CMBS LOANS
Many borrowers are unaware of CMBS loans and many who are aware of CMBS loans do not really understand them, how they work, or when it is an appropriate option.
In short, a CMBS is a fixed-income investment product backed by commercial real estate. CMBS is an acronym for "Commercial Mortgage-Backed Securities." CMBS can provide liquidity for both bond investors and investment property owners. CMBS loans are often used for very large projects in the hundreds of millions or even billions of dollars. CMBS-based loans are also available in amounts starting at $1-$2 million, as well.
A CMBS bond can be difficult to value, as it may contain a large number of underlying commercial mortgages of varying durations and returns. It may also be backed by numerous types of securities from multifamily to industrial to hotels to retail. CMBS does protect bond investors from prepayment risk, as most CMBS loans have fixed terms. This means that if the loan is scheduled for ten years, it will go ten years.
While you may be unfamiliar with CMBS loans, it may surprise you to learn that CMBS loans account for about two percent (2%) of all fixed-income investments in the US.
CMBS loans are quite versatile in that they are available in three different tranches:
- Senior tranche: Generally first mortgages backed by real estate and considered to be low-risk investments. Investor returns are lowest at this level.
- Mezzanine tranche: A little bit riskier than the senior tranche loans, as these loans often ride in the 65% to 80% LTV window, whereas the senior tranche loans would be from 0% to 65% LTV. Senior tranche loans have first priority for payment in the event of a default, so the mezzanine tranche loans are a bit riskier, but offset that with a higher rate of return for investors based on a higher interest rate for borrowers.
- Equity tranche: Offering the best potential gains, the equity tranche also provides the most risk exposure for investors, as all senior and mezzanine tranche investors have priority in the event of default.
CMBS loans have several components that combine to set the risk/reward combination for investors:
Interest rates: are generally fixed rates at a spread above the Treasury interest rate. CMBS loans sometimes will have promotional terms on the front-end of the contract, which may result in lower payments at the beginning of the loan term.
Term length: Most CMBS loans run five or ten years. Often, the ten-year loan will have a lower interest rate than the five-year loan, due to the long lock-in period. Amortization may be for 20, 25, or 30 years, so a balloon payment will be due at the end of the loan term.
Prepayment penalties: The prepayment terms on a CMBS loan can be quite severe, depending on the structure of the loan. Be sure that you understand these terms before proceeding with one of these loans. The potential penalties may be a huge factor in a borrower's decision process on whether to take a CMBS loan, especially if the borrower does not know if they will hold the asset for the long haul.
One great feature of CMBS loans is that they are non-recourse, which means that the funder is limited to recovery of the security only. In other words, repossession of the asset is the only recovery available to the investor, so the borrower has limited liability in case of default.
One of the great drawbacks of CMBS loans is that many require defeasance, which means that if the borrower pays-off early, they must replace the lost interest and collateral with similar securities. If your CMBS loan has a defeasance clause, discuss the terms with a knowledgeable real estate attorney before signing your acceptance.