Pros and Cons of Commercial Mortgage-Backed Securities

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Pros and Cons of Commercial Mortgage-Backed Securities

Commercial mortgage-backed securities (CMBS) are fixed-income investment products that are supported by mortgages on commercial properties rather than residential real estate. They can provide liquidity to real estate investors as well as commercial lenders alike.

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

Unsurprisingly, the senior issue is first in line to receive principal as well as interest payments. But the most junior issues will be the first to take a loss if a borrower defaults. People choose which issue senior or junior they invest in based on their desired yield and capacity for risk. As a reminder, investors pay more for senior issue CMBSs than junior issue due to the reduced risk.

Commercial mortgage-backed securities and important details

It is not as hard as it might appear at the first glance to learn more about commercial mortgage-backed securities. Imagine that a real estate investor or business owner buys a commercial piece of property. Investors or business owners use a bank to fund a purchase and receive a mortgage. The bank pools that mortgage with other mortgages and then turns them into the bonds they sell to investors after banks rate them.

The original lender receives the money from the bond sales, as well as 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 others. Loan securitization allows 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 obtain access to funds.

People can invest in commercial mortgage-backed securities, but CMBS are typically owned by wealthy investors, investment entities, or the managers of exchange-traded funds (ETFs). Several ETFs which specialize in mortgage-backed securities (MBS) also invest in commercial mortgage-backed securities. For retail investors, these ETFs may be the best way to invest in these debt securities as 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 in real estate. There are significant differences between real estate investment trusts and commercial mortgage-backed securities. REITs are equities, while CMBS are debt securities.

Returns on a CMBS

Commercial mortgage-backed security has an interest rate and credit rating on its own. These are based on the collection of underlying bonds that account for the CMBS portfolio. Determining credit rating, in particular, can often be a complex as well as difficult process. Single commercial security will often be made of a wide variety of various mortgages extended to different borrowers.

Investors in a CMBS are paid according to the overall results of the portfolio. Standard security will make regular payments to its noteholders based on the loan payments made by the underlying borrowers. There are several factors that determine the return on a CMBS. Interest, rate of payment, any nonpayment on the underlying mortgages, and any collections on defaulted mortgages.

As in the case of any other debt instrument, this creates an element of risk. The rate of payment on a CMBS can vary based on whether the underlying borrowers meet their obligations. Should developers not pay or go into liquidation, the bond’s rate will reflect this.

Nonetheless, at the same time, this is also a selling point of this asset. Unlike a typical bond, commercial mortgage-backed security represents a collection of the underlying debt. A single default will not ruin the value of the overall portfolio, meaning that risk is spread over a far wider as well as more diverse pool of borrowers.

As with all debt instruments, the rate of return on CMBS corresponds to the risk. In most cases, lenders will group their portfolios based on the risk of the underlying assets. Low-risk securities will generally have good credit ratings, but their rates of return tend to be lower to reflect the lower interest paid by more qualified borrowers. Nevertheless, a low-quality, high-risk CMBS tends to pay higher rates of return.

The Advantages and Disadvantages

When it comes to commercial mortgage-backed securities, there are several factors to consider before making a final decision. Let’s start with the advantages. CMBSs wrote after the 2008 financial crisis tends to be larger and characterized by more strict underwriting standards. CMBSs in the bond market usually offer higher returns than either corporate or government bonds.

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

Prepayment risk is the possibility that declining 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 expected.

We should mention the disadvantages as well. For instance, CMBSs are at risk of default. If the underlying borrowers fail to make their principal as well as interest payments, investors can experience a loss. The risk to individual issues can differ based on the strength of the property market in the specific area where the loan originated and the date of issuance.

Commercial mortgage-backed securities can also be negatively affected by weakness in the real estate market. CMBS lending dried up in the wake of the financial crisis of 2008, but it gradually recovered as market conditions improved.

CMBSs offer investors a legal way of investing in the U.S. real estate market. But if they aren’t accurately rated or dishonestly represented, they can present the same risks to buyers as the mortgage crisis that threatened the U.S. economy in 2008.

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