How Do Commercial Mortgage-Backed Securities Work?
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A commercial mortgage-backed security (CMBS) is a type of fixed-investment product that is backed by commercial property mortgages as opposed to residential property mortgages. Banks issue CMBS when they sell the debt from commercial mortgages in the form of bonds.
The structure of CMBS is similar to mutual funds. The security is a pool of mortgage debt that is combined into a single product that generates periodic returns. CMBS, as an investment product, are capable of generating high returns but carry risks inherent to the real estate market.
There is no standardization for CMBS, so they can consist of a diverse range of property types, valuations, and loan terms. Since mortgage rates of commercial loans are usually fixed, they typically generate less risk of prepayment than residential mortgage-backed securities.
How Do Commercial Mortgage-Backed Securities Work?
The basics of CMBS are the same as other types of securitization. When people buy commercial properties, they take out commercial loans from a bank. Banks will then combine debt from these loans into securities and sell them as bonds. Investors who buy the bonds then make money from interest payments on the original mortgages.
When a bank makes a commercial loan, they have less available capital, meaning that borrowing money is more expensive. Selling mortgage debt in the form of CMBS provides a steady flow of capital for other projects and lets banks lower interest rates on loans. In some cases, well-run CMBS can generate less risk than US Treasury bonds.
CMBS contain debt from loans on various types of commercial properties, such as factories, retail stores, office parks, hotels, and much more. In the event of loan defaults, the investors can claim the underlying properties as collateral.
Types of Commercial Mortgage-Backed Securities
Banks divide CMBS into tranches depending on the risk levels of the underlying assets. Higher-quality tranches are less risky but safer investments, while lower-quality tranches have high interest rates but riskier underlying assets.
Tranches from lowest to highest quality are as follows:
- Equity tranche. These are the lowest-quality securities and offer potentially high returns but also offer the most risk.
- Mezzanine tranche. Mezzanine CMBS have higher yields and more risk than higher-quality tranches.
- Senior tranche. The senior tranche level contains the highest-quality CMBS with the most stable rates and lowest risks.
If borrowers default on their loans, investors are paid in order of priority from the senior level down to the equity level. Depending on the interest rates and principal payments, it’s possible that investors with lower-quality CMBS won’t receive funds after default.
Commercial vs. Residential Mortgage-Backed Securities
Residential mortgage-backed securities (RMBS) are different from CMBS in that the underlying loans in RMBS are for residential properties, such as condos, single-family homes, or multi-family homes.
The differences in underlying securities give the two investment products different features:
- Terms on residential loans have 15 to 30-year terms. Commercial loans can have 2, 3, 5, 7, or 10-year terms.
- Payments on commercial loans usually go mostly to interest with little to the principal. In contrast, payments on residential mortgages go towards interest first and more towards the principal later.
- Unlike residential loans, most borrowers never pay off the full amount of commercial loans by the end of the term. As such, many commercial borrowers end up refinancing their loans.
- RMBS carry prepayment risk if the borrower pays off the loan before the term ends, which can affect future cash flow. CMBS carry little to no prepayment risk.
RMBS usually have lower risk because it is less likely that many residential borrowers will default on their loan at the same time. However, this is still possible, such as during the 2008 market crash.
CMBS Historical and Current Performance
CMBS first arose in the 90s as a response to reduced commercial loan activity from banks due to the S&L crisis. CMBS issuance was extremely active throughout the late 90s and early 2000s. However, the 2008 recession and the collapse of the real estate market were followed by a steep decline in CMBS issuance.
Despite gains over the resulting decade, CMBS issuance has fallen again after three years of subdued activity from the pandemic. CMBS issuance plunged nearly 85% at the beginning of 2023. Federal interest rate hikes have made it more difficult to issue loans and purchase properties.
Pros and Cons of CMBS
Like all kinds of securities, CMBS have pros and cons. Whether CMBS investments are right for you depends on your risk tolerance and investment goals.
Pros
The advantages of CMBS have to do with their flexible structure and potential yields.
#1 – Higher Yields
Generally speaking, CMBS have higher yields than their residential alternative, as commercial lenders usually pay higher interest rates and pay less into the principal.
#2 – Fixed Returns
Commercial loans have fixed returns and a set payment schedule, so CMBS investors are less likely to lose money from early repayments.
#3 – Fewer Restrictions on Loan Structure
Commercial loans have fewer lender restrictions than residential loans, so the underlying assets of CMBS can consist of several different types of loans, terms, and interest rates, giving them broader potential coverage.
Cons
Most of the disadvantages of CMBS pertain to their higher risks and default rates
#1 – Sensitive to Commercial Real Estate Market
CMBS are extremely sensitive to real estate market conditions and can quickly lose value if there is a real estate crisis. The 2008 recession was caused in part by mass loan defaults that tanked the values of CMBS.
#2 – Depend on Banks for Ratings
CMBS receive individual ratings from the banks and institutions that issue them, so you need to be sure the issuer is a reliable and reputable institution. Unfortunately, banks and financial institutions have been caught misrepresenting the quality of CMBS in the past.
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