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Commercial building

A commercial mortgage-backed security (CMBS) is a type of income-generating security that’s backed by commercial real estate mortgages instead of residential property mortgages. These assets can be good investments in one regard, given the steady returns they generate but are somewhat speculative in another, given that the commercial real estate market can often be volatile. However, they are rarely available to retail investors, often being more expensive than products available on the common market. Here’s what you need to know about this type of investment.

What Is a CMBS?

A commercial mortgage-backed security is a debt asset not dissimilar in structure to a mutual fund or an exchange-traded fund.

A CMBS is a pool of debt that has been grouped together into a single bond that makes periodic payments to the bond holders. The goal is to take a group of diverse, individual debts and treat them as one single, overarching loan for the purposes of investment and interest payments.

To create a CMBS, banks take loans that they have issued to commercial borrowers, such as developers looking to build a new apartment or office building, and bundle them together into a single portfolio. The mortgages are typically placed into a trust that manages this portfolio of debt, and the portfolio is then seen from the outside as a single overarching asset. The bank will then sell shares in this portfolio. Investors collect returns based on the principal and interest payments made by the commercial borrowers who make up the underlying portfolio of commercial mortgages.

A commercial mortgage security is sold as a bond because it is a debt instrument, being comprised of underlying debts. However, as noted above, it has a similar structure to the way a fund will invest in equities, by gathering a group of diverse assets together in a single portfolio and then selling shares of that portfolio as a single investment product.

Typically a bank or other lender will write the terms of the underlying commercial mortgages specifically as a CMBS loan. This allows the lender to set terms such as interest and pre-payment options based on the needs of the CMBS portfolio it intends to create. Borrowers are incentivized to accept this as these loans typically offer better interest rates.

Returns on a CMBS

Office buildingBecause a CMBS is seen as a single bond product it has an interest rate and credit rating of its own. These are based on the collection of underlying bonds that make up the CMBS portfolio. Determining credit rating in particular can often be a complex and difficult process, as a single commercial mortgage security will often be made of a wide variety of different mortgages extended to different borrowers.

Investors in a CMBS are paid based on the overall results of the portfolio. A standard security will make regular payments to its note holders based on the loan payments made by the underlying borrowers. The return on a CMBS is determined by interest, rate of payment, any nonpayment on the underlying mortgages and any collections (such as seized and sold properties) on defaulted mortgages.

As with any other debt instrument this creates an element of risk. The rate of payment on a CMBS can fluctuate based on whether the underlying borrowers meet their obligations. Should developers not pay or go bankrupt, the bond’s rate of return will reflect this.

However, at the same time this is also a selling point of this asset. Unlike a typical bond, a CMBS represents a collection of underlying debt. A single default will not ruin the value of the overall portfolio, meaning that risk is spread over a far wider and more diverse pool of borrowers.

As with all debt instruments, the rate of return on a CMBS correlates with this risk. Lenders will generally group their portfolios based on the risk of the underlying assets. Low-risk securities will generally have strong credit ratings and are considered the “high quality” versions of this product, however their rates of return tend to be lower to reflect the lower interest paid by more qualified borrowers. A low quality, high-risk CMBS tends to pay higher rates of return, sometimes considerably higher. This reflects the higher interest rates paid by the underlying borrowers but also the greater risk of nonpayment, sometimes considerably greater.

Haven’t We Seen This Before?

A CMBS is what’s known as a derivative. This means that it’s a product that takes (or “derives”) its value from other underlying assets. It is also a collateralized debt obligation, meaning that it is a group of debts backed by underlying assets, each of which is treated as collateral. Readers would be forgiven if they recognize these terms. A CMBS is very close in structure to the mortgage-backed securities that were behind much of the 2008 financial crisis. Both were bundled securities based on underlying mortgages which paid returns based on the mortgage payments made by the individuals in the portfolio.

The primary difference is that the securities that became infamous in 2008 were based on residential mortgages, while a CMBS is based on commercial mortgages. Basing a security on commercial borrowers tends to make it more secure, as the underlying assets tend to have more value and the borrowers are often (but not always) more likely to pay.

The Bottom Line

A CMBS is one way of investing in real estate. It is a form of bond that is based on a portfolio of underlying commercial mortgages. It pays a rate of return based on the principal and interest payments made by the borrowers in the portfolio.

Tips for Investing

  • A CMBS is a sophisticated product, one typically beyond the reach of most investors. However, if you’re looking for income generation for your portfolio then the best way to start is by consulting with a financial advisor. Finding one doesn’t have to be hard. SmartAsset’s matching tool can help you find a financial advisor in your area, within minutes, to discuss this and any other issues you might have. If you’re ready, get started now.
  • Asset-backed securities are a significant part of the debt-based market. When they work, they can help investors secure a steady stream of income and help borrowers get access to the capital they need. Learn more about them and how they work in our primer on the subject.

Photo credit: ©iStock.com/pastorscott, ©iStock.com/buzbuzzer, ©iStock.com/buzbuzzer

Eric Reed Eric Reed is a freelance journalist who specializes in economics, policy and global issues, with substantial coverage of finance and personal finance. He has contributed to outlets including The Street, CNBC, Glassdoor and Consumer Reports. Eric’s work focuses on the human impact of abstract issues, emphasizing analytical journalism that helps readers more fully understand their world and their money. He has reported from more than a dozen countries, with datelines that include Sao Paolo, Brazil; Phnom Penh, Cambodia; and Athens, Greece. A former attorney, before becoming a journalist Eric worked in securities litigation and white collar criminal defense with a pro bono specialty in human trafficking issues. He graduated from the University of Michigan Law School and can be found any given Saturday in the fall cheering on his Wolverines.
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