Commercial Mortgage-Backed Securities (CMBS)

What Are Commercial Mortgage-Backed Securities (CMBS)?

Commercial mortgage-backed securities (CMBS) are fixed-income investment products that are backed by mortgages on commercial properties rather than residential real estate. CMBS can provide liquidity to real estate investors and commercial lenders alike.

Because there are no rules for standardizing the structures of CMBS, their valuations can be difficult. The underlying securities of CMBS may include a number of commercial mortgages of varying terms, values, and property types — such as multi-family dwellings and commercial real estate. CMBS can offer less of a pre-payment risk than residential mortgage-backed securities (RMBS), as the term on commercial mortgages is generally fixed.

How Commercial Mortgage-Backed Securities Work

As with collateralized debt obligations (CDO) and collateralized mortgage obligations (CMO) CMBS are in the form of bonds. The mortgage loans that form a single commercial mortgage-backed security act as the collateral in the event of default, with principal and interest passed on to investors.

The loans are typically contained within a trust, and they are highly diversified in their terms, property types, and amounts. The underlying loans that are securitized into CMBS include loans for properties such as apartment buildings and complexes, factories, hotels, office buildings, office parks, and shopping malls, often within the same trust.

A mortgage loan is typically what is considered a non-recourse debt — any consumer or commercial debt that is secured only by collateral. In case of default, the lender may not seize any assets of the borrower beyond the collateral.

Because CMBS are complex investment vehicles, they require a wide range of market participants — including investors, a primary servicer, a master servicer, a special servicer, a directing certificate holder, trustees, and rating agencies. Each of these players performs a specific role to ensure that CMBS performs properly.

The CMBS market accounts for approximately 2% of the total U.S. fixed-income market.

Types of CMBS

The mortgages that back CMBS are classified into tranches according to their levels of credit risk, which typically are ranked from senior — or highest quality — to lower quality. The highest quality tranches will receive both interest and principal payments and have the lowest associated risk. Lower tranches offer higher interest rates, but the tranches that take on more risk also absorb most of the potential loss that can occur as the tranches go down in rank.

The lowest tranche in a CMBS structure will contain the riskiest — and possibly speculative — loans in the portfolio. The securitization process that's involved in designing a CMBS's structure is important for both banks and investors. It allows banks to issue more loans in total, and it gives investors easy access to commercial real estate while giving them more yield than traditional government bonds.

Investors should understand, however, that in the case of a default on one or more loans in a CMBS, the highest tranches must be fully paid off, with interest, before the lower tranches will receive any funds.

Criticism of CMBS

Typically, only very wealthy investors invest in CMBS because there are not many options here for the average investor. It's difficult to find mutual funds or exchange traded funds (ETF) that invest solely in this asset class, though many real estate mutual funds invest a portion of their portfolios into CMBS.

Requirements for CMBS

In December 2016, the Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) introduced new regulations to mitigate some of the risks of CMBS by creating margin requirements for covered agency transactions, including collateralized mortgage obligations.