What are CMBS Tranches?
Just like asset backed securities and mortgage backed securities (MBS), commercial mortgage backed securities (CMBS) are divided into tranches based on credit risk. The highest-rated, least risky loans will be placed in the highest tranches, while the lowest-rated, riskiest loans will be placed in the lowest tranches.
CMBS are Split Into Tranches Based on Credit Risk
Just like asset backed securities and mortgage backed securities (MBS), commercial mortgage backed securities (CMBS) are divided into tranches based on credit risk. The highest-rated, least risky loans will be placed in the highest tranches, while the lowest-rated, riskiest loans will be placed in the lowest tranches. Higher tranches will generally offer interest rates (and lower returns for investors), while lower tranches offer higher interest rates (and higher potential returns for investors). Investors should understand, however, that, in the case of a default on one or more loans in a commercial mortgage backed security, the highest tranches must be fully paid off, with interest, before the lower tranches will receive any funds.
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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 tranches?
The different types of CMBS tranches are typically classified into two major categories — investment-grade CMBS, and sub-investment-grade CMBS. Investment-grade CMBS tranches comprise the AAA/Aaa through BBB-/Baa3 rated securities, while the BB+/Ba1 through B-/B3 ranked securities make up the sub-investment-grade tranches. In the industry, sub-investment grade CMBS tranches are collectively referred to as CMBS B-pieces.
What are the advantages of investing in CMBS tranches?
Investing in CMBS tranches offers a variety of advantages. The highest tranches, which are the least risky, offer lower interest rates and lower returns for investors. The lower tranches, which are the riskiest, offer higher interest rates and higher potential returns for investors. In the event of a default on one or more loans bundled in a commercial mortgage-backed security tranche, the highest tranches (lowest risk, highest quality credit rating) must be fully paid off, with interest, before the lower tranches can receive any funds. Source, Source, Source.