Commercial Mortgage-Backed Securities (CMBS) Definition

Commercial Mortgage-Backed Securities

Commercial mortgage-backed securities (CMBS) are fixed-income investment products that are backed by mortgages on commercial properties rather than residential real estate. CMBS can provide liquidity to real estate investors and commercial lenders alike.

Because there are no rules for standardizing the structures of CMBS, their valuations can be difficult. The underlying securities of CMBS may include a number of commercial mortgages of varying terms, values, and property types—such as multi-family dwellings and commercial real estate.

CMBS can offer less of a pre-payment risk than residential mortgage-backed securities (RMBS), as the term on commercial mortgages is generally fixed.

How Commercial Mortgage-Backed Securities Work

As with collateralized debt obligations (CDO) and collateralized mortgage obligations (CMO) CMBS are in the form of bonds. The mortgage loans that form a single commercial mortgage-backed security act as the collateral in the event of default, with principal and interest passed on to investors.

The loans are typically contained within a trust, and they are highly diversified in their terms, property types, and amounts. The underlying loans that are securitized into CMBS include loans for properties such as apartment buildings and complexes, factories, hotels, office buildings, office parks, and shopping malls, often within the same trust.

A mortgage loan is typically non-recourse debt—any consumer or commercial debt that is secured only by collateral. In case of default, the lender may not seize any assets of the borrower beyond the collateral.

Because CMBS are complex investment vehicles, they require a wide range of market participants—including investors, a primary servicer, a master servicer, a special servicer, a directing certificate holder, trustees, and rating agencies. Each of these players performs a specific role to ensure that CMBS performs properly.

The CMBS market accounts for approximately 2% of the total U.S. fixed-income market.

Types of CMBS

The mortgages that back CMBS are classified into tranches according to their levels of credit risk, which typically are ranked from senior—or highest quality—to lower quality.

The highest quality tranches will receive both interest and principal payments and have the lowest associated risk. Lower tranches offer higher interest rates, but the tranches that take on more risk also absorb most of the potential loss that can occur as the tranches go down in rank.

The lowest tranche in a CMBS structure will contain the riskiest—and possibly speculative—loans in the portfolio.

The securitization process that’s involved in designing a CMBS’s structure is important for both banks and investors. It allows banks to issue more loans in total, and it gives investors easy access to commercial real estate while giving them more yield than traditional government bonds.

Investors should understand, however, that in the case of a default on one or more loans in a CMBS, the highest tranches must be fully paid off, with interest, before the lower tranches will receive any funds.

CMBS Loans

CMBS Loans

Anyone advocating for a commercial real estate borrower — especially mortgage brokers and lenders who influence the front end of a loan scenario — should be aware of some common misconceptions about cash management for loans underpinned by commercial mortgage-backed securities (CMBS).

About 70 percent of all CMBS loans originated-ed today have some sort of cash-management system, or lockbox, that allows a lender to capture a property’s cash flow. Understanding “springing” lockboxes, which are especially common, can help borrowers avoid deals that start well but wind up going bad.

There are three types of cash-management systems for CMBS loans. They include hard lockboxes, which do not allow the borrower to have control over the property’s cash flow; soft lockboxes, which allow some control of cash flow; and springing lockboxes, which are triggered when certain situations occur.

The general premise of springing cash management is that it gives lenders the power to capture cash flow in the event of declining property performance. Mortgage brokers and borrowers may agree with this premise and understand its intent when they sign a deal with springing cash-management provisions, but it’s important to remember the devil is in the details.

Income restrictions

Some borrowers think they won’t need to worry about cash management springing on their loan if the property is performing well and the debt-service coverage ratio (DSCR) is above the threshold spelled out in the loan agreement.

Typical CMBS loan agreements, however, include many definitions within definitions that give the servicer the right to calculate DSCR, and the servicer’s calculation is “final absent a manifest error.” These words actually appear in many loan agreements and the definitions are very important as they state what should be included in both the income and expense components of the DSCR calculation. With interest-only loans, the debt service used in the DSCR calculation often assumes the loan is of the 30-year amortizing variety, making the monthly payments in the formula much higher than interest-only payments.

Mortgage brokers and their clients should know about income that may be excluded from the DSCR calculation in the typical CMBS loan agreement.

The bottom line is there are many well-performing properties today with DSCRs of 1.5 and higher that are being placed into cash-management plans. This is because the servicer has performed its own calculation based on the specific details of the loan agreement and is excluding certain income line items, adding other expenses and using an amortizing payment plan (even for interest-only loans). The servicer’s DSCR is often much lower than the actual ratio. Again, however, the servicer’s numbers are final, absent an obvious error. Just because the actual DSCR is above the documented threshold for springing cash management, it doesn’t mean the servicer’s calculation won’t be below the threshold.

Occupancy and rental rates

A second misconception is that a borrower won’t need to worry about cash management when his or her property is outperforming market expectations because of higher occupancy rates or higher rental rates.

“Underwritten operating income” is a term often included in the details of the servicer’s DSCR calculations. This stipulation allows the servicer to adjust rental rates, occupancy rates and other factors to the lower of (a) actual, (b) market, or (c) underwritten rates. So, in cases where the borrower has negotiated higher-than-market rental rates or has an occupancy rate above the market average, they will not get credit for that when the servicer calculates their DSCR as it relates to cash management.

This can really sting a borrower, for example, if the loan was originated with an underwritten occupancy rate of 80 percent, but the current occupancy is 90 percent. If the loan agreement defines the occupancy rate as the lower of actual, market or underwritten rates, then the income will always be calculated assuming 80 percent occupancy — or lower, if market-rate occupancy is below that — regardless of the actual occupancy rate of 90 percent.

Once again, just because the actual DSCR is above the documented threshold for springing cash management, it doesn’t mean the servicer’s DSCR calculation won’t be below the threshold and cause the lockbox to be sprung. Income will be adjusted downward to the lowest allowable number in the loan documents.

Loan assumptions

Many buyers entering into an assumption of an existing loan believe they will receive the same terms as the previous borrower. This is partially true — but not entirely — and this one issue causes many lawsuits between buyers and sellers when the conditions for approval contain what the buyer believes are deal changes.

Without a modification, there are loan-assumption terms that cannot change, such as the interest rate and maturity date. There are other requirements that are wide open to change, however.

Reserves. Servicers can add reserve requirements that aren’t in the current loan documents, and they can increase the amount of reserves as much as they feel warranted. Often, any caps in place on the reserves are removed at the time of assumption.

Additional collateral. This can be in the form of a cash reserve, a letter of credit or a personal guarantee. The point is that the servicer can request additional collateral from the assuming borrower for any number of reasons — or no perceived reason at all.

Cash management. If the loan includes springing cash management, you can bet that it will be sprung at the time of assumption, regardless of the property’s performance. In today’s marketplace, this is a common condition for loan-assumption approvals.

Don’t be fooled into thinking a buyer can request changes to the loan documents at the time of assumption. A servicer is unlikely to entertain changes requested by the borrower. When buying a property with existing CMBS debt, mortgage brokers and their clients should be prepared for higher reserve amounts, cash management and other conditions. Don’t expect to be able to change the loan documents.

Purchase-price adjustments

When a buyer assumes an existing CMBS loan, they may believe the purchase price of the property doesn’t matter since the loan is already in place. This used to be the case. From 2009 to 2014, loan-to-value (LTV) ratios at the time of assumption didn’t matter.

But times have changed. Some special servicers now require a buyer to establish a reserve at the time of assumption in order to make the LTV equal to the original loan-to-purchase (LTP) ratio. This is best understood with an example.

Let’s say a CMBS loan was originated on a property with an appraised value of $25 million and the borrower got a 65 percent LTV loan — $16.25 million — at that time. Fast forward a few years and the property is being sold to a new buyer for $22 million. The original loan is interest-only, so the total balance is still $16.25 million.

On a property valued at $22 million, a 65 percent LTV loan would equal $14.3 million. Since the current loan is for $16.25 million, however, the difference between $16.25 million and $14.3 million ($1.95 million) would be required in the form of a collateral reserve at the closing of the loan assumption.

To make matters worse from a borrower’s perspective, the $1.95 million cannot be used to pay down the loan because CMBS loans have prepayment prohibitions or penalties. So, the $1.95 million sits in a reserve account and cannot be used by the buyer for the life of the loan. This one item can impact a buyer’s internal rate of return so severely that many back out of deals when they learn of this requirement.

What does all this mean for commercial mortgage brokers and their clients? Don’t enter into new CMBS loan documents without a thorough understanding of the specific terms, definitions and servicer processes. Don’t assume cash management will not be sprung based on actual DSCR calculations. This decision is based on the servicer’s DSCR calculation, which is binding unless there is an obvious error.

Be prepared for additional cash requirements when a buyer is assuming an existing CMBS loan, including the possibility of an LTV reserve. And, most of all, know that every word in the loan documents matters in regard to springing cash-management and DSCR calculations.