The last several years has seen a large influx of properties that are a part of a commercial mortgage-backed security issuance (CMBS) and involve a special servicer. The real estate industry is constantly evolving and the increased amount of this type of property has been striking. But this sector is also not the most straight-forward to understand so we are going to tackle this in two parts. This month, we will discuss what exactly a CMBS loan is; next month, we will discuss the specific role of a special servicer.
A CMBS issuance is one of those things that sounds simple but actually involves several layers of complexity. Let’s start with the simple part – a CMBS issuance is comprised of several individual loans that are bundled together and sold as a package. How that actually happens is a whole different story.
At its inception, an individual CMBS loan is originated as a commercial mortgage backed by real estate collateral via a mortgage conduit that specializes in this type of debt. The money is borrowed from an investment bank and, as any borrower that has been involved in this process can attest, the loan is made under a very specific set of standards. But the hassle can be worth it, as a CMBS loan typically carries no personal recourse back to the borrower. The mortgage conduit can be very specific as to the type, size and location of the underlying real estate collateral and the loan documents are both specific and extensive. Once the loan is originated, it is transferred back to the source investment bank.
The investment bank will then pool or bundle a number of these individual mortgages to form a CMBS issuance. The issuance will typically select various individual mortgages based on underlying property size, tenancy, location and product type in an attempt to balance overall risk. The issuance is then sold to investors, oft en pension funds, who own the right to the subsequent principal and interest payments. The issuance has a variety of classes, commonly called tranches, that dictate risk and return. Investors chose to purchase among these various classes and, similar to bonds, they range from A classes (AAA, AA and A) through B classes (BBB, BBB-, BB and B) through unrated.
The lower classes carry higher returns, but also have higher risk. As the principal and interest payments from all of the individual mortgages are paid and collected, they are sequentially distributed to the investors in a subordinated order. The investors that hold the highest rated credit classes (AAA) are paid first, followed by the next highest class (AA) and so forth. So the holders of the lowest credit classes are the last to be repaid, with the unrated class being at the end of the line. However, in the event there are losses, the process is reversed. Any losses are first charged to the lowest classes (unrated), then to the next lowest class (B), then the BB class and so forth. Therefore, the AAA-rated – or highest rated – class can only lose money if the losses have been charged to all of the lower-rated classes.
Because the mortgage pool was chosen based on the characteristics of the individual loans that make up each issuance, a loan that is a part of a CMBS issuance tends to be very restrictive on loan restructuring, property improvements and, most importantly, prepayment ability. Removing an individual loan can have far-reaching consequences in terms of the issuance’s ability to repay the various classes. For this reason, borrowers with CMBS loans are typically locked for the entire loan term. The only way a borrower can have the loan removed is a process called defeasance. In this instance, an individual loan is replaced with a portfolio of treasuries or agency securities whose cash flow replicates that of the cash flow schedule of the mortgage. But this process is neither easy or inexpensive.
Now let’s talk about what happens if there is a default by one of the loans that make up the securitized bundle. In the case of a residential mortgage-backed security (RMBS), the issuance is guaranteed against default by the Government National Mortgage Association or one of the government-sponsored entities such as the Federal National Mortgage Association or the Federal Home Loan Mortgage Corporation. But there is no underlying entity providing a guarantee for a CMBS issuance, only a trustee associated with the securitization issuance. And, unlike a traditional bank loan, there is typically no personal recourse back to the individual borrower. So who is left holding the bag? Guess you will have to tune in next month to find out! Ira Krumholz CPM
