What Are Commercial Mortgage-Backed Securities?

Definition & Examples of Commercial Mortgage-Backed Securities

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A commercial mortgage-backed security (CMBS) is a type of fixed-income security. It is backed by real estate loans.

These loans are for commercial properties. They might include 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. They take a group of commercial real estate loans, put them in a bundle, and sell them as a series of bonds.

These bundles are often divided into tranches, also called segments. The bonds are ranked based on risk and rating.

The ones with the highest rating have lowest risk. They are known as senior issue. The ones with the lowest rating have the highest risk. They are known as junior issue.

You'll have to pay more for senior issue CMBSs than junior issue due to the reduced risk. This means they are a safer and more secure place to invest your money.

The senior issue is first in line to receive principal and interest payments. The most junior issues will be the first to take a loss if a borrower defaults.

You can choose which issue to invest in based on what type of yield you are looking for and how much risk you are willing to take on.

How Do CMBSs Work?

A real estate investor or business owner buys a commercial piece of property. They use a bank to get a mortgage that lets them buy the property.

The bank pools that mortgage with other mortgages. Then, the bank turns the pooled mortgages into bonds. They rate these bonds, then sell them to investors.

The bank gets the money from the bond sales. After that, a servicing manager takes over the bonds.

The bonds then begin earning fixed yields for the people holding them. The bank, because they have sold the bonds, can use its money to lend to someone else.

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

Loan securitization lets banks make more loans. It also gives institutional investors a higher-yielding alternative to government bonds.

This structure makes it easier for commercial borrowers to gets access to funds and mortgages.

What It Means for Individual Investors

You can invest in commercial mortgage-backed securities one by one. But these are often only owned by wealthy investors, investment entities, or the managers of exchange-traded funds (ETFs). 

There are ETFs that focus on mortgage-backed securities (MBS). These are securities created from residential mortgages instead of commercial. These ETFs may also invest in commercial mortgage-backed securities. 

For retail investors, these ETFs may be the best way to invest in these debt securities. They present a way to access diversified risk without a large investment.

CMBSs are an alternative to real estate investment trusts (REITs). They are a convenient way to invest in the U.S. real estate market.

There are major differences between the two types of investments. REITs are equities. CMBS are debt securities, or investments that are created from debt instruments.

Pros and Cons of CMBSs

Pros
  • Careful underwriting standards

  • Higher returns

  • Fixed term loans

Cons
  • High risk of default

  • Respond to real estate market

  • Ratings depend on bank

Pros Explained

Careful underwriting standards: CMBSs written after the 2008 financial crisis tend to be larger. They have more careful underwriting standards than MBSs.

Higher returns: CMBSs in the bond market often have higher returns than either corporate or government bonds. This means you can make a good profit with them.

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

Prepayment risk is the chance that falling interest rates will cause borrowers to refinance. This means they will pay back their old mortgages sooner than expected. Mortgage prepayment causes real estate investors to receive a lower yield than they expect.

Cons Explained

High risk of default: As is the case with corporate bonds, commercial mortgage-backed securities are at risk of default. If borrowers fail to make their principal and interest payments, CMBS investors can experience a loss.

The risk of default can vary. It is often based on the strength of the market in the area where the loan originated. It can also depend on the date the loan was issued.

Respond to real estate market: Commercial mortgage-backed securities issued during a market peak or at a time when underwriting standards are low are likely to pose higher risks. CMBSs can also be negatively affected by weakness in the real estate market.

This happened in 2008 and 2009. CMBS lending dried up in the wake of the financial crisis of 2008. It gradually came back as market conditions improved. 

Ratings depend on bank: The ratings that CMBSs get depend on the honesty and integrity of the bank that first made the loan. If they are poorly rated or dishonestly represented, investors don't know what they are buying. This can create the same risks as the sub-prime mortgage crises in the Great Recession of 2008.

Key Takeaways

  • CMBSs are backed by commercial real estate, not residential.
  • Banks pool commercial mortgages together and create bonds 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.