By: Yara Zakharia, Esq. Commercial mortgage backed securities (CMBS)- a relatively new kid on the financial block, have given a noticeable boost to the commercial real estate sector by catering to an increasing need for capital by commercial lenders. To private investors, these popular bonds offer diversification as well as liquidity and serve as a profitable instrument through which objectives can be realized. Loans that are secured with commercial as opposed to residential property back CMBS. It is the type of property that is pledged as collateral- residential or commercial- that distinguishes the definition of mortgage backed securities from that of commercial mortgage backed securities. A pool of commercial mortgages operates to secure investments in a CMBS. Firms seeking to finance the properties they occupy can choose to issue CBMS or borrow from a creditor that will refinance by way of the CMBS market.
A CMBS transaction involves the pooling and subsequent transfer to a trust of numerous commercial loans of diverse location, property type, and size. Typically, a trust assembles these mortgage loans into a sizable trust valued at approximately $1 billion. The number of mortgages per individual portfolio generally ranges from 100 to 200, and the term of a traditional CMBS is 3, 5, or 10 years. Some of the commercial properties forming the basis of CBMS are:
- Multi-family apartment buildings
- Retail shopping centers
- Hotels
- Office towers
- Mobile home parks
- Industrial buildings
- Retirement homes
- Restaurants
- Self-storage facilities.
The most represented real estate sectors in the trusts tend to be office properties, multi-family dwellings, and retail centers. The trust then groups the mortgages into a series of "classes" or "tranches" that feature distinct terms, duration, payment priority, yield, and risk of default. Bonds backed by the home loans assigned to the tranches are then sold by the trust. Nationally-renowned rating agencies rate the different bond classes as follows: 1) investment grade (AAA/Aaa to BBB-Baa), 2) below investment grade, and 3) an unrated junior classification (NR). The type of bonds that investors choose to buy depends on the duration, yield, and credit risk that they are envisaging. Since commercial mortgage backed securities are usually intended for a fixed term, they carry a lower level of prepayment risk than their residential counterparts, namely residential mortgage-backed securities (RMBS). The risk of loss is minimal for the highest-grade tranches and moderate to elevated for BBBs and below.
The issued CMBS offer an indivisible interest in the pooled loans, with principal and interest passed to investors over the term of the bonds and on a pro-rata basis. Each month, investors- beginning with those holding triple-A investment grade bonds- receive the accrued interest. Investors holding the next highest bonds are then paid interest, followed by those belonging to lower bond classes and so on. The same process is undertaken with respect to principal as payments are obtained.
Commercial mortgage backed securities offer a plethora of benefits to investors, issuers, and borrowers, which include the following:
1. Avoidance of federal income taxes
Commercial mortgages are typically secured through the mechanism of a real estate mortgage investment conduit (REMIC). CMBS mortgages are held under this single entity known as a REMIC, which enables the trust to be exempt from taxation. A transaction involving commercial mortgage backed securities is priced and structured on the basis that it will not be subject to double taxation as concerning its activities. Rather, income passes through to investors and interest holders.
2. Attractive rate of return - While the risks and returns may fluctuate due to changes in the real estate market, commercial mortgage backed securities offer a lucrative package with respect to rates of return.
3. Additional source of capital - CMBS constitutes an attractive source of financing for commercial lenders such as developers and banks. Through commercial mortgage backed securities, companies can make private holdings accessible to the public and consequently raise funds through new investors.
4. Increased liquidity - The structure and enhanced liquidity of commercial mortgage backed securities appeal to a wider segment of investors.
5. Investor Opportunities - Investors have the opportunity to engage in real estate lending with small amounts. Investors can also access segments of the real estate market at reduced transaction costs.
6. Opportunity for investors to achieve their goals by selecting options that correspond to their maturity and credit preferences
7. Competitive pricing of loans, which directly benefits borrowers
8. Eligibility for the retirement plan known as the Registered Retired Savings Plan [RRSP]
9. Diversity of exposure for commercial real estate market participants
10. Decreased presence of risk due to monitoring by independent rating agencies
11. Assurance of adequate financing for developers' projects due to the availability of funds from a diversified pool of investors.
