What Borrowers Should Know About CMBS Financing
When it comes to getting a CMBS loan for a commercial property, there’s a lot that potential borrowers need to know. In recent years, CMBS loans have been increasingly popular, due to the fact that they offer fixed-rate, non-recourse financing for a variety of commercial property types. Plus unlike bank or agency loans, CMBS loans, which are also referred to as conduit loans, have relatively low borrower net worth and liquidity requirements, which makes them available to a wide swath of borrowers that otherwise might not qualify for other types of commercial financing.
However, CMBS loans aren’t for everyone. They often have strict requirements in terms of borrower documentation during the life of the loan, and borrowers may risk technical defaults for relatively minor mishaps. That’s why we’ve developed this CMBS primer--- a short, but comprehensive guide to CMBS financing, which should allow any borrower to determine whether pursuing CMBS financing could be beneficial for their individual investment objectives.
Who Qualifies for CMBS Financing?
Unlike agency loans, which are restricted to multifamily properties, CMBS lenders are typically willing to offer financing for almost any type of commercial property, provided that it generates sufficient income and has good financials. This includes traditional apartment buildings, student housing, affordable housing, assisted living and skilled nursing properties, industrial properties, hotels, motels, and resorts, retail assets, office buildings, hospitals, and even more unique property types, such as parking lots or marinas.
When it comes to borrowers, experience is important, but not as important as for other types of commercial real estate loans. Lenders typically want borrowers to have a net worth, excluding their primary residence, of at least 25% of the total loan amount, with about 10% of the loan amount in liquid assets. Lenders generally prefer credit scores of 660-680+, but both net worth and credit score requirements are often negotiable, particularly for highly-profitable properties in good markets.
In the vast majority of cases, properties must not be owner-occupied, though this requirement may occasionally be waived for extremely strong tenants. Properties with ground leases are generally permissible, as long as the life of the lease significantly exceeds the term length of the loan.
What are the Terms for CMBS Loans?
CMBS loans are generally fixed-rate loans with 5, 7, or 10-year terms and amortizations of 25-30 years. Interest-only (I/O) loan options are sometimes available for well-qualified borrowers but typically are provided at lower leverages than non-I/O financing. CMBS financing begins at $2 million, with occasional acceptions, and has no upper limit, with some loans exceeding $1 billion for massive properties or portfolios.
When it comes to leverage, CMBS lenders often provide between 75-80% for the highest-quality assets with qualified borrowers, such as Class-A multifamily properties in major MSAs, such as New York, Los Angeles, or Miami. Riskier property types, such as nursing homes or unflagged hotels, may be provided lower leverage, sometimes around 65%. DSCR requirements are also determined by risk, with high-quality, lower-risk assets required to have 1.25x DSCR, while riskier property types are sometimes required to have up to 1.40-1.50x DSCR.
In some situations, CMBS loans can be combined with mezzanine debt or preferred equity to increase leverage, though this often requires lengthy negotiations with the CMBS lender and the use of an intercreditor agreement to define the rights and responsibilities of each lender. This type of subordinate financing may be ideal for borrowers who are assuming a lower-leverage CMBS loan from an existing borrower upon the purchase of a property. For instance, a borrower assuming a CMBS loan with 55% LTV may be able to acquire mezzanine debt to boost their LTV up to 70-75%, provided they stay within the predetermined DSCR limits.
What are the Pros and Cons of CMBS Loans?
Now that we’ve gone over some of the basics of CMBS financing, it may serve borrowers well for us to address some of the basic pros and cons of CMBS debt.
CMBS Loan Pros:
Low borrower net worth and liquidity requirements
Flexibility in regards to the borrower experience level and credit score
Loans can be provided for a wide array of commercial property types
Loans are non-recourse with standard “bad boy” carve-outs
Loans are fixed-rate with competitive pricing
High leverage allowed, sometimes up to 25%
DSCR requirements are relatively low, often as low as 25%
Loans are generally fully assumable with servicer approval and a small fee
CMBS Loan Cons:
Loan agreements are highly complex, requiring the extensive use of a borrower’s legal counsel
Borrowers are responsible for all lender legal fees, which typically start at $15,000 and may go up to $100,000 for particularly large CMBS loans
CMBS loans are not serviced by the original lender, leading to potential customer service issues
Minor mistakes, such as turning in a quarterly P&L (profit and loss) statement late or losing a major tenant may trigger a technical default
In the case of default, loans will be serviced by a special servicer, who may attempt to immediately repossess the property
Borrowers may not be able to make any significant changes or upgrades to their property during the life of the loan
CMBS vs. Bank Loans
For borrowers with sufficient cash, say, 25%, who want to purchase an income-producing property, a CMBS loan is often significantly easier to get approved for, and will usually offer rates very competitive with bank financing (if not substantially better). In many cases, banks will only offer 5-year loans for commercial properties, and will generally put a lot of emphasis on a borrower’s credit score, net worth, and commercial real estate experience. This is not the case for CMBS financing, where the property itself is the most important factor in the loan approval process.
Unlike banks, which generally keep loans on their balance sheets, CMBS lenders pool their loans together, creating commercial mortgage-backed securities, and selling them to investors on the secondary market. Due to risk retention rules, CMBS lenders do have to keep 5% of each loan on their balance sheet. However, this does not generally change anything for the average borrower.
Unlike borrowers for commercial bank loans, CMBS borrowers will not continue to deal with the same lender that originated their loan during the remainder of its life; instead, they will have to work with a loan servicer, referred to as a master servicer. If a borrower defaults on their loan, they will have to work with another type of servicer, known as a special servicer. This is not always ideal, as a special servicer will generally put the investor’s needs (and their interests) above the needs of the borrower.
CMBS Multifamily Loans vs. Agency and HUD Multifamily Loans
For multifamily borrowers, CMBS loans are also an effective alternative to Freddie Mac and Fannie Mae multifamily loans, especially in situations where borrowers do not have the best credit or the highest net worth. Fannie and Freddie (the “agencies”) are also particular about the fact that they usually want borrowers to have significant multifamily real estate experience.
However, for those who can get them, agency multifamily loans can offer significant benefits, with interest rates even lower than CMBS, supplemental financing options, and even (in some cases) fully-amortizing financing. The same can be said of HUD multifamily loans, in particular, the HUD 223(f) program, which offers LTVs up to 85% for market-rate properties.
Like CMBS loans, both agency multifamily loans and HUD multifamily loans are securitized. However, in many cases, the servicing process for these loans is a little less onerous for borrowers. This is especially the case for agency loans, as many Fannie Mae and Freddie Mac lenders operate as seller/servicers, meaning that they also service the loans they issue to borrowers.
CMBS Deal Structuring and Flexibility
One of the major downsides to CMBS lending is the fact that lenders are often relatively inflexible when it comes to structuring loans. In general, this is because loans that differ from standardized CMBS requirements can make the securitization process a major challenge. In fact, many lenders will sometimes say that CMBS rules prevent them from making changes-- when really they do not. They will often say this in order to avoid needing to register an exemption during the CMBS process, as this could lead to headaches for them down the line.
Therefore, borrowers who are looking to make a CMBS transaction with certain alterations should be sure to read (or have a lawyer or advisor read) the exact rules and agreements under which that lender does business. Some lenders may be more flexible than others, so it can pay to make sure you’re working with a lender who will not have to stretch themselves in order to accommodate relatively minor requests.
CMBS Loan Assumption
One of the benefits of CMBS loans is the fact that they are generally fully assumable for a small fee. This makes it much easier for borrowers to get out of a loan early without paying a prepayment penalty. It can also make it easier for a borrower to sell a property, as the new owner/borrower will not have to go through the entire approval process, including paying expensive legal fees (though they will still need to be approved).
CMBS Can Be A Great Financing Option, But Borrowers Need to Remain Aware
In conclusion, CMBS loans are a great opportunity for many kinds of commercial real estate investors— especially those who wish to acquire or recapitalize properties that simply aren’t suitable for bank financing.
However, CMBS loans are more complex, and have somewhat more risks than a typical commercial bank loan, especially if a borrower anticipates having trouble repaying their loan payments or believes they might need a more flexible loan structure. For these reasons, borrowers should be familiar with all the ins and outs of conduit loans before making a final decision about whether CMBS financing is an appropriate choice for their individual circumstances.