Individuals looking to finance commercial real estate can choose from quite a few loan options, all with very different terms and caveats.
To help with your property debt research, in this post we will discuss how CMBS loans work and review their features, including underwriting parameters, prepayment penalties, and more.
What is a Commercial Mortgage-Backed Security Loan?
Commercial mortgage-backed security (CMBS) loans are a type of popular commercial real estate loan secured by a first-position mortgage for properties such as warehouses, offices, apartments, hotels, shopping centers, and retail buildings.
They are offered by conduit lenders, as well as investment and commercial banks.
CMBS Loan Features
CMBS loans typically come with five, seven, or ten year term lengths, however they are amortized over a 25-30 year duration.
Because of the loan term and amortization schedule being out of sync, a balloon payment is required to be paid at the end of the term. Alternatively, the outstanding balance can be refinanced.
The minimum loan amount for a CMBS loan is $2 million, and the maximum is determined by the underwriting parameters we will discuss in the next section.
- CMBS loans come with fixed interest rates, which are generally based on the swap rate plus a spread, or the lender’s profit. Over the years, the rates have been hovering in the 4-5% range, though in certain market conditions have gone as low as 3%.
CMBS loans are non-recourse. While the lender can use the property and any profit generated from it as a repayment for the loan, the borrower has no personal liability and the lender cannot seek any further compensation beyond the collateral.
The lender can however pursue legal action if a borrower purposely damages the property.
A conduit loan is also fully assumable. This means that if the borrower decides to sell their commercial property, they can pass the loan on to the buyer. In some circumstances however, the borrower may have to pay an extra fee to the conduit lender to undertake the CMBS loan assumption process.
CMBS Underwriting Parameters
CMBS loans are popular with many commercial real estate investors due to their forgiving underwriting parameters.
Many CRE buyers can access this type of loan even if they do not meet the typical liquidity and net worth requirements of conventional banks.
Conduit loans are guided by two underwriting parameters:
The DSCR is the ratio of the net operating income to annual debt. The debt service coverage ratio is determined solely by the lender and varies depending on the level of risk associated with the property.
For example, offices are generally seen as less risky than land investments by CMBS lenders.
The LTV ratio is the ratio of the amount of money borrowed to the value of the commercial property. The value of the real estate is determined by an independent third-party appraisal firm.
LTV is a guide to the amount of risk for the lender – a higher LTV ratio indicates a riskier loan. CMBS loans typically offer investors LTV maximums of 75%.
Both parameters are taken into account in the loan analysis, in conjunction with a predicted debt yield, or the net operating income to loan amount ratio, of at least 7%. This allows lenders to determine the maximum amount of the loan they can extend to the borrower.
Borrowers will also need to demonstrate equity of around 30-40%, post-closing liquidity of 5% of the total sum to be borrowed, and a total net worth equal to a minimum of 25% of the loan. Additional factors that play a role in the underwriting process include expense ratios and vacancies on the market.
How a CMBS Loan Works
Conduit loans are pooled with a diverse selection of other mortgage loans, placed into a Real Estate Mortgage Investment Conduit (REMIC) trust, and then sold to investors.
Each loan sold to an investor carries with it a risk equal to its rate of return. This is known as the CMBS securitization process.
Once the borrower has received the actual funds from the lender, all their future dealings regarding the loan take place with a commercial mortgage servicer, also called a master servicer. This third-party servicer will collect all CMBS loan payments and interact with the borrower as needed.
However, if the borrower fails to make the payments due on their loan, then a special servicer will step in and work on modifying the loan terms, or send the property to foreclosure, and sell it if needed.
CMBS loans are a popular product, because they allow lenders to offer borrowers a loan that does not affect their liquidity position once sold to an investor.
- Related Reads: NAR’s 2019 Commercial Lending Report
CMBS Loan Prepayment Penalties
CMBS loans come with two types of prepayment penalties – yield maintenance and defeasance.
Prepayment penalties are designed to allow the lender to make the same profit that they would have made if the loan had been paid off within the agreed time frame.
In the case of yield maintenance, the borrower pays a penalty of 1 to 3% of the loan value in addition to the outstanding loan balance. The borrower’s note is then canceled and the loan is considered paid off.
In contrast, CMBS defeasance does not allow for the loan to be repaid or the borrower’s note to be canceled. Instead, the real estate is replaced by alternative collateral such as bonds, allowing the borrower to sell or refinance the property.
Lenders typically won’t allow borrowers to defease their conduit loan within the first 2 years of the term.
More About CRE Loans
Commercial mortgage-backed security loans offer low interest rates and lax underwriting parameters to CRE investors. They are also an appealing choice because they are non-recourse and fully assumable.
If you’d like to compare and contrast commercial mortgage-backed security loans against other popular commercial loans, check out our past blog post.
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