The Benefits and Drawbacks of CMBS for Commercial Real Estate Investors
CMBS loans can be a great source of financing for commercial real estate investors. In general, they’re the only type of non-recourse loan that can finance nearly all income-producing property types, including assets such as hotels, self-storage facilities, industrial properties, and much much more. However, CMBS loans aren’t all roses and daisies, as they do come with certain drawbacks that borrowers should be aware of.
Below, we’ll review some of the main pros and cons of CMBS and conduit loans in order to help you better understand if they could be the right option for your commercial property.
The Pros of CMBS and Conduit Loans:
Non-recourse: Most CMBS loans are fully non-recourse, which means that borrowers do not have to sign a personal guarantee (PG). This means that, unless the borrower breaks certain rules, the borrower’s personal property is off-limits in the case of property foreclosure. Therefore, if a property default occurs, the special servicer is only permitted to try to repossess and sell the property to make the CMBS investors whole, and cannot attempt to repossess a borrower’s personal possessions, like homes, vehicles, or other investments.
Fully assumable: Most CMBS loans are fully assumable with servicer approval and a small fee. This may make it easier for a current CMBS borrower to sell their property, particularly if there is still a lot of leverage left on the loan and the loan’s interest rate is equal to or lower than the current interest rates. Even more importantly, it prevents the existing borrower from needing to pay prepayment penalties. For the assuming borrower, taking on the loan can speed up the closing process and eliminate tens of thousands of dollars in legal fees.
Low, fixed-rate terms up to 10-years: CMBS loans offer some of the lowest fixed-rate terms in the industry, often lower than comparable bank loans. Many banks may only offer 5-year loans, which also gives CMBS loans an advantage.
Amortizations up to 30-years: Longer amortizations increase DSCR, as well as generally increase a property’s ROI and IRR, by reducing a property’s monthly debt service. Most banks only offer amortizations of up to 25 years, so 30-year amortizations can be a welcome relief for borrowers.
Available for a wide array of property types: If you’re a well-heeled borrower looking to purchase or refinance a stabilized apartment building, you have a gamut of inexpensive, fixed-rate non-recourse options, including agency loans from Fannie Mae and Freddie Mac, as well as potentially HUD multifamily loans. However, for most office, retail, hospitality, industrial, and self-storage borrowers, debt options are limited to banks and private lenders, which typically offer shorter-term, full-recourse loan options. CMBS, therefore, is often the least expensive non-recourse loan option available.
Flexible in regards to net worth and credit score: Many banks, as well as agencies, require a borrower to have a net worth of at least 100% of the loan amount, as well as a high degree of liquidity. CMBS lenders, in contrast, typically require a net worth of only 25% of the loan amount, with 5-10% liquidity.
Can finance portfolios in addition to single properties: CMBS portfolio loans can be an ideal way to finance multiple properties at once. In some situations, lenders may allow property’s with lower occupancy and lower DSCR than typically required, provided that the portfolio’s overall occupancy rate and DSCR are within optimal ranges.
The Cons of CMBS and Conduit Loans:
High legal fees: When it comes to closing on CMBS debt, lender legal fees can be quite expensive. Lender legal costs generally start at $10,000 for loans of $2 million and above, often rise to $15,000-$20,000 for loans $10 million and above, and can spike to $100,000 plus for the largest CMBS loans.
Servicers can be hard to work with: Unlike banks and many other lenders, which often service loans themselves, CMBS loans are serviced by separate servicers, known as master servicers. Sometimes, a master servicer will assign the CMBS loan to another servicer, known as a primary servicer or sub-servicer. Since the servicer does not carry the loan on their balance sheet, their interests are generally not aligned with that of the borrower, and legally, their only responsibility is to protect the investors in the commercial mortgage-backed securities that the borrower’s loan collateralizes.
Special servicers can be even harder to work with: If a CMBS borrower defaults on their loan, the loan will be serviced by a new servicer, known as a special servicer. These servicers have a reputation of being particularly difficult to work with, and, while they may sometimes offer a borrower a loan workout or modification, in other situations, their first step may be to attempt to repossess the property outright. Worse, some special servicers opt for repossession so they can hold onto the property in their own portfolio and profit from a borrower’s losses.
Loans may easily go into technical default: Unlike other kinds of loans, CMBS loans can go into default for reasons other than simply missing a mortgage payment. For example, failing to send in a quarterly profit and loss (P&L) report to a servicer, losing a major tenant, or even making unapproved upgrades to a property could lead a borrower to default on their loan. That can lead to unpleasant interactions with a special servicer, such as the ones we’ve mentioned above.
Borrowers may not be able to make changes to their property: Due to the strict loan covenants that are often contained within a CMBS loan’s pooling and servicing agreement (PSA), a borrower is often not allowed to make changes to their property during the life of the loan, even if these are value-add changes which would increase a project’s profitability and reduce the default risk. In fact, as we mentioned above, making unapproved upgrades could even cause a CMBS loan to go into technical default.
Prepayment can be time-consuming and expensive: Unlike many bank and agency loans, which offer relatively inexpensive step-down or soft-step-down percentage-based prepayment penalties, CMBS borrowers are generally required to choose between yield maintenance and defeasance. Defeasance involves replacing the collateral of the loan with equivalent income-producing bonds, such as U.S. Treasuries, or sometimes, agency bonds from Fannie Mae, Freddie Mac, or Ginnie Mae. This can be quite expensive and usually requires the help of a group of specialized consultants, including attorneys, accountants, and broker-dealers. Yield maintenance, in contrast, requires full prepayment of the loan’s UPB (unpaid principal balance), in addition to a lump sum repayment of all the interest income the CMBS investors would have received if the borrower had not pre-paid their loan. This can be quite expensive as well.