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Lesson 4 of 4 11–14% of the exam

Commercial mortgage-backed securities (CMBS)

Commercial mortgage-backed securities (CMBS) are backed by a smaller number of large, non-recourse loans on income-producing property. Investors judge each property's debt service coverage and loan-to-value, enjoy call protection that limits prepayment, and face balloon risk: the chance a borrower cannot refinance the large final payment.

6 min cram, 32 min full read. Based on the 2027 CFA® Program Level I curriculum, Fixed Income, Learning Module 19. Also part of the 2026 curriculum, so it applies to the November 2026 exam too.

Tailor this to you: take the self-assessment

Before this: Mortgage pass-throughs and CMOs, Fixed-Income Cash Flows and Types

On the exam

  • Describe characteristics and risks of commercial mortgage-backed securities

Describe CMBS characteristics and risks. Expect: compute a debt service coverage ratio (DSCR) with net operating income (NOI) net of replacement reserves; name a call-protection mechanism; treat balloon risk as extension risk; compare residential mortgage-backed securities (RMBS) with CMBS.

How deeply to learn each part
Know the idea
Understand it in general. It frames other topics, but you will not calculate with it.
Use it
Understand it well enough to solve a question with it. Recognize when it applies.
Memorize
Learn it by heart. The exam will not give it to you.

You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.

You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.

Cram mode: the one-screen version of this lesson. Switch to Full for the explanations, worked examples and interactives.

What are CMBS?

In short, commercial mortgage-backed securities (CMBS) are backed by loans on income-producing property: apartment blocks, offices, warehouses, shopping centers, hotels and health care facilities. The borrower repays from rents and other revenue the property generates. CMBS use the same securitization steps as RMBS, but the pool is different: a few to a few dozen large loans, not thousands of small ones.

Commercial loans are typically non-recourse, so the property’s cash flow is all the lender has. One default can matter a great deal. That concentration risk means investors must look at the individual loans, the properties and the owners, as well as the structure of the deal.

Loading the interactive

How do you judge a commercial loan? NOI and DSCR

Lenders look at two ratios. LTV works as in the previous lesson. The second measures whether the property’s income covers the loan, and it starts with net operating income (NOI).

Net operating income Memorize
NOI=Rent−Opex−Reserves\text{NOI} = \text{Rent} - \text{Opex} - \text{Reserves}

Opex is cash operating expenses. NOI also deducts a non-cash replacement reserve for the wear on the building. It excludes principal and interest on the loan, capital expenditure, depreciation and amortization. The debt service coverage ratio (DSCR) compares NOI with the loan payments.

Debt service coverage ratio Memorize
DSCR=NOIAnnual debt service\text{DSCR} = \frac{\text{NOI}}{\text{Annual debt service}}

Debt service is the year’s interest plus principal. A DSCR above 1.0× means the property’s income pays the loan and still keeps the building in good repair. The higher it is, the safer the loan.

Questions ask for the DSCR, but they also give a target and ask for the debt service the property can bear, or the rent it must earn.

Rearrange itDebt service coverage: solve for NOI, DSCR, debt service or rent
The question asks for
A property earns rent of 2.70 million, has cash operating expenses of 1.00 million and sets aside replacement reserves of 0.10 million. Net operating income, in millions, is closest to:

(2.70 − 1.00) − 0.10 = 1.60

Net operating income (millions)1.60

On your calculator
  1. 2.7−1−0.1=NOI
  1. 2.7ENTER1−0.1−NOI

ENTER enter (on the HP, puts the number on the stack)

Go deeper Replacement reserves are not actual capital spending

A reserve is an annual charge for the wear on the building, set aside in advance. It is not the cash actually spent in the year, which can be lumpy. NOI uses the smooth, planned figure so that a good year is not flattered by deferred repairs, and a bad year is not punished by one large bill. That is also why leaving the reserve out overstates the DSCR.

How do CMBS limit prepayment?

The call protection in CMBS is what makes them trade more like corporate bonds than RMBS. It comes at two levels.

How CMBS limit early repayment
Call protectionwhy CMBS trade more like corporate bonds than RMBS
  • Structural Memorize built into the deal
    • Sequential-pay tranches Memorize a lower-rated tranche waits until higher-rated tranches are retired; losses hit junior tranches first
  • Loan level Memorize covenants in each loan
    • Prepayment lockout Memorize no prepayment for a set period
    • Prepayment penalty points Memorize one point = 1% of the outstanding loan balance
    • Defeasance Memorize prepay only by buying government securities that replicate the remaining payments

Structural protection comes from sequential-pay tranches: a lower-rated tranche cannot be paid down until the higher-rated tranches are retired, and losses hit junior tranches first. At the loan level, covenants do the work:

  • A prepayment lockout bans prepayment for a set period.
  • prepayment penalty points are fees set in advance that a borrower who wants to refinance must pay. One point is 1% of the outstanding loan balance.
  • defeasance lets the borrower prepay only by buying a portfolio of government securities that replicates all the remaining payments, including the balloon. The portfolio is sized so that nothing is left over after the final payment.
Prepayment penalty Use it
Penalty=Points×1%×Balance\text{Penalty} = \text{Points} \times 1\% \times \text{Balance}
Go deeper Why defeasance leaves investors as well off as at maturity

The government securities are chosen to pay exactly what the loan would have paid: every interest payment and the balloon. The investor therefore receives the original schedule of cash flows, from a government-quality source. Nothing is lost to early repayment. The cost of buying the portfolio falls on the borrower.

What is balloon risk?

Residential mortgages are usually fully amortizing. Many commercial loans are not. They pay interest and some principal, then require a large final payment at maturity, for example at the end of year 5 or year 10. That is the balloon maturity .

The resulting balloon risk is the risk that the borrower cannot make that final payment, because it cannot refinance or cannot sell the property for enough. The lender may then extend the loan through a workout period . The investor’s cash arrives late, so balloon risk is a form of extension risk.

Exam tip Balloon risk is extension risk. If an option says contraction, it is the trap.

How do RMBS and CMBS compare?

The two differ more in what can go wrong than in how they are built.

RMBSCMBS
CollateralThousands of home loansFew to dozens of large commercial loans
RecourseVaries (often recourse outside the US)Typically non-recourse
Key credit metricsLTV, debt-to-income (DTI), credit scoreLTV, DSCR
PrepaymentLargely free in the US; the main riskLimited by call protection
AmortizationUsually fully amortizingUsually balloon
ConcentrationLow: one default barely mattersHigh: one default can matter a lot
What a CMBS investor worries about
CMBS risksswap prepayment risk for these
  • Concentration risk Memorize few large loans; one default can matter a lot
  • Balloon risk Memorize a form of extension risk; borrower cannot pay or refinance the final payment
  • Credit of the property Use it DSCR and LTV for each loan
  • Legal risk Use it European deals pool loans from several countries

European CMBS often pool a few loans from several countries, which adds legal risk when a property must be sold under local rules, and usually pay floating, sometimes capped, coupons. US CMBS usually pay a fixed rate.

Go deeper Single-asset and single-borrower deals

Some CMBS securitize a single loan on one high-value property in a major city. Others pool several loans made to one borrower. In both, the investor is exposed to one name, so analysis of that property and owner is the whole credit story.

Memorize this

MemorizeCommercial credit metrics

MetricFormulaReading
NOI(Rent − cash opex) − replacement reservesExcludes debt payments, capex, depreciation
DSCRNOI ÷ annual debt serviceAbove 1.0× covers debt service and upkeep; higher is safer
LTVLoan ÷ property valueLower is safer

Memory hook NOI is what is left for the lender after the building is kept up. DSCR asks if that covers the loan.

Know it cold Do not forget the replacement reserve. Debt service is interest plus principal.

MemorizeCall protection

LevelTool
StructureSequential-pay tranches
LoanLockout; penalty points (1 point = 1% of the outstanding balance); defeasance

Memory hook Structure shields the senior; the loan itself locks, taxes or replaces the prepayment.

Know it cold Defeasance: pay off the loan by buying a government-securities portfolio that replicates the remaining payments.

MemorizeRMBS vs CMBS

RMBSCMBS
CollateralThousands of home loansFew to dozens of large loans
RecourseVariesTypically non-recourse
Credit metricsLTV, DTI, credit scoreLTV, DSCR
PrepaymentMain risk (free in the US)Limited by call protection
AmortizationUsually fully amortizingUsually balloon
ConcentrationLowHigh

Memory hook CMBS swap prepayment risk for concentration and balloon risk.

Know it cold Balloon risk is extension risk, not contraction risk.

How CMBS limit early repayment
Call protectionwhy CMBS trade more like corporate bonds than RMBS
  • Structural Memorize built into the deal
    • Sequential-pay tranches Memorize a lower-rated tranche waits until higher-rated tranches are retired; losses hit junior tranches first
  • Loan level Memorize covenants in each loan
    • Prepayment lockout Memorize no prepayment for a set period
    • Prepayment penalty points Memorize one point = 1% of the outstanding loan balance
    • Defeasance Memorize prepay only by buying government securities that replicate the remaining payments
What a CMBS investor worries about
CMBS risksswap prepayment risk for these
  • Concentration risk Memorize few large loans; one default can matter a lot
  • Balloon risk Memorize a form of extension risk; borrower cannot pay or refinance the final payment
  • Credit of the property Use it DSCR and LTV for each loan
  • Legal risk Use it European deals pool loans from several countries
Net operating income Memorize
NOI=Rent−Opex−Reserves\text{NOI} = \text{Rent} - \text{Opex} - \text{Reserves}
Quick example

Rent EUR 4.1 million, cash operating expenses 1.6 million, replacement reserves 0.3 million. (4.1 − 1.6) − 0.3 = EUR 2.2 million.

On your calculator
  1. 4.1−1.6−0.3= 2.2
  1. 4.1ENTER1.6−0.3− 2.2

ENTER enter (on the HP, puts the number on the stack)

Debt service coverage ratio Memorize
DSCR=NOIAnnual debt service\text{DSCR} = \frac{\text{NOI}}{\text{Annual debt service}}
Quick example

NOI of 2.2 and annual debt service (interest plus principal) of 1.8. 2.2 ÷ 1.8 = 1.22×.

On your calculator
  1. 2.2÷1.8= 1.2222
  1. 2.2ENTER1.8÷ 1.2222

ENTER enter (on the HP, puts the number on the stack)

Prepayment penalty Use it
Penalty=Points×1%×Balance\text{Penalty} = \text{Points} \times 1\% \times \text{Balance}
Quick example

Three points to refinance a loan with GBP 6.5 million outstanding. 3 × 1% × 6,500,000 = GBP 195,000.

On your calculator
  1. 3×0.01×6500000= 195,000
  1. 3ENTER0.01×6500000× 195,000

ENTER enter (on the HP, puts the number on the stack)

How it is asked

  1. Compute DSCR

    Rent 4.1, cash opex 1.6, reserves 0.3, debt service 1.8 (EUR millions). DSCR?

    NOI = 2.2; 2.2 ÷ 1.8 = 1.22×. Traps: 1.39× (no reserve) and 2.28× (rent over debt service).

  2. Name the call protection

    The borrower may prepay only by buying government securities that replicate the loan payments. This is...

    Defeasance. Traps: lockout (no prepayment at all) and penalty points (a fee).

  3. Balloon risk

    A borrower cannot refinance the final payment and the lender extends the loan. The investor faces...

    Balloon risk, a form of extension risk. Trap: contraction risk.

  4. RMBS or CMBS

    Which has more concentration risk and less prepayment risk?

    CMBS. Trap: saying CMBS have more prepayment risk.

Exam traps

  • Forgetting the replacement reserve in NOI. It is deducted, along with cash operating expenses.
  • Treating balloon risk as contraction risk. It is extension risk: the final payment comes late.
  • Saying CMBS carry more prepayment risk than RMBS. Call protection limits it.
  • Treating sequential-pay tranches as loan-level call protection. They are structural.

Checkpoint

6 exam-style questions. About 90 seconds each.

  1. 1An office building earns rental income of EUR 3.2 million, has cash operating expenses of EUR 1.1 million and sets aside replacement reserves of EUR 0.2 million. Annual debt service is EUR 1.5 million. Its debt service coverage ratio is closest to:

  2. 2A CMBS loan lets the borrower prepay only by buying government securities that replicate the loan's remaining payments. This is:

  3. 3A commercial borrower cannot refinance a large final payment and the lender extends the loan. The CMBS investor is experiencing:

  4. 4A commercial borrower took out a GBP 20 million loan that now has GBP 8 million outstanding. The loan carries 2 prepayment penalty points, and the borrower refinances. The penalty is closest to:

  5. 5Which of the following is not a loan-level call protection feature of a CMBS?

  6. 6Compared with RMBS, CMBS most likely have:

Key takeaways

  • CMBS: few large non-recourse loans on income property; concentration risk.
  • NOI = rent − cash operating expenses − replacement reserves; DSCR = NOI ÷ annual debt service.
  • Call protection: sequential-pay tranches (structural); lockouts, penalty points and defeasance (loan level).
  • Balloon risk is extension risk.
Net operating income Memorize
NOI=Rent−Opex−Reserves\text{NOI} = \text{Rent} - \text{Opex} - \text{Reserves}
Quick example

Rent EUR 4.1 million, cash operating expenses 1.6 million, replacement reserves 0.3 million. (4.1 − 1.6) − 0.3 = EUR 2.2 million.

On your calculator
  1. 4.1−1.6−0.3= 2.2
  1. 4.1ENTER1.6−0.3− 2.2

ENTER enter (on the HP, puts the number on the stack)

Debt service coverage ratio Memorize
DSCR=NOIAnnual debt service\text{DSCR} = \frac{\text{NOI}}{\text{Annual debt service}}
Quick example

NOI of 2.2 and annual debt service (interest plus principal) of 1.8. 2.2 ÷ 1.8 = 1.22×.

On your calculator
  1. 2.2÷1.8= 1.2222
  1. 2.2ENTER1.8÷ 1.2222

ENTER enter (on the HP, puts the number on the stack)

Prepayment penalty Use it
Penalty=Points×1%×Balance\text{Penalty} = \text{Points} \times 1\% \times \text{Balance}
Quick example

Three points to refinance a loan with GBP 6.5 million outstanding. 3 × 1% × 6,500,000 = GBP 195,000.

On your calculator
  1. 3×0.01×6500000= 195,000
  1. 3ENTER0.01×6500000× 195,000

ENTER enter (on the HP, puts the number on the stack)

All Fixed Income formulas, every lesson

Practice exam-style questions on Mortgage-Backed Securities: RMBS, CMOs and CMBS

Questions about this lesson?

Where this comes back

Questions candidates ask

What is the debt service coverage ratio in CMBS?

The property's net operating income divided by the loan's annual interest and principal payments. Above 1.0× the property covers its debt service while being kept in repair. NOI is rent less cash operating expenses and a replacement reserve.

What is defeasance?

A way to prepay a commercial loan: the borrower buys a portfolio of government securities that replicates the loan's remaining payments, including the final balloon. The investor receives the same cash flows as if the loan had run to maturity.

What is balloon risk?

The risk that a borrower cannot make the large final payment on a loan that does not fully amortize, because it cannot refinance or sell. The lender may extend the loan through a workout period, so balloon risk is a form of extension risk.

Spotted an error? Tell us and we will fix it.

  1. Prepayment risk and time tranching
  2. Residential mortgage loans: the features that matter
  3. Mortgage pass-throughs and CMOs
  4. Commercial mortgage-backed securities (CMBS)

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