Commercial mortgage-backed securities (CMBS)

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.

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).

$$\text{NOI} = \text{Rent} - \text{Opex} - \text{Reserves}$$

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.

$$\text{DSCR} = \frac{\text{NOI}}{\text{Annual debt service}}$$

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.

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.

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.

$$\text{Penalty} = \text{Points} \times 1\% \times \text{Balance}$$

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.

	RMBS	CMBS
Collateral	Thousands of home loans	Few to dozens of large commercial loans
Recourse	Varies (often recourse outside the US)	Typically non-recourse
Key credit metrics	LTV, debt-to-income (DTI), credit score	LTV, DSCR
Prepayment	Largely free in the US; the main risk	Limited by call protection
Amortization	Usually fully amortizing	Usually balloon
Concentration	Low: one default barely matters	High: one default can matter a lot

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.