Commercial Mortgage Backed Securities (CMBS Financing)

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Underwriting Parameters

For CMBS Loans, Conduit Lenders have reverted back to more prudent real estate credit decisions, with a much more conservative attitude towards risk.  As part of the underwriting process, lenders are simultaneously assessing the risks of default while trying to minimize such risks, so they are now requiring more detailed borrower and property information and are paying closer attention to any inaccuracies or deviations from traditional norms.  Underwritten cash flows are more conservative and based on “in place” income and rents rather than anticipated income or further rent escalations and leases are analyzed with closer scrutiny to ensure market rates. Market vacancies and expense ratios are also taken into consideration.

In addition to more traditional loan to value (LTV) maximums of 75%, and debt service coverage ratios (DSCRs) of at least 1.25x, Lenders are also calculating the anticipated debt yield (net operating income/loan amount) of at least 7-8%.  Additionally, Borrowers should expect to have “hard cash” equity invested in their projects, while being able to maintain a post-closing liquidity of at least 5% of the loan amount and an overall net worth of at least 25% of the loan amount.

Loan Features

Term Length/Amortization. CMBS (Conduit) Loans typically have terms of 5, 7, or 10 years (with 15 years as a rare exception) and 25-30 year amortizations. Part or all of the term may be interest-only depending on market conditions. Because the term doesn’t match the amortization schedule, the loan will “balloon” at the end of the term, meaning that the remaining loan balance will need to either be paid off or refinanced.

Recourse. CMBS (Conduit) Loans are always Non-Recourse, except for what is colloquially termed the “bad-boy carve outs.” What this means is that the Borrowers are not personally liable for the repayment of the loan and that the collateralized property and its cash flows would be the sole source of repayment of the debt in the event of a default or foreclosure. However, in the event the Borrower actively participates in an activity that could cause harm to the property, Conduit Lender, or investors, there could be springing recourse in some limited circumstances; this may include loan fraud, property transfer or subordinate financing without consent of the Lender, voluntary or collusive activity leading to a bankruptcy filing or failure to maintain SPE status, among other such actions.

Prepayment Penalty Structures. There are two prepayment penalty structures for CMBS Loans – Yield Maintenance and Defeasance.  With a Yield Maintenance prepayment penalty, the loan is actually paid off and the mortgage note is cancelled, whereas a Defeasance is a substitution of one source of collateral (the property) with another (typically treasury bonds) which is then transferred to a special purpose entity (SPE) called a “Successor Borrower.” Both of the structures can cause the Borrower to incur significant monetary penalties if the loan is prepaid well before the maturity date or the US Treasury bonds fall substantially, so anticipated hold time and consideration of future markets should be taken into consideration when contemplating the term for this type of loan structure.

Yield Maintenance. The goal of Yield Maintenance is to allow the bond investors to maintain the same yield as if the borrower made all scheduled mortgage payments until maturity. The penalty is typically calculated by a formula contained in the Note of the Loan Documents. The language will vary between different institutions, but will typically have the same two amounts to be repaid, namely: 1) The loan’s unpaid principal balance and 2) a prepayment penalty, which is typically determined by calculating the difference between the loan’s interest rate and the replacement rate (based on the US Treasury rate that most closely corresponds to the maturity date), with the remaining loan payments discounted back for the time value of money. For an example with a more mathematical representation of this calculation, click here. One thing to keep in mind is that yield maintenance provisions usually contain a prepayment penalty “floor” of at least 1%.

Defeasance. With defeasance, the loan is not repaid and the note remains in place, but substitute collateral (typically in the form of bonds or other securities) is arranged by the defeasing firm and replaces the commercial real estate securing the loan so the property can be sold or refinanced. The cash flows generated from these new securities are in the form of coupons and maturing securities which will cover all future loan payments. When the average yield on the substitute collateral is higher than the loan, it is cheaper to purchase securities to cover the loan’s remaining principal and interested (P&I) payments. Unlike yield maintenance, defeasance provisions do not contain a floor.  However, the third-party administrative fees in order to defease typically range from $50,000 to $100,000, depending on the loan’s size and complexity.

Loan Assumption. The vast majority of CMBS (Conduit) Loans are assumable, typically for a fee. Typically this occurs when the Borrower wants to sell the commercial real estate that secures the CMBS Loan, and the Purchaser of the property wants to take the loan over. Once the property sale and assumption is completed, the Purchaser becomes the owner of the property and is bound by the original terms of the assumed loan and the original Borrower/Seller is released from its obligation to the property and the existing loan. The benefit of this structure is that the assumption of the loan allows the Borrower/Seller to avoid defeasance or other pre-payment costs and give the buyer the opportunity to assume a loan that may have favorable terms than what is market.  Loan assumption is an especially attractive option in high interest rate environments or tight credit environments.

Rating Agencies

CMBS rating agencies assign credit ratings to bond classes ranging from investment grade (AAA/Aaa through BBB-/Baa3) to below investment grade (BB+/Ba1 through B-/B3) and an unrated class which is subordinate to the lowest rated bond class. Rating agencies do not look at each individual loan in the pool but rather the pool’s characteristics as a whole. The following factors are important in judging the credit quality of the pool: 1) Overall average LTV and DSCR 2) Dispersion in LTV and DSCR 3) Quality of LTV and DCR information 4) Property types in the pool 5) Property ages and lease expirations 6) Geographical location of properties 7) Loan sizes and total number of loans. Major CMBS Credit Rating Agencies for the US Include: Moody’s, Fitch, Kroll, S&P, DBRS, and Morningstar.

Loan Servicing

The trust’s pooling and service agreement (PSA) outlines the many responsibilities for each servicing entity by requiring that each servicer uphold an established standard.  The Trustee is responsible for supervising the master and special servicers, ensuring that these companies act in accordance with the PSA. The Master Servicer is responsible for day-to-day loan servicing practices including collecting loan payments, managing escrow accounts, analyzing financial statements inspecting collateral and reviewing borrower consent requests. All non-performing mortgages are usually sent to the special servicer. The special servicer is responsible for preforming customary work-out related duties including extending maturity dates, restructuring loans, appointing receivers, foreclosing the lender’s interest in a secured property, managing the foreclosed real estate and selling the real estate. Under some situations, master servicers subcontract some of their responsibilities to a primary or sub servicer in order to uphold the servicing standard when they need additional assistance.