CMBS Loans: What Business Owners Should Know
A commercial real estate loan can help you purchase property for your business, covering the cost of the building, the land or construction. Lenders often package and sell these loans through a process called securitization, creating a commercial mortgage backed security, or CMBS.
As a borrower, you may not know when a lender bundles your loan as part of a CMBS, but the arrangement could change some aspects of your funding. Here’s what you should understand about CMBS loans before moving through the financing process.
- CMBS loan process explained
- How CMBS loans affect business owners
- Understand the risks of CMBS loans
CMBS loan process explained
Banks and other financial institutions use securitization to remove loans from their balance sheets and reduce their risk. They package commercial real estate loans into a single asset, typically in the form of bonds, then sell those bonds to market investors. Investors can generate a return on commercial mortgages without having to originate them, and banks are able to issue more loans with fewer assets on the books.
Nearly all commercial real estate lenders issue CMBS loans, with or without borrowers’ knowledge, said Elaine Worzala, executive director of the Carter Real Estate Center at the College of Charleston.
“The lenders reserve the right to sell their loans to a company that securitizes them,” she said.
Why would you get a CMBS loan?
Borrowers can benefit from access to reliable long-term and fixed-rate loans, even when other capital sources are constrained. CMBS loans may even offer better rates than other types of commercial mortgages. Because of these potential advantages, you might consider seeking out a lender that outwardly offers CMBS loans.
“It provides more liquidity and provides more money to borrow, which should bring down the pricing,” Worzala said.
CMBS loans typically have a loan-to-value ratio up to 75% with terms of five, seven or 10 years and amortizations of 25 to 30 years. At the same time, terms don’t match amortization schedules, so CMBS loans balloon at the end of the term, which means the remaining amount must be paid in full or refinanced.
What is a conduit loan?
A conduit loan is similar to a CMBS loan, in that the party issuing your commercial mortgage does not service the loan. A conduit lender often acts like a broker, selling loans on behalf of another financial institution and earning commission.
“They’re not really part of the picture once they do the deal,” Worzala said.
Conduit loans are also packaged with other commercial mortgages and sold to investors. As mentioned earlier, the securitization of conduit financing should reduce the pricing for the borrower, compared to the cost of traditional commercial real estate loans that remain on a financial institution’s books.
CMBS loans as an investment
Investors trade commercial mortgage backed securities to profit off the real estate market. Credit rating agencies like Moody’s assign CMBS ratings to measure the strength of the collateral that backs the loans within the security.
These ratings start with an investment grade of AAA through BBB indicating the lowest risk, then fall to a below-investment grade and an unrated class for a high-risk CMBS. The probability of default and the severity of loss upon default determines the rating. The types of property in the loan pool, geographic location of properties and age of the buildings also inform the overall rating of the CMBS.
Investors take a risk when buying into a pool of securities, which are divided into different slices or tranches, each with varying risks and returns. Even with the rating, it can be difficult to know the quality of borrowers and collateral backing the loans. If borrowers begin to default and the assets are not of high value, investors stand to lose considerable amounts of money.
How CMBS loans affect business owners
Borrowers may be able to secure lower fixed interest rates with CMBS or conduit loans compared to traditional commercial mortgages. These loans are often non-recourse, which means you would not be personally responsible for the debt — however, you would likely be on the hook if you intentionally cause damage to the property.
Most CMBS and conduit loans are assumable, meaning you could sell your property and the buyer could take over the loan. Lenders usually charge a fee for the switch.
The repayment process for CMBS loans differs from that of a traditional commercial real estate loan. For example, you’ll face a prepayment penalty if you want to pay off your loan early. Prepayment penalties would be calculated through one of two processes — yield maintenance or defeasance.
Yield maintenance vs. defeasance
Yield maintenance is a penalty that’s charged when you pay off your loan early or refinance your loan for a lower interest rate. The lender charges the penalty to ensure they earn the same amount they would have if you made all scheduled payments at the same rate. The penalty is usually calculated using the difference between the current interest rate and the replacement rate, as well as the remaining unpaid payments.
Yield maintenance penalties are often high to discourage borrowers from repaying debt early or refinancing. Still, you may be able to get a better rate on loans that have these penalties because the lender is guaranteed to collect all of the interest on the loan.
Defeasance releases the lien on the commercial property that secures the loan, replacing the property with substitute collateral. It’s not technically a prepayment, as the loan remains in place, but it would allow you to sell or refinance your commercial property. The new collateral needs to generate the same amount of interest for the lender — another property or a piece of equipment, for example, whose value and potential for risk would be ultimately determined by the lender — or you could face a penalty. Sometimes, you may not be able to pursue defeasance for a conduit loan for at least two years.
Understand the risks of CMBS loans
Although a CMBS loan may be less expensive than a traditional commercial real estate loan, borrowers should be aware of potential downsides.
Difficulty tracking down your servicer. Because loans are pooled with others, borrowers sometimes have trouble contacting the party that’s servicing their individual loan. This can be a problem if you’re struggling to make payments or would like to restructure your loan, Worzala said. Missing payments or defaulting on a CMBS loan would lead to foreclosure.
“You’ve got nobody to go to if [the loan] has been sold off,” she said. “It’s very difficult to renegotiate terms if you’re in a pool.”
Risk of foreclosure. If you misunderstand any aspect of the CMBS loan process, such as prepayment penalties or balloon terms, you could lose your business property. There are three types of default that can happen with a CMBS loan:
- Term default: Occurs when you can’t make your scheduled interest payments or principal-plus-interest payments.
- Maturity default: Occurs when you’re unable to refinance your loan at maturity, leaving you with a large balloon payment that you can’t afford.
- Technical default: Occurs when you’re up to date on payments but have otherwise violated an aspect of your loan agreement.
Non-bank lenders typically have higher CMBS default rates, as banks often have stricter underwriting requirements — however, you could still default with either a bank or non-bank loan.
When applying for a commercial real estate loan, consider asking the lender if they typically securitize loans. Although the lender may not disclose that information, asking could end up being to your advantage.
“If a borrower can get a lender to agree not to securitize it, from their perspective it’s probably a better loan for them,” Worzala said. “It isn’t a bad idea to get a sense of what happens.”