries for the senior tranches.
  • However, the security afforded to senior tranches comes at the expense of the junior tranches, which absorb most of the shortfall.
Flexibility in Risk-Return
  • Since investors can select the tranche that best suits their interest in a CMBS loan, the potential to realize a return that meets (or exceeds) their minimum required rate of return tends to be greater.
  • In other words, the tranches of a CMBS cater to each specific investor’s unique investment style and appetite for risk.

On the other hand, there are several drawbacks to the commercial mortgage-backed securities (CMBS) market that investors (and borrowers) must be informed of.

Disadvantages Description
Credit Risk
  • Like all debt and interest-bearing securities, CMBS loans are subject to credit risk.
  • The issuer can default on its interest obligations or mandatory principal payments – albeit the risk is disproportionately concentrated on the riskier tranches.
Prepayment Risk
  • CMBS are also subject to prepayment risk, which refers to the occurrence where borrowers decide to repay their loans earlier than originally expected.
  • In effect, the bondholders miss out on interest payments post-repayment, reducing their yield.
  • However, the lending agreement can contain provisions to prohibit prepayment or conditional “triggers” for fees to offset some of the risk.
Prepayment Penalties
  • The CMBS lending agreement can contain lock-out periods that prohibit borrowers from early repayments until a set date has passed, or conditional penalties to offset the missed interest payments (and reinvestment risk) to discourage borrowers.
Yield Maintenance
  • The yield maintenance is a form of prepayment penalty where the lender is paid a premium, or percent-based fee, set to be an equivalent value to the interest owed on the bond across the remaining term until maturity.
Defeasance Clause
  • The defeasance clause is yet another prepayment penalty, in which the borrower must pay down the outstanding loan balance using interest-bearing securities with comparable yield, such as government bonds or investment-grade corporate bonds.
Borrower 3rd-Party Fees
  • CMBS loans incur more fees for the borrowers, namely legal fees, compared to other forms of financing in the commercial real estate (CRE) market.

CMBS vs. RMBS: What is the Difference?

In real estate lending, mortgage-backed securities (MBS) are structured finance product offerings, where the issuance is secured by a pool of residential or commercial mortgage loans.

  • Commercial Mortgage-Backed Securities (CMBS) → The asset-backed debt security is secured by commercial loans, rather than residential loans. Since commercial loans are secured by properties such as office buildings and industrial facilities, the credit risk (and the chance of default) tends to be lower, with less fluctuations in market pricing compared to that of residential properties.
  • Residential Mortgage-Backed Securities (RMBS) → Mortgage-backed debt securities (RMBS) are secured by residential mortgages, i.e. homes. While both mortgage-backed securities (MBS) are structured products split up into different tranches based on risk, there is less variety in property types for the assets that are securing RMBS loans, and the residential market tends to be more sensitive to fluctuations in economic conditions.

The structure of CMBS loans and RMBS loans carries more similarities than differences. However, one notable distinction is the principal amortization schedule.

  • Partially Amortized Loan → For most CMBS loans, the repayment of the original loan principal is on a partial amortization schedule. Over the lending term, a portion of the principal is repaid, followed by a lump sum payment (or “balloon payment”) at maturity to retire the loan.
  • Fully Amortized Loan → In contrast, RMBS loans are often structured as fully amortized loans (“self-amortizing”). The principal is paid off in full at maturity. The interest paid on RMBS loans declines in tandem with the reduced principal over the borrowing term. However, residential loans are paid over longer maturities (15 to 30 years), while commercial loans are usually shorter-term arrangements (5 to 10 years).
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