What is a CMBS Loan?
At one point or another, every commercial real estate lender finds themselves weighing their options for financing. Typical commercial loan terms won’t always fit the needs of every business, but there are plenty of options that fit unique cases and conditions. One such option for lenders is a Commercial Mortgage-backed Security loan (or CMBS loan).
CMBS loans are complex, offering attractive financing options for commercial real estate lenders seeking a large loan. This complexity has its downsides. It’s essential to understand the differences between a CMBS loan and typical commercial loan terms before considering it as a solution.
This blog will break down the different components of a CMBS loan and go over the pros and cons.
What Is a CMBS Loan?
A Commercial Mortgage-backed Security (CMBS) loan is a commercial real estate loan backed by a first-position mortgage for spaces designated for commercial use. They don’t function the same way a traditional loan does, at least not in full. A CMBS loan is combined with other loans and sold on the secondary market by commercial and investment banks and conduit lenders in a process called securitization.
Investors gain ownership in a pool of real estate assets and then invest in a bond based on their desire for risk.
CMBS loans are designed to produce returns for investors – this is an important fact to understand when considering them.
To qualify for a CMBS loan, the property in question must be an income-producing property. Some examples of income-producing properties are:
Unlike typical commercial loan terms, these loans are pooled together with many other types of mortgage loans. They are compiled into a Real Estate Mortgage Investment Conduit trust (also known as a REMIC trust) and sold on the secondary market by conduit lenders, investment firms, commercial banks, and other large investors. This style of loan comes with more relaxed requirements in terms of credit but stricter guidelines for the type of properties allowed for use.
Conduit loans separate into tranches based on the loan’s risk, return, and maturity. Investors will then purchase the different tranches depending on the risk. Riskier loans come with higher interest and longer terms which are more likely to be bought by investors focused on higher risk, such as a hedge fund investor. Loans with less risk involved are more likely to be purchased by a lower-risk investor, such as a pension fund.
These loans come with a risk equal to their rate of return in the CMBS securitization process and are serviced through a commercial mortgage servicer or a master servicer. The master servicer enforces any terms in the loan contract and an additional agreement called a PSA (Pooling and Servicing Agreement). A PSA aims to lay out the responsibilities and rights of each entity in the trust for the duration of the loan. Any repayment or communication goes through this third-party servicer, and the terms are often non-negotiable or, at the very least, hard to adjust.
The master servicer may also send mortgage performance reports to the investors or report to the trustee. The trustee is generally a stand-alone legal entity separate from the other parties in the loan. If there is trouble with repayment, a specialized servicer can take multiple steps, including:
Trying to secure payments
Making changes to the loan
Deciding on repossession of the property to sell and make a return on investment
CMBS loans are popular because they offer terms that don’t affect a commercial real estate lender’s liquidity position, freeing up assets that can be turned into cash rather quickly if needed.
Features and Qualifications
There are many advantages to CMBS loan terms over typical commercial loan terms, the biggest one being lower interest rates at competitive levels. These loans allow lenders to leverage a higher collateral value when deciding on the loan amount, otherwise known as a higher LTV (Loan-to-value) ratio. This ratio will enable them to borrow a higher amount but also has higher interest rates based on risk. These loans sometimes offer the borrower more cash flow for the life of the loan due to interest-only payments.
Term Lengths and Amortization
CMBS loans have several term lengths. Some are five years, while others can be seven or even 10-year loans. However, the amortization of the loan is usually 25 to 30 years.
Amortization is an accounting technique that lowers the book value of a loan over a period of time. This is done by spreading out payments over time for most loans. However, CMBS loans payment schedule (term length) is not in sync with the amortization schedule, creating the need for a balloon payment by the borrower at the end of the life of the loan. For this reason, a CMBS loan needs to be thoroughly researched based on the type of properties purchased and the rate of return on investment. In some cases, the balance left at the end of this term can be refinanced.
CMBS loans target higher-income borrowers with a minimum loan amount of $2 million.
Who qualifies for a CMBS Loan?
One of the biggest appeals of CMBS loans is speed – they often have less time-consuming and heavy-handed qualification measures. Meaning less credit or liquidity doesn’t always rule out the borrower from accessing this type of loan. A few things are taken into consideration to determine qualification for a CMBS loan:
Is the loan for an income-producing property?
One of the first ways to determine qualification is whether or not the desired property will be used to produce income.
What is the net worth of your borrower?
Typical commercial real estate loan terms require that the borrower have at least a net worth of 25% of the loan amount. Release of collateral, substitution of collateral, or expansion of collateral can be flexible.
Other areas should be agreed upon before the loan is finalized, including:
What will happen upon the release of lease termination payments uncrossing of loans
Changes to escrow payments.
Loans that are crossed have more than one asset or property backing them. Once the loan finalizes, these requirements are locked in and no longer subject to change for most CMBS loans.
What are the pros and cons of a CMBS Loan?
While there are many upsides to a CMBS loan, they differ heavily from typical commercial loan terms. Here are the pros and cons:
Pros of CMBS Loans
One of the most attractive aspects of CMBS Loans is the competitive interest rates, which are lower than typical commercial loan terms offer.
Higher Loan-to-Value Ratio for Collateral
Has a higher loan-to-value ratio for collateral
Lower upfront fees than traditional commercial loan terms
These loans vary from portfolio loans because the original lender does not hold them until paid in full. Instead, they are tied into other similar loans and sold to investors. These factors create a list of important considerations that can be seen as both positive and negative, such as how to provide the balloon payment at the end of the term and whether the purchased property is to be sold off at the end of the loan lifespan.
Cons of CMBS Loans
While these loans come with many benefits, there are also disadvantages. For example, CMBS loans can have remarkably complex terms and limitations. The borrower is offered less flexibility for term negotiation and may be subject to quite a few restrictions that you don’t find in typical commercial loan terms.
Some of the major cons of CMBS loans are rife with complex terms and limitations, including:
Qualifying Properties Must Have a Single Purpose
One significant restriction is loan documents requiring the business to have a single purpose. Many commercial lenders find this stifling for their needs.
These loans are also collateralized, meaning lenders may seize the purchased real estate to make up for the unpaid balance if it is defaulted on. With the lack of support for defaulting already an issue, this can be devastating.
Lack of Support for Defaulting
In order to maximize returns, a CMBS loan does not allow for additional financing, refinancing, or prepaying. They’re structured for returns, so a long-term payment schedule is ideal. The ability to continually pay the loan is vital, with little room for error. Any negotiation is complicated, especially negotiating the ability to pay off the loan. Adjustments often require defeasance, yield maintenance, and hefty prepayment penalties.
It’s also difficult for borrowers to secure financial aid or other assistance that would help when payments are behind. Instead, a special servicer is assigned to borrowers in default and tasked with either helping resolve the issue or foreclosing on the home.
Cash Flow Issues
Defaulting on a CMBS loan also comes with intense practices, including seizing cash flow control throughout the default period.
In general, the cons of CMBS loans can be hefty when the borrower is unprepared, which is why research and weighing your options are crucial. Typical commercial loan terms offer more support and breathing room for error.
CMBS Loans are Complex
While conduit loans are favorable for some lenders, they are not one-size-fits-all. When searching for financing, remember that a CMBS loan is devised first and foremost to protect and serve the interest of investors. If the unique parameters match your business needs, it can be a rewarding choice in your commercial real estate journey.
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