What is a CMBS Loan? Pros and Cons

Loan options to finance commercial real estate projects are numerous in the United States of America. The various loan programs have different features and terms and conditions. CMBS loans are a common way for investors to finance commercial real estate projects in the USA. Here, we will discuss the characteristics, merits, and demerits of CMBS Loan.

Meaning of CMBS Loan

CMBS stands for Commercial mortgage-backed securities loan. It is a commercial real estate loan backed by a mortgage on commercial properties such as apartments, offices, warehouses, retail buildings, shopping malls, hotels, etc. The underlying commercial mortgages of a CMBS loan can vary concerning terms, property values, and property types.

CMBS loans are offered in the form of bonds, with the mortgage loans making up the underlying security acting as collateral in the event of default.

Mortgages in a CMBS loan are classified into tranches based on the extent of credit risk. The tranches are divided into senior, mezzanine, and equity tranches.

• The senior tranche carries a lower risk and has lower interest rates than other tranches. Thus, the senior tranche is the first to receive repayments of both the principal and the interest.
• The mezzanine tranche gives higher returns but carries greater risk than the senior tranche. In case of a default, the investors of this tranche are repaid after the investors in senior tranche
• The equity tranche provides the highest yields among all tranches. However, it also carries the most risk.

CMBS loan can have a term of 5,7 or 10 years depending upon the borrower’s credit risk and the level of cash flow. However, amortization can be carried out to spread the loan payments over a period of 25-30 years. Balloon payment must be made at the end of the 5-10 years term. The amount to be paid can be the principal amount.

The minimum amount to be secured under CMBS loan is USD 2 million. The maximum amount depends upon the underwriting parameters. The interest rate is fixed throughout the loan period, usually 4-5%, depending on the treasury interest rate.

Commercial and investment banks and conduit lenders offer CMBS loans.

Pros	Cons	Explanation
Lower Interest Rates	Complex Structure	CMBS loans often offer lower interest rates due to pooling multiple loans and spreading risk among investors. However, the structure of these securities is complex and can be difficult to understand for some borrowers.
Fixed Rates	Prepayment Penalties	CMBS loans typically have fixed interest rates, providing predictable payments. However, they often come with significant prepayment penalties, making it costly to pay off the loan early.
Non-Recourse Loans	Less Flexibility	Most CMBS loans are non-recourse, meaning borrowers aren’t personally liable if they default. However, these loans are less flexible in terms of modifications and restructuring compared to traditional loans.
Longer Loan Terms	Rigid Terms and Covenants	CMBS loans usually have longer terms, often 5-10 years, which can be beneficial for long-term projects. On the downside, they come with rigid terms and covenants that must be strictly adhered to.
High Leverage	Servicing Complexity	They often allow for higher loan-to-value (LTV) ratios, enabling higher leverage. However, the servicing of these loans can be complex, involving multiple parties and potentially leading to delays in decision-making.
Access to Capital Markets	Potential for Market Volatility	Borrowers can access capital markets for funding, providing a large source of capital. Yet, the value and performance of CMBS can be subject to market volatility, affecting the loan’s stability.
Diversification of Risk	Standardization Issues	Risk is diversified among various investors, reducing individual exposure. However, the standardization of loan terms can be an issue for borrowers with unique or specific needs.
Wide Acceptance for Various Property Types	Potential for Rating Downgrades	CMBS loans are widely accepted for various types of commercial properties, providing flexibility in property investment. However, the loans can be subject to rating downgrades, which may affect their terms and attractiveness.

Eligibility for CMBS Loan

A CMBS Loan lender assesses the borrower’s debt service coverage ratio or DSCR and loan-to-value ratio or LTV to decide whether to approve the loan. The debt-to-service coverage ratio is a ratio of the property’s net operating income to the loan amount. DSCR also depends upon the level of risk associated with the property.

Loan value ratio or LTV is the ratio of the loan amount to the value of the commercial property. The lender gets the commercial property valued by a third-party appraisal company.

The minimum DSCR commonly demanded by the lenders of CMBS loans is 1.25. This means the property’s net operating income should be at least 125% of the loan payments. Regarding the LTV, the maximum allowed figure is 75% because the higher the LTV ratio, the higher the risk for the lender. The minimum required debt yield is 7-8%.

Lenders of CMBS loans also require the borrowers to have liquidity of at least 5% of the loan amount, net worth of a minimum 25% of the loan amount, and equity of 35-40%.

Pros of CMBS Loan

CMBS loans are Non-recourse loans. In a non-recourse loan, the lender cannot use the personal properties of the borrower in the event of a default and can seize the cash flow from the commercial property and its value as a repayment for the loan. However, the borrower can be held personally liable in case of fraud, misrepresentation, or deliberate damage to the property.

CMBS loans have fixed interest rates. This means the repayment amount does not fluctuate throughout the loan period. Fixed interest rates benefit commercial real estate investors because there is no guarantee that revenues from commercial properties will increase consistently.

CMBS loans are assumable. Loan assumption means the commercial property owner under CMBS loan can sell it, and the buyer assumes the loan from the seller and continues to repay. As a result, both the buyer and the seller can purchase and sell the property respectively without taking new loans.

Cons of CMBS Loan

Prepayment penalties are higher in CMBS loans than mortgages on residential properties. The purpose of the prepayment penalties is to allow the lenders to compensate for the profits they would have made if the loan had been paid off in the original time frame. Apart from the outstanding balance, prepayment penalties can be 1-3% of the loan amount.

Defeasance clause may be present in a CMBS loan contract. This clause requires the borrower to purchase collateral such as bonds or securities if the loan is paid off early. The purpose is to make up for the profits and interest lost by the lender due to early repayment of the loan.

CMBS loans require the borrowers to have reserve funds for various purposes such as taxes, insurance, etc. Secondary financing is not allowed under the terms of CMBS loans. The rigid loan terms make loan restructuring and other modifications difficult.

Conclusion

CMBS loan market makes up about 2% of the fixed-income market in the USA. While there are multiple advantages of CMBS loans, such as fixed competitive interest rates, non-recourse terms, and loan assumptions, there are disadvantages, such as higher prepayment penalties and stricter terms.

Given their specific financial needs and investment goals, investors need to weigh the pros and cons of CMBS loans to decide whether to opt for this loan.