Commercial Mortgage-Backed Securities (CMBS): Definition & Overview

KEY TAKEAWAYS

• Commercial mortgage-backed securities (CMBS) are secured by a mortgage taken out on a commercial property, rather than traditional residential real estate. 
• The loans taken out on any CMBS are often used as collateral, which includes interest and principal that’s passed to investors if default happens. 
• Usually, CMBS comes in the form of bonds, with the underlying loans becoming contained in created trusts.

What Are Commercial Mortgage-Backed Securities (CMBS)?

Commercial mortgage-backed securities (CMBS) are a type of fixed-income investment product. They are used as backing for commercial properties instead of traditional real estate. Implementing the use of CMBS provides new liquidity options for both commercial lenders and real estate investors to explore. 

Determining evaluations of CMBS can often be a difficult task to undertake since there aren’t any standardized rules for their structuring. Many commercial mortgages that have varying term lengths are common underlying securities that are part of CMBS. They’ll have a range of values, terms, and specific property types. 

For example, both commercial real estate and multi-family dwellings can see CMBS. As well, there is less risk when it comes to pre-payment compared to more traditional residential mortgage-backed securities (RMBS). This is because commercial mortgage terms are often fixed. 

How Commercial Mortgage-Backed Securities Work

Commercial mortgage-backed securities (CMBS) come in the form of bonds. This works similarly to collateralized mortgage obligations (CMO) as well as collateralized debt obligations (CDO). A single commercial mortgage-backed security consists of loans that end up providing collateral should there be an event of default. 

If this happens, interest and principal amounts are then extended to investors. The loans that are often taken out are usually included within a trust. Within this, the terms, amounts, and specific property types are highly diversified.

There can be a range of underlying loans securitized into CMBS. They can often be included within the same trust, and can include:

• Office buildings 
• Office parks 
• Shopping malls
• Factories
• Hotels
• Buildings and complexes 

Typically, mortgage loans are considered to be non-recourse debt. This means that the commercial or consumer debt only gets secured by collateral. So, if a person or company defaults on the loan, the lender isn’t able to seize assets that go beyond the amount of initial collateral. 

There is a wide range of market participants within CMBS since they are complex investment vehicles. Some of the most common participants include:

• Primary services 
• Investors 
• Master servicers 
• Directing certificate holder 
• Special services 
• Rating agencies 
• Trustees 

Each of these participants plays their own important and specific role in the process of CMBS to ensure it performs properly. 

Types of CMBS

Mortgages backed by CMBS get classified into a few different tranches. This is based on the overall levels of credit risk that can be associated, and are often ranked from the highest quality to the lowest quality. 

Tranches that are of the highest quality are going to have the lowest associated risk as well as receive both principal and interest payments. The tranches that are of the lowest quality are going to have higher interest rates. However, when there is more risk for a tranche it will absorb most of the loss that could come from its lowering in rank. 

Senior mortgage bonds are considered to be the higher ranking CMBS tranches, whereas junior mortgage bonds are considered to be the lower ranking CMBS tranches. 

Within the structure of a CMBS, the lowest level tranches are often the riskiest loans that can be part of a portfolio. This is why, for both banks and investors, the securitization process that’s undertaken to design a CMBS structure is so important. 

Essentially, it’s able to allow a bank to issue more loans and provides investors with easier access to commercial real estate. As well, investors will often see a higher yield compared to a traditional government bond, for example. 

But with all of that said, there are still a few important distinctions that every investor should recognize when it comes to CMBS. In the case of default on one or more loans, the highest tranches will need to be paid off fully. This includes interest and it happens before any lower tranches can see funds. 

Requirements for CMBS

There are a few requirements that should be understood for CMBS. In 2016, there were new regulations introduced by the Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA). 

The regulations were created to help mitigate certain risks that can come from CMBS. To help, margin requirements were created for covered agency transactions. Which also includes collateralized mortgage obligations. 

Pros and Cons of CMBS 

As there is with any type of loan or financing, CMBS can come with a range of pros and cons to be aware of. Let’s take a closer look at a few.

Pros of CMBS

• Underwriting standards — Compared to traditional mortgage-backed securities (MBS), commercial mortgage-backed securities will have more careful and accurate underwriting standards.
• Fixed-term loans — Usually, loans used to back CMBS are fixed term. This means that the borrower isn’t able to repay them early without some type of penalty. Ultimately, there becomes a lower prepayment risk compared to residential mortgage-backed securities. 
• Higher returns — It can be common for a CMBS to have higher returns compared to government or corporate bonds in the bond market. 

Cons of CMBS

• Ratings can change — CMBS ratings will often depend on the integrity and honesty of the bank that issued the loan. This can lead investors to speculate and can contribute to a greater level of potential risk. 
• Risk of default — Similar to corporate bonds, CMBS offers a level of default risk. If the borrower doesn’t make their interest and principal payments, it can lead to a loss for investors. 
• Effect of the real estate market — CMBS issued when underwriting standards are lower or at a market peak can pose higher risks. The real estate market can also negatively impact the effect of the CMBS since it will respond to any changes. 

Summary 

Commercial mortgage-backed securities come in the form of bonds and they’re secured by mortgages taken out on commercial properties. This differs significantly compared to traditional real estate and the underlying loans are often contained within trusts. 

The loans that are part of CMBS end up acting as collateral in the event of default, and they include any interest and principal payments being passed to investors.