Commercial Mortgage-Backed Securities (CMBS)

Commercial mortgage-backed securities (CMBS) are bonds whose payments come from one or more mortgage loans secured on commercial real estate. The underlying properties are held for the income they produce: offices, shopping centres, hotels, warehouses, apartment blocks, self-storage sites and similar assets. Lenders originate the loans, transfer them to a trust, and the trust issues bonds in classes of differing seniority to investors.

CMBS are one of the two main branches of the mortgage-backed security (MBS) market. The other, residential mortgage-backed securities (RMBS), is backed by home loans to individuals. The distinction matters because the loans behave differently. Commercial mortgages are fewer and larger, are repaid mainly from rent and not from the borrower's personal income, usually have no recourse beyond the property, and restrict early repayment. The market is largest in the United States.

Two forms dominate. A conduit transaction pools dozens of fixed-rate loans, typically with ten-year terms, on different property types across many locations, contributed by several lenders. Diversification is its main strength. A single-asset, single-borrower transaction securitises one large loan on a major property or a portfolio owned by one sponsor, often at a floating rate with a shorter term; investors analyse the specific assets in depth.

The loans are sold to a special purpose vehicle, usually a trust that qualifies for pass-through tax treatment in the United States. The trust issues certificates divided by tranching. The senior tranche and other investment-grade classes are sold to insurers, banks, pension funds and money managers. The lowest classes, unrated or rated below investment grade and known as the B-piece, are sold to specialist investors who review every loan before the deal closes and can ask for loans to be removed.

Payments follow the securitisation waterfall. Interest is paid from the top class downward, and principal is generally paid sequentially, to the most senior class outstanding first. Losses are allocated in the opposite direction, from the bottom up.

CMBS depend on several parties with distinct duties:

• Master servicer. The servicer collects payments from borrowers, monitors the properties and reports to investors. If a borrower misses a payment, it advances the amount to the trust, to the extent it expects to recover it; see mortgage servicing advance.
• Special servicer. When a loan defaults or is at clear risk of doing so, it is transferred to the special servicer, which decides whether to modify the loan, extend it, foreclose or sell.
• Trustee. The trustee holds the loans for certificate holders and makes distributions.
• Controlling class. The most junior class that has not been substantially written down has rights to direct or replace the special servicer, on the reasoning that it bears the next loss.

A typical conduit loan has a ten-year term with repayments calculated over a much longer period, or with no amortisation at all, leaving a large amount due at maturity. These balloon payments mean that the borrower must refinance or sell, so conditions in the lending market at maturity are a central risk.

Voluntary early repayment is restricted. Loans are commonly locked out for an initial period, after which the borrower must either pay a prepayment penalty calculated to preserve the lender's yield, or substitute government securities that replicate the remaining payments, a process called defeasance. Investors in CMBS therefore face much less prepayment uncertainty than investors in residential securities.

Credit analysis centres on the property's cash flow. The key measures are the loan-to-value ratio (LTV), the debt service coverage ratio (DSCR), which compares net operating income (NOI) with loan payments. Rating agencies re-underwrite the income of each property and value it with their own capitalisation rate before assigning a credit rating to each class.

The main risks are a fall in property income or value, the inability to refinance at maturity, and concentration in a few large loans, tenants or property types. Because loans are non-recourse, a borrower whose property is worth less than its debt has an incentive to hand it back.

Issuance grew rapidly before 2007 on increasingly aggressive assumptions, then stopped almost completely during the financial crisis, and delinquencies on loans from that period rose to high levels. The market that resumed afterwards has lower leverage and more conservative underwriting. Later stresses have been specific to sectors: shopping centres as retail moved online, hotels during the COVID-19 pandemic, and offices as remote working reduced demand and higher interest rates from 2022 made refinancing harder.

In the United States, sponsors of CMBS must retain 5% of the credit risk of a transaction. Uniquely for this asset class, the requirement may be met by a third-party buyer of the B-piece, provided that it performs its own review of the loans and holds the position for a minimum period. In the European Union and the United Kingdom, the general securitisation rules on risk retention, transparency and due diligence apply, and the market is much smaller.

• U.S. Securities and Exchange Commission