What are CMBS Spreads?
A CMBS credit spread is defined as the difference in yield between a U.S. treasury bond and a specific commercial mortgage backed security.
CMBS Credit Spreads: How They Work
A CMBS credit spread is defined as the difference in yield between a U.S. treasury bond and a specific commercial mortgage backed security. The least risky CMBS securities have a lower credit spread, since they do not need to offer higher rates to attract investors, while riskier securities offer higher rates to compensate investors for their increased risk. For CMBS loan borrowers, a larger credit spread often means a higher interest rate.
What are the Factors that Influence CMBS Credit Spreads?
A variety of factors can affect CMBS credit spreads, and, as a result, CMBS loan interest rates. These include:
Inflation: Changes in inflation can affect market-wide supply and demand, which can have a trickle-down effect on CMBS loan rates/spreads.
Economic Uncertainty: If the economy begins to falter, investors may begin to flock to U.S. treasury bonds, driving down their rates, and therefore increasing the difference between treasury bond and CMBS yields.
Bond maturity: Credit spreads are typically larger for bonds that have longer maturities, as this increases the amount of risk for potential borrowers.
Quality/rating: Commercial mortgage backed securities composed of loans taken out by higher risk borrowers will naturally have a larger credit spread than those composed of lower-risk loans.
What is a CMBS loan?
A CMBS loan, also known as a conduit loan, is a type of real estate loan that’s secured by a first position mortgage on a commercial property. CMBS loans are typically offered by commercial banks, conduit lenders, or investment banks, and, once they are issued, they are packaged and sold to other investors. Due to that fact that banks do not hold CMBS loans on their balance sheets, they can offer these loans to borrowers at relatively low fixed interest rates, and can also offer borrowers relatively high leverage.
What are the benefits of a CMBS loan?
CMBS loans have several incredible upsides. First, these loans are available to a wide swath of borrowers, including those that might be excluded from traditional lenders due to poor credit, previous bankruptcies, or strict collateral/net worth requirements. Plus, CMBS loans are non-recourse, which means that even if a borrower defaults on their loan, the lender can’t go after their personal property in order to repay the debt. In addition, CMBS loans offer relatively high leverage, at up to 75% for most property types (and even 80% in some scenarios).
Perhaps most importantly, CMBS loan rates are incredibly competitive, and can often beat out comparable bank loan rates for similar borrowers. CMBS loans are also assumable, making it somewhat easier for a borrower to exit the property before the end of their loan term. Finally, it should definitely be mentioned that CMBS loans permit cash-out refinancing, which is a fantastic benefit for businesses that want to extract equity out of their commercial properties in order to renovate them, or to get the funds to expand their core business.
What are the risks associated with CMBS loans?
The major downside of CMBS loans is the difficulty of getting out the loan early. Most, if not all CMBS loans have prepayment penalties, and while some permit yield maintenance (paying a percentage based fee to exit the loan), other CMBS loans require defeasance, which involves a borrower purchasing bonds in order to both repay their loan and provide the lender/investors with a suitable source of income to replace it. Defeasance can get expensive, especially if the lender/investors require that the borrower replace their loan with U.S. Treasury bonds, instead of less expensive agency bonds, like those from Fannie Mae or Freddie Mac.
In addition, CMBS loans typically do not permit secondary/supplemental financing, as this is seen to increase the risk for CMBS investors. Finally, it should be noted that most CMBS loans require borrowers to have reserves, including replacement reserves, and money set aside for insurance, taxes, and other essential purposes. However, this is not necessarily a con, since many other commercial real estate loans require similar impounds/escrows.
What are the different types of CMBS loans?
CMBS loans are a type of financing that is provided by lenders who package and sell mortgages on to commercial mortgage-backed securities (CMBS) investors. These investors then receive the mortgage payments from borrowers. CMBS loans can be advantageous because they don’t require much scrutiny of a borrower. Rather, the loan is underwritten on the financial strength of the asset held as collateral.
CMBS loans are generally provided with fixed interest rates and have terms of five to 10 years, with amortization periods of up to 30 years. CMBS loans are available for most types of commercial real estate assets, including office buildings, apartment buildings, industrial properties, warehouses, parking garages, marinas, retail properties, mixed use properties, mobile home parks, nursing homes, hospitals, student housing properties, and more. Plus, CMBS portfolio loans are also available for larger businesses to refinance multiple properties while enjoying low interest rates and liberal cash-out restrictions.
What factors affect CMBS loan spreads?
A variety of factors can affect CMBS loan spreads, and, as a result, CMBS loan interest rates. These include:
- Inflation: Changes in inflation can affect market-wide supply and demand, which can have a trickle-down effect on CMBS loan rates/spreads. (Source)
- Economic Uncertainty: If the economy begins to falter, investors may begin to flock to U.S. treasury bonds, driving down their rates, and therefore increasing the difference between treasury bond and CMBS yields. (Source)
- Bond maturity: Credit spreads are typically larger for bonds that have longer maturities, as this increases the amount of risk for potential borrowers. (Source)
- Quality/rating: Commercial mortgage backed securities composed of loans taken out by higher risk borrowers will naturally have a larger credit spread than those composed of lower-risk loans. (Source)
- Property Type/Condition: Hospitality properties are generally some of the riskiest property types eligible for multifamily loans, while the safest property types include traditional multifamily and commercial properties. In addition, higher quality properties (think Class A) are less risky, while poorer quality properties (think Class C) are riskier and command higher spreads. (Source)
- Cash Flow/DSCR: The greater a property’s cash flow relative to its debt obligations, the safer a loan will be, and the lower its spread (and vice versa). The minimum DSCR for most CMBS-eligible property types is 1.20-1.25x DSCR, but riskier property types may need 1.40-1.50x DSCR to qualify. (Source)
- Loan Term/Size: Larger loans typically have lower credit spreads, while longer-term loans have higher spreads. For instance, a large, short-term loan would have the smallest spread, while a smaller, long-term loan would have the highest spread. (Source)
- Leverage/LTV: The average maximum LTV for a CMBS loan is 75%, but this can vary based on other risk factors. Highly desirable properties may be permitted LTVs up to 80%, while riskier properties may only be allowed 70%. Higher LTVs typically lead to higher spreads, as they increase the risk for lenders. (Source)
- Lease/Tenant Strength: If the tenant in a commercial property is a large corporation with a long-term lease (for instance, if a credit tenant lease is involved), CMBS spreads are usually lower, while smaller or lesser known tenants may face higher spreads. (Source)