Commercial mortgage-backed securities (CMBS) offer investors the opportunity to gain exposure to rental income from a diverse portfolio of commercial properties, while benefiting from varied levels of credit protection through the securitization process. Since its inception in 1994, the U.S.-based asset class has grown significantly, reaching $1 trillion in size.

However, the recent turbulence in the U.S. banking sector has focused attention on this market, as concerns about capital structure have led banks to consider selling off real estate loans. This has understandably made some investors cautious, especially in light of the 2008-09 global financial crisis (GFC) and the stigma surrounding structured products with mortgage-backed collateral.

Despite these concerns, it’s essential to recognize that the majority of CMBS transactions successfully weathered the storm of declining property values during the GFC. Furthermore, subsequent enhancements to deal structures have bolstered investor protection, offering even greater security for those considering this investment avenue.

CMBS pass rental income from a variety of property types to investors. The actual properties serve as collateral to protect investors. In the event of actual losses, where rental income stops, and the value of the underlying properties is insufficient to fully compensate bond holders, lower-rated tranches¹ of a CMBS deal absorb any shortfalls.

A typical loan that backs a CMBS structure is about 70% of the value of the property at the time of the loan. If shortfalls occur in interest payments, the property acting as collateral may end up being sold, but losses to even the most junior tranches start at 30% declines in value of the property. At the AAA level, there is another 30% of loan value (21% of property value, in this example) that absorbs declines in prices. As a result, an AAA-rated CMBS starts out with about 50% credit protection and that generally increases over the life of the securitization.

In terms of structure, CMBS deals generally fit in one of four broad categories:

1)    Conduit deals, in which many properties are used to support the deal. These deals offer both geographic and property-type diversification.

2)    Single-asset/single-borrower (SASB) deals. These deals are backed by one large property, such as a large office building in a major city, or a well-known destination hotel.

3)    Agency multi-family housing deals. Guaranteed by FNMA or FHLMC, these deals are backed by large apartment complexes.

4)    Commercial real estate collateralized loan obligations (CRE CLOs). Similar to conduit deals, these are backed by a basket of commercial properties. These structures are relatively new in the history of the CMBS market but allow a manager some flexibility in determining the underlying collateral.

Credit ratings and actual losses for CMBS issues compare favorably with credit ratings in corporate credit. While investors understandably worry about the potential for rental revenue to dry up as property values fall, most of this risk is typically borne by investors who own the equity parts of a deal, or some of the lower-rated tranches that are most sensitive to any losses. At the AAA level, historic losses are confined to a small loss experienced from pre-crisis.