CMBS: Structure and Call Protection

Commercial Mortgage Backed Securities (CMBS) are securities that are collateralized by commercial real estate mortgages on income generating properties.

Income generating properties backing CMBS commonly include: apartment buildings, office buildings, industrial properties, hotels, shopping malls, and elderly care facilities.

Differences between CMBS and residential MBS

  • Commercial Mortgages are Nonrecourse: Residential mortgages are recourse loans, whereas commercial mortgages are nonrecourse.  This means that the lender has legal recourse for a residential mortgage default.  In the event of a commercial mortgage default, however, the lender can only sell the underlying property in order to obtain repayment.

  • Collective Credit Risk for RMBS: residential mortgage backed securities have their credit assessed on a collective basis, as loans with similar profiles are pooled together.  Alternatively, CMBS loans have their credit assessed on an individual basis and this assessment must be continuously refined as different loans are paid off.

CMBS Structure

CMBS bonds are commonly sliced into tranches and the credit rating assigned to each tranche will reflect its specific credit risk.

CMBS have sequential pay structures and the highest rated tranche will be paid first.

As a result of the sequential pay structure, the lowest rated tranches have higher credit risk as they are the first to absorb losses from borrower defaults.

CMBS Deal Types (3)

  • Liquidating Deal Trusts: Backed by non-performing mortgage loans.

  • Multi-property Single Borrower: Security pool is composed of multiple loans from one borrower.

  • Multi-property Conduit: This is the most common type of CMBS, where the security pool includes loans for multiple properties from multiple commercial lending institutions.

CMBS and Call Protection

A CMBS investor holds a bond that is backed by a pool of underlying commercial mortgages.

When a borrower prepays a commercial mortgage, the mortgage is effectively “called away” from the investor.

CMBS investors can obtain call protection at both the loan level and by way of the CMBS structure.

Loan Level CMBS Call Protection Forms

  • Prepayment Lockout: Contractually prevents borrower from prepaying during a specified lockout period, which is commonly two to five years from loan origination.
  • Defeasance: Borrower invests prepayment funds in a portfolio of Treasuries that replicate mortgage cash flows.
  • Prepayment Penalty Points: Borrower must pay a fixed rate premium for prepayments made over the life of the loan.  The penalty declines over time.
  • Yield Maintenance or “Make Whole” Charge: Requires the borrower to pay a premium on prepayment that allows the lender to maintain the yield of the original mortgage contract.  With this type of protection, the lender becomes indifferent to prepayment timing and such a loan clause dis-incentivizes the borrower from refinancing.

Structural CMBS Call Protection

  • The sequential pay structure offers investors will call protection as well.

  • The higher rated tranches will be paid down first and have lower risk of principal loss resulting from borrower default.

CMBS Balloon Risk

  • This is the risk that a commercial mortgage buyer will be unable to make a lump-sum principal payment at the end of the loan term.
  • Balloon risk translates to extension risk as the borrower may be forced to extend the life of the loan.
  • As a result of the tranche structure of a CMBS, significant refinancing may need to take place in the event of a balloon payment default so that obligations to the senior tranche can be met.