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# Commercial Mortgage-Backed Securities (CMBS)

Aug 31, 2021


What Are Commercial Mortgage-Backed Securities (CMBS)?

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 what is considered a 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. 

Criticism of CMBS

Typically,  only very wealthy investors invest in CMBS because there are not many  options here for the average investor. It’s difficult to find mutual  funds or exchange traded funds (ETF) that invest solely in this asset  class, though many real estate mutual funds invest a portion of their  portfolios into CMBS. 

Requirements for CMBS

In December 2016, the Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) introduced new regulations to  mitigate some of the risks of CMBS by creating margin requirements for  covered agency transactions, including collateralized mortgage  obligations.