In this article, we will review some of the key features and concepts of CMBS, based on the Morgan Stanley CMBS Primer PDF 48, which is a comprehensive educational resource for CMBS participants. The primer covers the following topics:
The history and evolution of CMBS
The origination and underwriting process of commercial mortgages for CMBS
The structuring and rating of CMBS securities
The investment strategies and relative value analysis of different CMBS tranches
The life cycle and administration of CMBS transactions
The taxation and accounting implications of CMBS
The history and evolution of CMBS
CMBS originated in the late 1980s, as a response to the savings and loan crisis that caused a severe contraction in the availability of commercial real estate financing. The first CMBS deals were backed by pools of diversified loans on various property types, such as office, retail, industrial, multifamily, and hotel. These deals were known as conduit or fusion deals, as they combined loans originated by different lenders into one securitization vehicle.
In the 1990s, CMBS issuance grew rapidly, as the market developed more standardized underwriting, servicing, and legal frameworks. The market also introduced new types of CMBS deals, such as single-asset single-borrower (SASB) deals, which are backed by one large loan on a single property or portfolio; large loan floating rate (LLFR) deals, which are backed by one or more floating rate loans on transitional or value-add properties; and commercial real estate collateralized loan obligations (CRE CLOs), which are backed by pools of bridge or mezzanine loans on properties that require repositioning or redevelopment.
In the 2000s, CMBS issuance reached its peak in 2007, before the global financial crisis hit the market and caused a sharp decline in demand and liquidity. The market also faced challenges from rising delinquencies, defaults, and losses on the underlying loans, as well as from structural issues such as conflicts of interest among deal parties, misalignment of incentives between originators and investors, and lack of transparency and disclosure. The market underwent a period of reform and regulation, such as the Dodd-Frank Act in the US and the Basel III Accord globally, which aimed to improve the credit quality, risk retention, and reporting standards of CMBS.
In the 2010s, CMBS issuance recovered gradually, as the market adapted to the new regulatory environment and benefited from the low interest rate environment and the strong performance of the commercial real estate sector. The market also witnessed innovation and diversification in terms of deal structures, property types, geographies, and investor base. Some of the emerging trends include green or ESG-focused CMBS deals, which are backed by loans on properties that meet certain environmental, social, or governance criteria; non-performing loan (NPL) or real estate owned (REO) CMBS deals, which are backed by pools of distressed or defaulted loans or properties; and non-US CMBS deals, which are issued in other regions such as Europe or Asia.
The origination and underwriting process of commercial mortgages for CMBS
The origination and underwriting process of commercial mortgages for CMBS involves several steps and parties. The main parties are:
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The borrower, who is the owner or operator of the property that seeks financing
The lender or originator, who is the entity that provides the loan to the borrower
The issuer or sponsor, who is the entity that securitizes the loan into CMBS securities
The underwriter or arranger, who is the entity that structures, markets, and sells the CMBS securities to investors
The servicer or master servicer, who is the entity that collects payments from the borrower and distributes them to investors
The special servicer, who is the entity that handles delinquent, defaulted, or troubled loans
The trustee, who is the entity that represents the interests of investors and enforces the terms of the deal documents
The steps of the origination and underwriting process are:
The borrower submits a loan application to the lender, along with information about the property, such as location, size, occupancy, income, expenses, leases, tenants, and market conditions.
The lender performs a preliminary screening of the loan application, based on criteria such as loan size, loan-to-value (LTV) ratio, debt service coverage ratio (DSCR), debt yield, property type, and market risk. The lender also conducts a site visit and an appraisal of the property.
The lender issues a term sheet or a letter of intent to the borrower, which outlines the key terms and conditions of the loan, such as interest rate, amortization schedule, maturity date, prepayment penalty, recourse provision, and covenants.
The borrower accepts the term sheet or the letter of intent and pays a deposit or a fee to the lender. The lender then performs a detailed due diligence on the loan application, which includes verifying the financial and legal information provided by the borrower, obtaining third-party reports on the property's environmental, engineering, and zoning status, and conducting a market analysis and a stress test on the property's cash flow and value.
The lender issues a commitment letter to the borrower, which confirms the final terms and conditions of the loan. The borrower signs the commitment letter and pays a closing fee to the lender. The lender then funds the loan and transfers it to the issuer or sponsor for securitization.
The issuer or sponsor pools the loan with other loans into a securitization vehicle, which issues CMBS securities backed by the cash flows from the loans. The issuer or sponsor hires an underwriter or arranger to structure, market, and sell the CMBS securities to investors. The underwriter or arranger also obtains ratings from credit rating agencies for the CMBS securities, based on their credit quality and risk profile.
The issuer or sponsor sells the CMBS securities to investors through a public offering or a private placement. The proceeds from the sale are used to pay off the lender and other deal costs. The issuer or sponsor also appoints a servicer or master servicer, a special servicer, and a trustee to manage the ongoing administration of the CMBS transaction.
The structuring and rating of CMBS securities
The structuring and rating of CMBS securities involves dividing the cash flows from the underlying loans into different tranches or classes of securities with different seniority levels, interest rates, maturities, and credit ratings. The main objectives of structuring and rating CMBS securities are:
To create securities that cater to different investor preferences in terms of risk-return profile, duration, liquidity, and diversification
To enhance the credit quality and reduce the default risk of senior tranches by providing credit support or protection from junior tranches
To increase the efficiency and profitability of securitization by maximizing the issuance amount and minimizing the funding cost
The main types of tranches or classes of CMBS securities are:
Senior tranches or classes A, which have the highest priority in receiving principal and interest payments from the underlying loans. They also have the lowest interest rates, longest maturities, highest credit ratings (typically AAA), and largest issuance amounts. They are designed for investors who seek low-risk fixed-income investments with stable cash flows.
Mezzanine tranches or classes B through E (or F), which have lower priority than senior tranches but higher priority than junior tranches in receiving principal and interest payments from the underlying loans. They also have higher interest rates, shorter maturities, lower credit ratings (typically AA to BB), and smaller issuance amounts. They are designed for investors who seek higher-yield fixed-income investments with moderate risk exposure.
Junior tranches or classes F through J (or K), which have lower priority than mezzanine tranches but higher priority than equity tranches in receiving principal and interest payments from the underlying loans. They also have higher interest rates, shorter maturities, lower credit ratings (typically B to NR), and smaller issuance amounts. They are designed for investors who seek high-yield fixed-income investments with high risk exposure.
Equity tranches or classes K through Z (or X ), which have the lowest priority in receiving principal and interest payments from the underlying loans. They also have the highest interest rates, shortest maturities, lowest credit ratings (typically NR), and smallest issuance amounts. They are designed for investors who seek equity-like returns with very high risk exposure. They are also known as the residual or first-loss tranches, as they absorb the first losses from the underlying loans.
The structuring and rating of CMBS securities is based on various factors, such as:
The characteristics and performance of the underlying loans, such as loan size, LTV ratio, DSCR, debt yield, property type, market risk, and historical and projected cash flows
The credit enhancement or protection mechanisms for each tranche, such as subordination, overcollateralization, excess spread, cash reserve accounts, and credit default swaps
The cash flow waterfall or allocation rules for each tranche, such as sequential pay, pro rata pay, controlled amortization, interest-only, principal-only, and turbo features
The prepayment and extension assumptions for each tranche, such as constant prepayment rate (CPR), single monthly mortality (SMM), weighted average life (WAL), yield maintenance, defeasance, and call protection
The stress scenarios and loss assumptions for each tranche, such as default rate, loss severity rate, recovery rate, timing of losses, and loss distribution
The structuring and rating of CMBS securities is done by using various models and tools, such as:
Cash flow models or software, which simulate the expected cash flows from the underlying loans and the CMBS securities under different scenarios and assumptions
Rating agency models or criteria, which assess the credit quality and risk profile of each tranche based on their cash flow characteristics and credit enhancement levels
Relative value models or metrics, which evaluate the attractiveness and profitability of each tranche based on their yield, spread, duration, convexity, and option-adjusted spread
The investment strategies and relative value analysis of different CMBS tranches
The investment strategies and relative value analysis of different CMBS tranches depend on the objectives and preferences of different types of investors. The main types of investors in CMBS are:
Fixed-income investors or bond buyers, who invest in senior or mezzanine tranches of CMBS for their stable income streams and low default risk. They include institutional investors such as insurance companies, pension funds, banks, mutual funds, hedge funds, and asset managers.
Equity investors or property buyers, who invest in junior or equity tranches of CMBS for their potential capital appreciation and high returns. They include real estate investors such as private equity firms, real estate investment trusts (REITs), opportunity funds, and distressed debt funds.
Arbitrage investors or deal makers, who invest in multiple tranches of CMBS or across different CMBS deals for their risk arbitrage opportunities and high returns. They include investment banks, broker-dealers, market makers, and proprietary traders.
The investment strategies and relative value analysis of different CMBS tranches are based on various factors, such as:
The expected cash flows and risks of each tranche, which are influenced by the characteristics and performance of the underlying loans, the structuring and rating of the CMBS securities, and the market conditions and expectations
The pricing and valuation of each tranche, which are determined by the supply and demand of the CMBS market, the benchmark interest rates and credit spreads, and the comparable securities in other asset classes
The trading and liquidity of each tranche, which are affected by the size and diversity of the investor base, the availability and cost of financing and hedging, and the regulatory and reporting requirements
The investment strategies and relative value analysis of different CMBS tranches are done by using various models and tools, such as:
Cash flow models or software, which estimate the expected cash flows and risks of each tranche under different scenarios and assumptions
Pricing models or metrics, which calculate the fair value and yield of each tranche based on their cash flow characteristics and market inputs
Trading models or platforms, which facilitate the execution and settlement of CMBS transactions in the primary or secondary market
The life cycle and administration of CMBS transactions
The life cycle and administration of CMBS transactions involve several stages and activities. The main stages are:
Origination and underwriting, which is the process of originating and underwriting commercial mortgages for CMBS securitization, as described in the previous section
Issuance and distribution, which is the process of issuing and distributing CMBS securities to investors, as described in the previous section
Servicing and reporting, which is the process of servicing and reporting on the performance of the underlying loans and the CMBS securities throughout their life cycle
Resolution and termination, which is the process of resolving delinquent, defaulted, or troubled loans and terminating the CMBS transaction at maturity or earlier
The main activities involved in each stage are:
Stage
Activities
Origination and underwriting
Loan application screening
Loan term sheet or letter of intent issuance
Loan due diligence
Loan commitment letter issuance
Loan funding
Loan transfer to issuer or sponsor
Issuance and distribution
Loan pooling into securitization vehicle
CMBS security structuring and rating
CMBS security marketing and pricing
CMBS security sale to investors
CMBS security issuance documentation
CMBS security settlement
Servicing and reporting
Loan payment collection and distribution
Loan covenant monitoring and enforcement
Loan modification or refinancing
Loan performance and property valuation analysis
CMBS security interest rate and credit risk management
CMBS security cash flow projection and analysis
CMBS security performance and valuation reporting
Resolution and termination
Loan delinquency or default detection and notification
Loan workout or foreclosure
Loan recovery or loss realization
CMBS security principal repayment or write-down
CMBS transaction maturity or defeasance
CMBS transaction termination or dissolution
The main parties involved in each stage are:
Stage
Parties
Origination and underwriting
Borrower
Lender or originator
Issuer or sponsor
Issuance and distribution
Issuer or sponsor
Underwriter or arranger
Credit rating agencies
Investors
Servicing and reporting
Borrower
Servicer or master servicer
Special servicer
Trustee
Investors