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A Brief Guide to CMB Securities

By RealtyBiz News | February 6, 2023

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Commercial mortgage-backed securities (also known as CMBS) are a type of fixed-income security forming 2% of the fixed-income market. These are financial investment products on commercial properties, as opposed to residential realty. They are also mortgage loans (typically non-recourse debts), so any commercial or consumer debt is secured solely by collateral. In the event of a default, the lender cannot seize any assets belonging to the borrower over the collateral amount.

How CMB Securities Function

The purpose of a CMB mortgage is to offer liquidity to both real estate investors and commercial lenders. Like CMOs (collateralized mortgage obligations) and CDOs (collateralized debt obligations), CMBS are available as bonds. 

If a business owner or real estate investor purchases a piece of commercial property, they obtain a mortgage from a bank to purchase it. The bank then groups this mortgage with other mortgages, which are then turned into bonds, rated, and sold back to the investors. 

Once the bank then receives profits from the bond sales, a servicing manager then takes control of the bonds. The bonds can then produce fixed yields for those holding them, while the bank uses money gained from selling the bonds to lend to another shareholder.

Segments

These bonds are composed of underlying loans, usually contained within trusts. The loans work as a type of collateral, with interest and principal being passed to investors in case of a default.

These are then divided into tranches known as segments.

The mortgages backing CMBS are classed according to the level of credit risk, ranked from highest (low-risk senior issue) quality mortgages, which receive both principal and interest rates to cheaper, higher risk junior issue mortgages that absorb more potential loss.

How CMBS Assets Are Organized

Securitization refers to the pooling of assets to create interest bearing securities like CMBS. Those involved in buying these repackaged securities then obtain interest and principal payments of the original assets. As an investment vehicle, CMB securities are complex, requiring a number of different participating bodies to ensure functionality.

  • Rating agencies
  • Trustees
  • Certificate holder 
  • Both a special and master servicer
  • Investors

Securities within CMBS may include a collection of commercial mortgages with various values, terms, and a diverse range of property types (often within the same trust), including:

  • Commercial real estate (such as malls)
  • Multi-occupancy residential dwellings
  • Factories, offices and other places of work
  • Apartment complexes or individual apartments


Benefits

  • CMBs wrote after the 2008 financial crisis are larger, with more careful underwriting standards than MB securities.  
  • Frequently fixed term, so offer a lower prepayment risk than residential. mortgage-backed securities and cannot be repaid early without a penalty. 
  • CMBS provides less of a prepayment risk than RMBS (residential mortgage-backed securities) due to the term on commercial mortgages being fixed. 
  • For individual investors, exchange-traded funds (ETFs) center on residential mortgages rather than commercial ones. For retail investors, EFTs offer a way to access diversified risk minus a large investment.
  • The securitization process lets banks issue a higher number of total loans while allowing investors ease of access to commercial real estate allowing for a higher yield than standard government bonds. It’s also easier for commercial borrowers to gain access to mortgages and funds.
  • Ratings also depend on the integrity of the bank, as this helps to avoid crises like that of the subprime mortgage lenders in 2008.

Potential Downsides

  • No set rules for regulating CMBS structures, making valuation challenging.
  • In the event of a default on one or more loans, the highest tranches must be paid off in full with interest before the lower tranches can receive any funds. 
  • Sometimes criticized as not appealing to the average investor since wealthy stakeholders tend to benefit most. 
  • Although a high number of real estate mutual funds invest part of their portfolios into CMB securities, it can be challenging to find mutual funds or ETFs (exchange-traded funds) that invest solely in this particular asset type. 
  • Typically have “lock-out” periods, which can prevent early repayment.
  • High risk of default depending on strength of the market and the date when the loan was issued. 
  • CMB securities are also sensitive to fluctuations in the real estate market. 
  • CMBs issued during a market peak or when underwriting standards are lower tend to be higher risk. 

Requirements

New regulations for CMBS were introduced in December 2016, when the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) brought in measures to mitigate some potential risks of CMB securities through margin requirements for covered agency transactions like collateralized mortgage obligations (CMOs).

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