Fixed-income investment products known as commercial mortgage-backed securities (CMBS) are backed by mortgages on commercial buildings. The liquidity of CMBS can benefit both commercial lenders and real estate investors.
CMBS loans are often a desirable choice due to their distinctive features. But because they have more intricate terms than conventional loans, it’s crucial to understand the benefits and potential drawbacks of taking one out when investing in commercial real estate. This article discusses the benefits and drawbacks of CMBS in comparison to conventional loans.
CMBS Benefits
The interest rates for commercial mortgage backed securities loans are competitive and lower than those of conventional loans. When calculating the loan amount, borrowers might use a larger loan-to-value ratio to leverage a higher collateral value. Additionally, because some CMBS loans permit interest-only payments for the loan duration, the borrower may have to make fewer debt service payments, which may free up cash flow.
Moreover, upfront costs for originating a new CMBS loan are frequently lower than those for a standard loan, which is also beneficial for freeing up additional funds.
In addition, upon payment of a fee, the loan may be assumed by a buyer of a piece of real estate that has been funded with a CMBS loan, enabling the owner or borrower to sell the property and pass the debt to the buyer without incurring the costs of locating and securing new financing. In this case, the buyer will often be subject to the same conditions as the first owner.
CMBS Drawbacks
There is less flexibility for the borrower to negotiate the loan terms, as CMBS loans are subject to a number of restrictions that may not be present with a typical loan.
CMBS loans also prohibit supplementary or secondary funding. The borrower might also be restricted from refinancing or prepaying a CMBS loan because a CMBS loan aims to maximize returns to investors. Where prepayment is allowed, achieving the payback is often difficult and costly due to prepayment penalties. In a procedure known as defeasance, the borrower can also be obliged to swap out the property for another type of security. Alternatively, the borrower might have to pay yield maintenance, which entails paying the difference between their current interest rate and U.S. Treasury yields. But as was already mentioned, a home buyer might be able to assume the loan.
A servicer also administers CMBS loans in accordance with the PSA and the conditions of the underlying loan papers. These conditions and limitations provide less freedom in loan servicing than may otherwise be allowed in the event of a standard loan. As a result, it could be quite challenging for the borrower to get the master servicer to provide financial support to prevent a loan default. So instead, the loan is transferred to a specific servicer upon the borrower’s default under the loan, whose responsibility is to negotiate with the borrower to resolve the default.
A special servicer can discuss workouts or pursue the foreclosure of defaulted properties. However, a typical loan lender has more flexibility and alternatives for a loan workout with the borrower than a special servicer. Special servicer options include loan modifications, negotiated payoffs, selling the loan, and accepting a transfer instead of foreclosure.
It’s important to note that a CMBS loan has a cash management process that controls cash flow. As a result, the special servicer assumes management of the borrower’s cash flow during the default period once the borrower defaults. This may deprive the asset of vital financial flow needed to maintain the property correctly and need the appointment of a receiver to oversee it. Additionally, because CMBS loans are meant to safeguard the interests of investors, in addition to non-payment, failing to satisfy specific covenant levels may result in cash sweeps or loan defaults.
Loan fees and costs may also be higher in the event of default than they would be with a conventional loan. For example, default interest costs, reports for special services, special servicer fees, legal expenses, loan modification costs, and additional equity contributions add up quickly and are not common in conventional loans.
Final Thoughts
CMBS loans might be a desirable option for borrowers searching for financing because of their competitive upfront costs, rates, and debt servicing obligations. However, before choosing a specific financing option, potential borrowers should carefully analyze their lending alternatives and consider a CMBS loan’s drawbacks.
Jason is the Marketing Manager at a local advertising company in Australia. He moved to Australia 10 years back for his passion for advertising. Jason recently joined BFA as a volunteer writer and contributes by sharing his valuable experience and knowledge.
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