What Are Commercial Mortgage-Backed Securities?

Definition & Examples of Commercial Mortgage-Backed Securities

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The commercial mortgage-backed security (CMBS) is a type of fixed-income security collateralized by commercial real estate loans. These loans are typically for commercial properties, such as office buildings, hotels, malls, apartment buildings, and factories.

Learn more about CMBSs, how they work, and what they mean for individual investors.

What Is a CMBS?

Banks create commercial mortgage-backed securities by taking a group of commercial real estate loans, bundling them together, and selling them in a securitized form as a series of bonds. They typically organize each series into tranches, also called segments. The bonds are ranked from the highest-rated and lowest-risk (senior issue) to the lowest-rated and highest-risk (junior issue).

Investors pay more for senior issue CMBSs than junior issue due to the reduced risk.

The senior issue is first in line to receive principal and interest payments, while the most junior issues will be the first to take a loss if a borrower defaults. Investors choose which issue they invest in based on their desired yield and capacity for risk.

How Do CMBSs Work?

Imagine that a real estate investor or business owner purchases a commercial piece of property. They use a bank to fund the purchase and receive a mortgage. The bank pools that mortgage with other mortgages and then turns them into bonds they sell to investors after they rate them.

The original lender receives the money from the bond sales, and a servicing manager takes over the bonds. The bonds then begin generating fixed yields for the bondholders, and the original lender uses the funds to lend to someone else.

Commercial mortgage-backed securities usually have lock-out periods that prevent the underlying loans from being repaid early.

Loan securitization enables banks to make more loans, and provides institutional investors with a higher-yielding alternative to government bonds; it also makes it easier for commercial borrowers to gain access to funds.

What It Means for Individual Investors

Although it's possible to invest in commercial mortgage-backed securities individually, they are typically only owned by wealthy investors, investment entities, or the managers of exchange-traded funds (ETFs). 

Several ETFs specializing in mortgage-backed securities (MBS), which are securities created from residential mortgages instead of commercial, also invest in commercial mortgage-backed securities. For retail investors, these ETFs may be the best way to invest in these debt securities because they present a reasonably diversified risk without a large investment.

CMBSs offer investors an alternative to real estate investment trusts (REITs) as a convenient way to invest in the U.S. real estate market. There are significant differences between the two investments. REITs are equities, whereas CMBS are debt securities (investments that are created from debt instruments).

Advantages and Disadvantages of CMBSs

  • CMBSs are larger and have more stringent underwriting standards than MBSs

  • Higher returns than corporate or government bonds

  • The loans behind a CMBS are fixed term

  • Lower pre-payment risk than MBSs

  • There is a high risk of default

  • Can be affected by real estate market

  • Ratings depend upon the honesty and integrity of the original lender

Advantages Explained

CMBSs wrote after the 2008 financial crisis tend to be larger and characterized by more stringent underwriting standards. CMBSs in the bond market generally offer higher returns than either corporate or government bonds.

The loans that back CMBSs are typically fixed term. They can’t be repaid early by the borrower without a penalty. As a result, CMBSs usually offer substantially lower prepayment risk than residential mortgage-backed securities.

Prepayment risk is the possibility that falling interest rates will cause borrowers to refinance and pay back their old mortgages sooner than expected as a result. Mortgage prepayment causes real estate investors to receive a lower yield than anticipated.

Disadvantages Explained

As is the case with corporate bonds, commercial mortgage-backed securities are at risk of default. If the underlying borrowers fail to make their principal and interest payments, CMBS investors can experience a loss. The risk of individual issues can vary based on the strength of the property market in the specific area where the loan originated and the date of issuance.

For example, commercial mortgage-backed securities issued during a market peak or at a time when underwriting standards were low are likely to pose higher risks. CMBSs can also be negatively affected by weakness in the real estate market, as demonstrated in 2008 and 2009. CMBS lending dried up in the wake of the financial crisis of 2008, but it gradually came back as market conditions improved. 

CMBSs offer investors a legitimate way of investing in U.S. real estate, but if they are inaccurately rated or dishonestly represented, they can present the same uncompensated risks to buyers as the fateful sub-prime mortgage crises that threatened the U.S. economy in the Great Recession of 2008.

Key Takeaways

  • CMBSs are backed by commercial real estate, not residential.
  • Banks pool commercial mortgages together and create securities from them.
  • CMBSs are expensive to invest in, but individual investors can invest in ETFs created from CMBSs.
  • CMBSs are based on fixed-term loans, which reduces pre-payment risk.