Commercial Mortgage-Backed Securities Explained | CFA Level I Fixed Income

Time to dive into the world of commercial mortgage-backed securities (CMBS)! These investment products differ significantly from residential mortgage-backed securities, so let’s get right into it and explore their unique features.

What are Commercial Mortgage-Backed Securities?

CMBS are backed by income-producing real estate properties, including:

• Multi-family apartments
• Warehouses
• Shopping centers
• Office buildings
• Health care facilities
• Senior housing
• Hotels

Just like residential MBS, commercial mortgages are pooled and securitized to be sold to investors. These investors essentially become lenders for the underlying properties. However, an important distinction lies in the borrowers: they are the investors of the properties, relying on tenants and customers to generate cash flow for mortgage repayment.

Non-Recourse Loans and Credit Risk Analysis

CMBS mortgages are non-recourse loans, meaning that lenders can only claim the collateral property in case of default. Comparatively, some residential mortgages are recourse loans, which allow lenders to claim borrower assets if property liquidation doesn’t cover the outstanding loan.

This means that CMBS analysis focuses on the credit risk of the property, not the borrower. Two key ratios help assess this risk:

Debt-Service-Coverage Ratio (DSC)

DSC = Net Operating Income / Required Debt Service Cost

A higher DSC ratio is better for lenders, as it indicates that property cash flows can sufficiently cover debt service.

Loan-to-Value Ratio (LTV)

LTV = Current Mortgage Amount / Current Fair Market or Appraisal Value

A lower LTV ratio is better for lenders, as it provides more collateral to cushion any losses.

Subordinated Tranches and CMBS Structures

If a rating agency determines that a CMBS doesn’t meet desired rating criteria, issuers can structure it with subordinated tranches. Losses from defaults are absorbed by these lower-priority tranches, allowing senior tranches to achieve the desired rating.

Call Protection and Balloon Maturity Provision

Two features unique to CMBS structures are call protection and balloon maturity provision.

Call Protection

Call protection, similar to prepayment protection for MBS, helps mitigate prepayment risk. CMBS achieve call protection in two ways:

1. Structural-level call protection is provided by the CMBS structure, ensuring higher priority tranches are paid off first.
2. Loan-level call protection is provided by individual mortgage terms, using mechanisms like prepayment lockouts, penalty points, yield maintenance charges, and defeasance.

Balloon Maturity Provision

Unlike fully amortizing residential mortgages, commercial property mortgages often use longer amortization periods than loan terms. This creates a balloon payment due at the end of the loan term. The risk of a borrower failing to make this payment is called balloon risk. If a borrower defaults, they may be unable to refinance the loan or sell the property, leading to a default.

In these situations, the lender may extend the loan term during a workout period, making balloon risk a type of extension risk for CMBS.

Wrapping Up Commercial MBS

And that’s a wrap on commercial MBS! We’ve covered key differences between residential and commercial MBS, the importance of credit risk analysis, unique CMBS structures, and specific features like call protection and balloon maturity provisions.