Understanding CMBS Loans
Commercial real estate loans are not always as simple as they used to be. In the past a lender, usually a bank or a mortgage company, checked a borrower’s credit rating and the potential value of the real estate in question, and decided if the loan was a good risk. If the bank or mortgage company agreed to extend the loan, the actual money came from the lending institution’s reserves. Sometime in the 1990s, a new way of funding the loans was created. Dubbed Commercial Mortgage Backed Security (CMBS) loans, these loans were funded by investors looking to make a profit.
When a loan is sold as an investment, it must first be split up based on its risk factor. The way this is typically done is to combine multiple loans into one investment block. Shares in the blocks are sold based on the level of risk involved with the loans they contain. Usually, higher risk means a higher rate of return on the investment. Obviously, loans that are not quite as risky will return a lower amount of profit to the investors. The interesting thing about CMBS loans is that a particular share may represent parts of multiple loans. The loans are combined and then split up into shares based on risk level.
Since these loans are primarily an investment vehicle, they have attributes that differ from conventional commercial mortgages. One major difference is a penalty for early payments. When the borrower decides to pay off the loan early, the investors do not receive all of the returns they were expecting. To compensate for this fact, the loan agreement usually includes the addition of penalties when the loan is prepaid. This helps protect the investors from losing out on money that is lost by the borrower trying to avoid paying interest. CMBS loans favor the investors since they are the ones who provide the capital for the loan in the first place.
Using commercial mortgages as an investment can be a risky venture. It is up to the entity who combines the multiple loans and rates the risk level to make sure that the investors know what they are getting into. The rating of the loans as prime or subprime is actually considered by some as the most crucial part of the process. If investors believe they are getting a low-risk investment, but in reality the loans have been overvalued, a crash can occur. Overall, when handled properly, CMBS loans are usually beneficial for both the investors and the ones who receive the money to purchase commercial real estate.