CMBS: Risks, Structure, and Securitization Process

CMBS: Risks, Structure, and Securitization Process

The Securitization Process

The process of creating CMBS involves several key steps, transforming individual commercial mortgages into tradable securities.

1. Loan Origination:

   • Commercial banks, insurance companies, and mortgage finance companies originate first-lien commercial mortgages.
   • Originators assess loan financials and borrower creditworthiness. Key characteristics include:
     • Debt Yield (DY): Net Cash Flow (NCF) / Loan Size
     • Loan-to-Value (LTV) Ratio: Loan Amount / Property Value. Property value is typically estimated using net cash flow and assumed capitalization rates.
     • Debt Service Coverage Ratio (DSCR): Net Cash Flow / Annual Debt Service
   • Example: A loan of $10 million with a net cash flow of $1 million has a debt yield of 10%. DY = 1,000,000 / 10,000,000 = 0.10 = 10%

2. Warehousing:

   • Originators hold the loans in a “warehouse” facility, typically for 2-4 months, until a sufficient collateral pool is formed.

3. Due Diligence and Structuring (10-12 weeks total):

   • Underwriters and potential B-piece buyers evaluate collateral quality.
   • Rating agencies assess the loans and assign preliminary ratings to the CMBS tranches.
   • Initial document preparation and servicing bids take place.
   • B-piece buyers can request loan removals from the pool.

4. B-Piece Buyer Selection:

   • The B-piece buyer is selected around week 8.
   • The final collateral pool composition and bond structure are set, based on subordination levels determined by rating agencies.

5. Marketing:

   • Marketing begins around week 8 and lasts up to a month.
   • A term sheet, detailing the deal structure and top mortgage loans, is crucial.

6. Investor Road Shows:

   • The issuer conducts road shows to present the CMBS offering to potential investors.
   • Investors provide indications of interest.

7. Pricing:

   • The deal is priced typically within 2-4 business days after launch.

8. Final Documentation and Settlement:

   • A final offering circular is prepared.
   • The transaction settles the following week.

Overview of a Typical Securitization

Most modern CMBS are structured as Real Estate Mortgage Investment Conduits (REMICs).

• REMIC Status: This structure allows certificate holders to avoid double taxation.

  • interests❓ Test: The REMIC must have only one residual interest.
  • Assets Test: The REMIC must contain only ‘qualified mortgages’ or ‘permitted investments.’
  • Arrangements Test: Residual interests are not held by disqualified organizations.

• Tranche Issuance: The trust issues tranched certificates of beneficial ownership (CMBS securities).

• Funding: These certificates are funded via cash flow from the collateral pool.
• Private Placement: Since 2009-2010, most CMBS are private placement 144a transactions. This limits liability exposure for issuers and promotes greater transparency.
• Sequential-Pay, Senior/Subordinate Structure: Principal is paid from the top down, and losses are allocated from the bottom up.

Example Deal Structure: Consider a $1 billion CMBS deal.

• AAA Tranches: These have the highest credit rating and the lowest risk. They are further time-tranched into shorter and longer-duration bonds (e.g., 3-, 5-, 7-, and 10-year WALs). They have the lowest coupon rate.
• Mezzanine Tranches (AA, A, BBB): These are lower-rated, but still investment-grade, tranches. They offer higher yields than AAA tranches, reflecting their increased risk.
• B-Piece: This is the unrated, most subordinate tranche, sold privately. It carries the highest risk and offers the highest potential return. The B-piece buyer often has control over the special servicer.
• Interest-Only (IO) Strip: This pays a coupon equal to the strip rate (difference between collateral WAC and weighted average of pass-through certificates) and has a notional value equal to the total balance of the referenced classes.

Collateral Composition

• Typical Collateral:
  • 5-year Amortizing mortgages
  • 7-year Amortizing mortgages
  • 10-year Amortizing mortgages
  • 10-year Interest-Only mortgages

Risks in CMBS Investing

CMBS expose investors to several risks.

Asset-Level Credit Risk

• Investors in mezzanine tranches and the B-piece are particularly exposed to the credit quality of individual assets.
• Cyclical Nature: commercial real estate❓❓ is cyclical. Loan performance is tied to the broader economy.
• Probability of Default:
  • If LTV > 100% (negative equity), or
  • If the borrower cannot cover debt service payments from net cash flow.
  • Then, the probability of default rises rapidly.
• Term-from-Maturity Defaults:
  • Term defaults occur during the loan term due to fundamental problems with the asset (e.g., inability to cover debt service). These tend to have the highest severity.
  • Maturity defaults occur at the end of the term if the property cannot be refinanced. This can happen even with a ‘cashflowing’ property if the market value has declined significantly.

Concentration Risk

CMBS deals tend to be less diversified than other securitizations.

• Large Loan Exposures: A few large loans can account for a significant fraction of the principal balance. For example, the top 10 loans in a pool might represent 60% of the collateral.
• Property Type Concentrations: Disproportionate exposures to specific property types (e.g., office, retail, hotel) reduce diversification benefits. The rent-roll effect is important.
  • Hotel rates reset daily, making them very sensitive to economic conditions.
  • Office, retail, and industrial tenants sign longer leases, providing more stable income.
  • Multi-family leases are renewed annually.
• Geographic Concentrations: Exposures to particular metropolitan statistical areas (MSAs) or states make CMBS sensitive to local economic conditions.

Prepayment Risk

• Early return of principal affects the duration and yield of CMBS.
• Call Protection: CMBS includes strong call protection to mitigate voluntary prepayments.
  • Lockout Period: The loan cannot be retired during this period.
  • Defeasance: The borrower substitutes collateral with high credit-quality securities (typically US Treasury strips) that replicate the loan’s cash flows.
  • Yield Maintenance: The borrower prepays at a premium, ensuring the trust earns its expected yield. The penalty is often at least 1% of the outstanding principal.
• Involuntary Prepayments: These occur when a delinquent loan is liquidated.
  • Cause write-downs for subordinate bondholders.
  • Shorten the duration of front-pay AAAs.
  • Accelerate the pull to par, decreasing realized yield for bonds bought at a premium and increasing it for those bought at a discount.

Extension Risk

• Special servicers may modify troubled loans by pushing out the maturity date.
• Impact:
  • Longer bond durations.
  • Rise in yields for premium bonds (especially front-pay).
  • Lower yields for discount bonds.

Interest Shortfalls

• If interest income is insufficient to fund scheduled payments, the shortfall is allocated in reverse-sequential order (bottom-up).
• Primary Cause: Appraisal reductions.
• Master servicers advance principal and interest on delinquent loans up to the lesser of the outstanding balance or 90% of the reappraised property value.
• If commercial property prices decline sharply, appraisal reductions can reduce interest collected by the trustee and lead to large shortfalls.

Important Differences Between Legacy CMBS and More Recent Transactions

• Underwriting Standards: Newer CMBS typically have more conservative underwriting standards compared to pre-crisis (legacy) deals. For example, lower LTV and higher DSCR requirements for underlying loans.