CMBS Offers Longer-Term, Fixed-Rate Loans, While CRE CLOs Offers Shorter-Term, Transitional Financing
CMBS, commercial mortgage-backed securities, and CRE CLOs, collateralized loan obligations, are two forms of securities backed by loans issued to commercial property investors. CMBS and CRE CLOs are similar in some ways, but also have important differences. In general, the main difference is that CMBS are backed by longer-term fixed-rate loans, while CRE CLOs are backed by shorter-term, transitional financing. In this article, we’ll review both CMBS and CRE CLOs and discuss the main similarities and differences between these two types of debt securities.
What are CMBS (Commercial Mortgage-Backed Securities)?
The CMBS market began in the mid-1990s, and reached a height in 2007, with almost $230 billion in CMBS loans issued that year. In 2008, the CMBS market collapsed along with the broader mortgage-backed security (MBS) and real estate market, leading to massive defaults. Only $3 billion in CMBS loans were issued in 2009.
The CMBS lending market has since gradually recovered, reaching more than $45 billion in securitizations in 2021. However, the market has been substantially different since the Dodd-Frank Act of 2010, which imposed some limitations on CMBS lenders, and, most importantly, required lenders to hold onto some of the debt they issued on their own balance sheets, in a process referred to as “risk-retention.”
This was intended to ensure that lenders did profit by creating securities backed by loans likely to default. Overall, this has led to stricter lending standards in terms of leverage (lower LTV ratios), borrower quality (higher net worth requirements), and higher property quality requirements.
Commercial mortgage-backed securities are created by pooling multiple loans to create a security. Loans are generally issued in 5, 7, or 10-year terms. Properties must be fully stabilized, so CMBS debt (with very rare exceptions) is not issued for construction or rehabilitation projects.
The CMBS loans that undergird commercial mortgage-backed securities can be issued for a wide variety of property types, including traditional multifamily, retail, hospitality, office, and senior housing properties, as well as more unique property types, such as parking lots or marinas. Unlike other types of loans, due to the strict securitization rules, properties generally cannot be altered or improved upon during the life of the loan.
In addition, CMBS loans, also referred to as conduit loans, carry heavy prepayment penalties, typically in the form of yield maintenance or defeasance. Defeasance, the most common type of prepayment penalty, requires a commercial real estate borrower to provide substitute collateral (often U.S. Treasury or agency bonds) to replace the income that the bondholder would have lost due to the borrower paying off their loan early.
CMBS are issued in different tranches of bonds, from AAA to BBB, with the highest-rated bondholders getting paid back first, but receiving the lowest interest rate, and the lowest-rated bondholders (referred to as b-piece holders) getting paid back last, but receiving the highest interest rates.
What are CRE CLOs?
CRE CLOs are much newer, having only become popular in the last few years. Unlike CMBS, which securitizes fixed-rate, longer-term commercial real estate loans, CRE CLOs securitize short-term, floating-rate loans for transitional properties. These can include traditional stabilized properties, but can also include properties undergoing rehab, new construction projects in the lease-up period, or properties that may have significant upcoming lease turnovers.
CRE CLOs, unlike CMBS loans, are more tightly managed by lenders (much like construction loans), who can often control loan disbursements for activities such as property rehab. In this way, CMBS loans are more like bank or agency loans, while CLOs are closer to bridge loans. In addition, the CRE CLO securitization process is more flexible, which allows the sponsor or manager of the CLO to actively manage the pool of loans that backs it. Therefore, they can add or remove loans during a specified period in order to increase the performance of the overall bond/debt investment.
In addition, while CMBS loans (except for a small percentage) are generally sold to a third-party investor, CLOs are generally held on the balance sheet of the original lender. This can be beneficial for the borrower, as the CLO lender will generally be servicing the same loan they originated. In the case that financial troubles arise, this makes it much more likely that the borrower and lender/sponsor will be able to reach some type of loan workout or modification.
In contrast, CMBS loans are almost always serviced by a third-party servicer (not the original lender) referred to as a master servicer. Sometimes, this master servicer will delegate the day-to-day servicing responsibilities of the loan to another servicer, referred to as a sub-servicer.
If a borrower defaults (or comes close to defaulting) on their loan, the loan is then assigned to a third type of servicer, a special servicer, which may or may not attempt to try a good faith loan workout. In fact, many special servicers are notorious for attempting to repossess delinquent CMBS financed properties and keeping them on their own balance sheet, which is ideal for neither CMBS borrowers nor the investors.
During the COVID-19 pandemic, CMBS delinquencies soared, while CLO delinquencies did not rise aggressively, so it appears that there is a significant benefit to the hands-on loan management and servicing ability provided to CLO lenders vs. CMBS issuers.
It should also be noted that, unlike CMBS, CLO loans are generally recourse, which means that the lender can attempt to go after the borrower’s personal assets, not just the property itself, should the borrower default on their loan.
CMBS Loan Terms vs. CLO Loan Terms
Below, we display the average terms for both CMBS and CRE CLO loans.
CMBS Loan Terms:
Loan Size: $2 million minimum, no maximum
Loan Term: 5, 7, or 10-years
LTV: 75-80% max.
DSCR: 1.25x minimum
Interest Rate: Competitive, fixed-rate often around 5%
Recourse: Non-recourse with bad-boy carve-outs
CRE CLO Loan Terms:
Loan Size: Varies
Loan Term: 3-year typical loan term
LTV: Varies
DSCR: 1.0x minimum (sometimes lower in special situations)
Interest Rate: Floating rate, often between 5-10%
Recourse: Full-Recourse