Commercial mortgage-backed securities offer an important path for long-term financing

By Jeffrey Taylor, co-founder and executive vice president of capital-markets, Velocity Commercial Capital

Mortgage brokers are increasingly getting involved in helping to find financing for investment, multifamily and small-balance commercial properties as interest rates increase and the demand for rental properties accelerates. Commercial mortgage-backed securities (CMBS), which are bonds collateralized by commercial mortgage loans, are a popular financing vehicle for helping to make such deals possible.

CMBS offerings are underpinned by mortgage loans of varying dollar amounts and involve a range of property types and locations. The CMBS debt instruments vary in yield and duration, and the principal and interest paid on the mortgages go to the investors who buy the CMBS.

Through CMBS, borrowers benefit by gaining access to larger pools of capital that would otherwise be unavailable from traditional lending sources. Lenders benefit because the securitization of commercial mortgages enables them to obtain long-term financing for their loans.

Meanwhile, CMBS investors gain because the securities provide a creditworthy and potentially profitable investment vehicle that matches their desired risk profile, investment term and yield. The important role of mortgage brokers in all of this is that they are integral to helping borrowers find financing for their real estate projects, and CMBS financing is part of that picture.

Attractive investments

The top priority of the CMBS issuer is to pool the loans and to create a mix of loans to produce an attractive investment vehicle for bond investors. Often, the pool of assets used to back a CMBS issuance includes a mix of loans that vary widely by size, industry sector and location.

The process of putting together a CMBS deal starts naturally with individual commercial mortgage loans made by banks and other lenders. Many types of commercial real estate holdings serve as the collateral, and they vary in the type of project — apartment buildings, warehouses and factories, office complexes and shopping malls, for instance — and by location (urban, suburban or rural).

The history of CMBS financing has an interesting genesis. When hundreds of savings-and-loan institutions failed in the early 1990s, the federal government formed the Resolution Trust Corporation (RTC) to clean up the mess that remained. Wall Street and the RTC began selling nonperforming loans by packaging them into pools to back bond issues — a process dubbed securitization. Shortly after that, lenders also started to package performing loans as securities, and CMBS was born.

Before 1990, financial institutions held the majority the $1.1 trillion of commercial and multifamily mortgage loans. By the end of 2006, CMBS loans accounted for $770 billion (26 percent) of the $2.95 trillion of U.S. multi-family and commercial mortgage loans outstanding. In contrast, the capitalization of real estate investment trusts (REITs) was $438 billion.

CMBS differ from REITs because CMBS are debt securities that offer a reliable rate of return, while REITs are equities that may fluctuate more widely. CMBS are now one of the largest sources of capital for commercial and multifamily real estate and have brought much-needed liquidity to the industry. The key players in the CMBS marketplace are lenders who make initial commercial mortgage loans, investment banks that bundle them and create the bonds, bond-rating agencies and the investors who buy the bonds.

New rules

The rules for issuing CMBS debt, however, have changed since the collapse of the real estate market in 2008. CMBS issuers must now abide by a risk-retention rule that requires an issuer to maintain “skin in the game” by retaining at least a 5 percent share of any security deal issued, as determined by its fair value at the time of issuance.

CMBS issuers can meet the requirement by choosing to retain a portion of each investment tranche, which is known as a vertical retention. They also can meet the requirement by retaining a share of the junior tranche, dubbed horizontal retention. Or they can use a mixture of the two approaches, called L-shaped retention.

Requiring issuers to retain an interest in the loans they originate means that the issuers share in any losses that may occur. It’s a strong step in creating alignment with the investors who purchase the bonds.

The CMBS marketplace provides a liquid, viable and transparent funding method for larger real estate borrowers and for a wide array of global fixed-income investors. It has helped fuel the growth and stability of the commercial real estate market by providing attractively priced loans for borrowers while providing bond investors with lower-risk investment opportunities at attractive yields.

Small-balance properties

Whereas traditional CMBS are limited to commercial properties, some nonbank specialty-finance lenders issue bonds collateralized by a mixture of assets consisting of both small-balance commercial properties and residential investment properties — like single-family residences, townhomes, condominiums and small apartment buildings — all with loan amounts of less than $5 million.

For bond investors who purchase these small-balance CMBS issuances, pooling a large number of different mortgage assets mitigates the risk of investing in a single mortgage-asset class, and thereby provides a more diversified investment opportunity. It’s similar to the same diversification strategy often recommended for stocks and mutual funds. 

On the other side, small-balance CMBS financing allows lenders to combine a pool of real estate assets that otherwise might not be easy to trade. By assembling a large portfolio of less-liquid assets to back a CMBS issuance — including loans collateralized by warehouses, mixed-use properties and residential investment properties — lenders can offer investors a more diversified pool of assets.

Diversifying the underlying assets combines the risk/return profiles of different types of properties and makes small-balance CMBS more marketable to investors with varying appetites for risk. When the issuers of small-balance CMBS sell bonds in the financial markets, they receive an infusion of capital that can be used to originate more loans and thus generate more income.

Portfolio lenders

Some lenders are direct-portfolio lenders. They include specialty-finance and other nonbank lending institutions that originate mortgages and finance their portfolios of mortgage loans rather than sell them in the secondary market.

A portfolio lender generates income from origination fees and the spread between the interest-earning funded assets and the interest paid on the underlying financing in their portfolios. These types of lenders can create their own lending parameters and guidelines to finance an underserved niche or market segment that typically doesn’t qualify for traditional bank loans.

The flexibility of their underwriting process is key. It makes them an important option for investors and mortgage brokers looking to help their clients.

Mortgage brokers who can expand outside of their comfort zones are finding commercial-property deals to be a lucrative part of their overall business. This is particularly the case because of the strong economy and robust real estate market that are driving demand for property-financing options involving residential-investment and small-balance commercial properties. 

Jeffrey Taylor co-founded Velocity Commercial Capital in 2004 and serves as executive vice president of the company’s capital-markets team. He previously served as vice president of Bayview Financial Trading Group and as vice president of operations for an online trading platform for commercial real estate loan portfolios. He has a master’s degree in real estate development from the University of Southern California. Reach him at (866) 505-3863.

This article originally appeared in the November 2018 issue of Scotsman Guide here.