What Are Commercial Mortgage-Backed Securities (CMBS)?

What Are Commercial Mortgage-Backed Securities (CMBS)?

Let me explain what commercial mortgage-backed securities, or CMBS, really are. These are fixed-income investment products backed by mortgages on commercial properties, not residential ones. They provide liquidity to real estate investors and commercial lenders. Since there's no standardization in their structures, valuing them can be tough. The underlying securities might include various commercial mortgages with different terms, values, and property types, like multi-family dwellings or other commercial real estate. You'll find that CMBS offer less prepayment risk than residential mortgage-backed securities (RMBS) because commercial mortgages usually have fixed terms.

Key Takeaways

Here's what you need to know right away: CMBS are secured by mortgages on commercial properties, not residential real estate. They come in the form of bonds, with the underlying loans typically held in trusts. In case of default, these loans act as collateral, passing principal and interest to investors.

How Commercial Mortgage-Backed Securities (CMBS) Work

Think of CMBS like collateralized debt obligations (CDO) or collateralized mortgage obligations (CMO)—they're bonds. The mortgage loans in a CMBS serve as collateral if there's a default, with principal and interest going to investors. These loans are usually in a trust, varying in terms, property types, and amounts. They cover properties such as apartment buildings, factories, hotels, office buildings, office parks, and shopping malls, often all in one trust.

A mortgage loan here is typically non-recourse debt, meaning it's secured only by collateral. If there's a default, the lender can't go after the borrower's other assets. CMBS are complex, so they involve many players: investors, primary servicer, master servicer, special servicer, directing certificate holder, trustees, and rating agencies. Each has a role to keep things running smoothly.

Just to give you a sense of scale, the total U.S. issuance of CMBS in 2024 was $53.2 billion, according to the Securities Industry and Financial Markets Association.

Types of CMBS

The mortgages backing CMBS are divided into tranches based on credit risk levels, from senior (highest quality) to lower quality. Senior tranches get interest and principal first, with the lowest risk. Lower tranches offer higher interest rates but absorb more loss as you go down the ranks.

Typically, you'll see senior tranches, which are first for repayment and have lower risk, so they pay lower interest. Mezzanine tranches carry more risk but higher yields, repaid after seniors in a default. Equity tranches are the riskiest, with the highest potential gains.

The lowest tranche has the most risk and some speculation. This securitization helps banks issue more loans and gives you access to commercial real estate with risk-reward profiles matching your objectives—some tranches might yield more than government bonds with similar risk. Remember, in default, bankruptcy, or liquidation, higher tranches get paid fully with interest before lower ones, following credit seniority order.

Components of a CMBS

Beyond the mortgages, other terms in a CMBS contract affect profitability. Consider interest rates: CMBS loans have fixed rates based on Treasury rates, possibly with a favorable introductory period. Term length is usually 5 to 10 years, ending in a balloon payment, depending on borrower's credit risk and cash flow. Prepayment penalties encourage regular payments instead of early payoff.

Criticism of CMBS

Typically, only wealthy investors get into CMBS because options for average investors are limited. It's hard to find mutual funds or ETFs focused solely on this asset class, though some real estate funds include a portion in CMBS.

Requirements for CMBS

In December 2016, the SEC and FINRA introduced regulations to reduce CMBS risks by setting margin requirements for covered agency transactions, including collateralized mortgage obligations.

Advantages and Disadvantages of a CMBS

Like other debt securities, CMBS come with risks, but they have features that appeal to borrowers and investors. Most CMBS loans have fixed interest rates, so repayments don't fluctuate—great for commercial borrowers whose revenues might not rise with rates. Floating rate options exist but often have high default rates.

These are non-recourse loans, so lenders can't hold borrowers personally liable on default, except in cases like fraud. When selling a property, the new owner can assume the loan for a fee, easing buys and sells without new loans. Prepayment penalties compensate investors for lost interest if paid early; these are riskier than residential ones. Some contracts have defeasance clauses: if prepaid, borrowers replace lost interest and collateral with similar securities, like Treasury bonds, to cover investor cash flow. These can be complex, as detailed in the contract.

What Is the Difference Between CMBS and RMBS?

RMBS are backed by residential loans for homes or apartments, while CMBS are backed by commercial real estate like offices, storefronts, malls, or business spaces.

What Are the Risks of a CMBS?

The main risk for you as a CMBS investor is default in the underlying loans. Since they're non-recourse, borrowers can't be held personally responsible on default.

What Is the Main Benefit of a CMBS?

For investors, the key benefit is reliable cash flow from fixed or floating rates, plus prepayment penalties that discourage early payoffs, ensuring flow for the full term.

The Bottom Line

A CMBS is a security backed by bundled commercial real estate loans. As borrowers pay, that money repays you as an investor.