People in the business of buying and selling commercial real estate are likely familiar with Commercial Mortgage-Backed Security (CMBS) loans. CMBS is a type of fixed-income security loan that uses commercial real estate as collateral.
These loans are typically for commercial properties, such as hotels, offices, apartment buildings, malls, and factories. This type of loan offers many advantages for both borrowers and investors. As a borrower, you could get low fixed-rate terms and gain access to high-leverage financing that you may be difficult to find on other types of loans.
But how do Commercial Mortgage-Backed Security (CMBS) loans work? This article will guide everything you need to know about this type of loan, such as how it works, different from traditional commercial loans, and the advantages and disadvantages of choosing this type of financing.
What are Commercial Mortgage-Backed Securities (CMBS)?
Commercial Mortgage-Backed Security loans, also known as conduit loans, are often used to buy commercial real estate properties such as hotels, apartment and office buildings, malls, factories, etc.
The CMBS market is sometimes mistaken as residential mortgage-backed securities, but they are very different. Residential mortgages back home mortgage-backed, often single-family homes, while a CMBS is backed by income-generating commercial real estate property.
Banks create commercial mortgage-backed securities by bundling commercial real estate loans and selling them to investors as a series of bonds. They typically organize each series of loans into tranches, also known as segments. The bonds are ranked from the highest-rated and lowest-risk (senior issue) to the lowest-rated and highest-risk (junior point).
Investors choose which issue they would invest in based on their desired yield and capacity for risk. The senior issues are the highest-rated tranches and have the least chance, so these loans would be the first ones to be paid in full. The junior issues are low-rated tranches and come with higher credit risk, so these sets of bonds would be the first ones to absorb any losses when a borrower fails to pay.
This process of banks bundling CMBS loans and selling them to investors as bonds are known as securitization. Most mortgage lenders execute at least three and up to eight securitizations annually, depending on the lender’s size and the issued loans.
How do Commercial Mortgage-Backed Security loans work?
An investor in real estate or a business owner who is about to close on a commercial piece of the property asks a bank to fund the purchase, and then they will receive a mortgage. The bank pools that mortgage with other mortgages turns them into bonds, and sells them to investors.
The loans are bundled based on the loan terms, amount, and property type. The lenders also rate the bonds based on the average loan amount, debt-to-income ratio, and how many loans are in the bundle.
After the bonds have been rated, they are sold to investors based on their rating. Once the CMBS loan is sold, the original lender is repaid. This gives the bank more capital to continue issuing loans to new borrowers.
As a whole, the securitization process of the loans benefits the borrowers, investors, and lenders involved. This process makes it possible for borrowers to get early access to commercial properties. For investors, this process provides a higher-yielding investment alternative compared to government bonds. And as for lenders, this process enables them to issue more loans.
The Advantages of Commercial Mortgage-Backed Security Loans
- CMBS loans have fixed interest rates
These loans tend to come with better interest rates than what you will get with a traditional commercial loan. CMBS loans typically come with fixed interest rates, which means the rates would not increase throughout the loan term. Over the years, the rates of CMBS loans have been hovering in the 4-5% range, though in certain market conditions, they have gone as low as 3%.
These types of loans tend to be a better choice 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.
Business owners can also use a commercial mortgage to purchase a business property either for their business use, rent out, buy a company, or unlocking the equity within already owned buildings. This method has become a more flexible way of financing your property purchase as long as you have tangible assets to secure.
- CMBS loans come with relatively high leverage
CMBS loans offer relatively high leverage financing, at up to 75% for most property types, and can even reach 80% in some cases.
- CMBS loans are very accessible
These loans are available to many borrowers, including those that might be excluded from traditional lenders due to poor credit, previous bankruptcies, or strict collateral/net worth requirements. If you have been trying to figure out how to buy a house with bad credit, applying for a CMBS loan may be a good choice.
- CMBS loans are considered Non-Recourse Loans
CMBS loans are considered non-recourse, which means that even if a borrower fails to pay their loan, the lender could not pursue legal action or go after their personal property to repay the debt. But borrowers need to be aware that the loan contract can have fine prints that outline specific conditions under which the loan would become full recourse.
One example is that for most loan terms, there could be a condition that states that if a borrower commits fraud or misrepresents their financial situation during the application process, the loan becomes full recourse.
The lender can also pursue legal action if the borrower has purposely damaged the property.
- CMBS loans are assumable
CMBS loans are also assumable, though a small fee may be asked. If you decide to sell the commercial property and find another borrower willing to take on the loan, you can pass the loan to them. This makes it easier for a borrower to exit the property before the end of their loan term.
The Disadvantages of Commercial Mortgage-Backed Security Loans
- CMBS loans have prepayment penalties
The major disadvantage of CMBS loans is the difficulty of getting out of the loan early. Most, if not all, CMBS loans have 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 profit they would have gotten had the loan been paid off in the agreed time frame.
There are two types of prepayment penalties that are set up with CMBS loans, a.) Yield Maintenance; and b.) Defeasance.
In the yield maintenance penalty, the borrower must pay a fee from 1% to 3% of the entire loan amount. However, in defeasance, the borrower must purchase alternative securities or bonds to repay their loan and provide the lender/investors with a suitable source of income to replace it. Defeasance could get expensive, specifically if the lender/investors require that the borrower replace their loan with U.S. Treasury bonds.
- CMBS loans have financing restrictions
Another disadvantage of CMBS loans is that there is very little flexibility in loan terms negotiations. The loan terms prioritize the interests of the investors first, so borrowers have very little to say about the terms involved. And usually, once the loan documents have been signed, there are even fewer chances to make changes.
How to get a Commercial Mortgage-Backed Security Loan?
Many conduit lenders and banks offer CMBS loans. To qualify for this type of loan, most lenders require that borrowers have a net worth equal to 25% of the total loan amount. And at least 5% of the total loan amount must be available in liquid assets.
The length of payment on a CMBS loan is usually available in 5, 7, or 10 years with an amortization of 25 – 30 years. Since the terms do not match the amortization schedule, the loan balloons at the end of the period, during that time, the remaining balance must be either paid in full or refinanced.
Conclusion
A Commercial Mortgage-Backed Security loan is one way of investing in real estate. It is a form of security that is based on a portfolio of a bundle of commercial mortgages. It pays a rate of return based on the principal and interest payments made by the borrowers in the portfolio.
If you consider investing in commercial real estate, then a CMBS loan could be a good choice for you. But just like any other financial decision, you should feel all possible options and carefully plan your actions.
For More Information, Contact:
John (Adam) Watson, CEO, CanCap Mortgage Group Inc.
Email: adam@cancap.one Tel: 416-452-5281