The following article is reprinted from the May/June, 1999 issue of
On the Edge, the Interactive Data Fixed Income Analytics bimonthly newsletter.
Back-to-Basics: Commercial Mortgage-Backed Securities (CMBS)
Teri Geske
Senior Vice President, Product Development
In March of this year, Interactive Data Fixed Income Analytics initiated
coverage of commercial mortgage-backed securities (CMBS) in the BondEdge database. As the
CMBS market has grown, liquidity has improved (despite severe disruptions experienced
during last Fall's "flight to quality") and information on these securities has
become more readily available, allowing Interactive Data Fixed Income Analytics to obtain the data required to
reverse-engineer these deals. We released approximately two dozen CMBS deals in March,
with another 35-40 deals slated for release in April; we plan to cover the bulk of public,
(non-privately placed) investment grade issuance by late Spring. Since this asset class
has become increasingly important to many of our clients, we thought it might be useful to
review the basics of the CMBS market for those who may just be getting acquainted with
this market.
Background
CMBS have been around since the early 1990s when the RTC issued securities backed by
commercial mortgage loans from assets of failed savings and loan institutions. When the
RTC's efforts were completed, Wall Street began to structure CMBS deals with new
commercial mortgage loans that were originated with the aim of being securitized. These
are called "conduit transactions", where the conduit exists to provide a source
of capital to commercial real estate borrowers (compared to deals backed by seasoned
mortgages held by insurance companies who securitize a portion of their loan portfolios
for balance sheet management purposes). The vast majority of CMBS issuance today is
comprised of conduit transactions. As different conduits accumulated mortgages of varying
criteria with respect to property types and loan size, the logical next step was to create
deals involving two or more conduits, called "joint securitization," which
increases the size of the deal and offers the benefit of more diversification in the loan
pool.
Most CMBS deals are structured with a "senior/subordinate" form of credit
enhancement, where defaults (net of recoveries) on the underlying loans are absorbed by
the investors in the subordinate and mezzanine classes to protect the senior (AAA-rated)
classes. There is also typically an IO security associated with CMBS deals, created from
the difference between the coupon paid to the investors and the average loan rate on the
underlying mortgages. The IO may be "stripped" from the highest-rated class or
from a combination of classes. IOs from a CMBS deal are qualitatively different than IOs
backed by pools of single family mortgages, due to the different prepayment and default
risks of the two types of collateral.
Call Protection
One of the most critical aspects of the CMBS market is the call protection offered in a
deal, as they affect the likelihood of prepayments. Most deals are structured with a
"lock-out," a period of time during which the borrower is not permitted to
prepay the mortgage. The lock-out may extend for as little as two years, or for more than
five years, depending upon the final maturity of the loan and other factors. In addition
to a lock-out provision, CMBS deals are typically structured with either a declining
prepayment penalty (similar to the call premium on a corporate bond's call schedule), or a
Yield Maintenance clause which requires the borrower to provide compensation to the
original lender if the borrower chooses to refinance. The Yield Maintenance is often
expressed as a spread to a designated benchmark Treasury rate at the time of prepayment.
Although the yield maintenance requirement increases the cost of refinancing, the borrower
may choose to incur the additional cost and refinance, depending upon the market value of
the property.
CMBS Terminology
In analyzing a CMBS deal, investors may come across some unfamiliar terminology. The Debt
Service Coverage Ratio (DSCR) indicates how easily the mortgage payment is met by the
property's Net Cash Flow (NCF) or Net Operating Income (NOI). The coverage ratio is
computed by dividing the NOI or NCF by the annual mortgage payment. In addition to the
original or current loan-to-value (LTV) ratio, CMBS investors also consider the LTV at
Balloon. Most commercial mortgages are structured with a balloon payment at maturity (some
may have little amortization of principal prior to the balloon date), and the LTV at
Balloon is an indication of the borrower's ability to refinance the loan when the balloon
payment is due. CMBS investors also look at the occupancy rate and tenant lease rollover
schedule to help determine the certainty of cash flows from the underlying properties.
Agency Deals (Multi-family)
In addition to deals structured by private conduits, there are Agency CMBS deals
underwritten by Fannie Mae and Freddie Mac. These deals are backed by multi-family housing
loans, compared to retail centers, office buildings and other types of commercial
properties found in non-agency CMBS deals. Fannie Mae has securitized multi-family housing
loans purchased under its Alternative Credit Enhancement Structures (ACESŪ) and Delegated
Underwriting and Servicing (DUSŪ) programs. Freddie Mac has a Multi-Family Gold PC
program where it purchases multi-family housing loans. While there are some similarities
between these agency deals and the non-agency CMBS market, there are important differences
(which are beyond the scope of this article). Interactive Data Fixed Income Analytics will be modeling Agency deals, subject
to demand and availability of data.
We hope this brief review of CMBS has been useful. If you have any comments about this
article, please feel free to contact marketing at fia.marketing@interactivedata.com.
