Differences Between Commercial Mortgage-Backed Securities and Residential Mortgage-Backed Securities

David Cohn
Apr 13, 2023

Investors have two options for investing in mortgage-backed securities (MBS): commercial mortgage-backed securities (CMBS) and residential mortgage-backed securities (RMBS). These MBS types are created when a group of mortgages is securitized and sold to investors as bonds.

The critical distinction between CMBS and RMBS is that loans on commercial properties support CMBS, whereas loans on residential properties support RMBS. More specifically, RMBS can be secured by various residential loans products such as home equity loans and FHA loans.

In contrast, CMBS can only be supported by loans on commercial properties that generate income. These properties can include retail centers, hotels, office buildings, warehouses, and apartment buildings. In addition, although less common, CMBS loans can also be granted to other income-generating assets such as parking garages and marinas.

Before proceeding, you may wonder: Which is "better"? CMBS or RMBS? There is no clear-cut answer to this question. Some investors may favor CMBS for their higher yields and relative immunity to interest rate fluctuations, while others may prefer RMBS for the perceived stability of residential properties.

The choice of which type of MBS to invest in will depend on each investor's investment goals and risk tolerance. Let's examine the differences between CMBS and RMBS and explore the benefits of CMBS loans for both lenders and borrowers.

Understanding residential mortgage-backed securities

As mentioned, RMBS is secured by loans on residential properties like single-family homes, townhomes, and condominiums. Government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac, generally issue these securities.

To form RMBS, a GSE purchases home mortgages from loan originators like banks or other financial organizations. The GSE then bundles the loans into securities sold to investors as bonds. These bonds are typically issued in tranches or segments, each with a different level of risk.

For example, the equity tranche (the riskiest tranche) has the highest yield, while the AAA tranche (the least risky tranche) has the lowest yield.

As you can see, the process is similar to CMBS creation, but the main difference is that RMBS are backed by loans on residential properties, whereas loans on commercial properties back CMBS.

RMBS are considered a safe investment since the underlying loans are made to creditworthy borrowers. However, there are some risks involved that investors should be aware of.

  • One of the risks is interest rate risk, which is the possibility of interest rate changes impacting the value of the RMBS. For example, if interest rates rise, the value of the RMBS may decline as the present value of the cash flows Conversely, if interest rates fall, the value of the RMBS may increase as the current value of the cash flows increases.
  • Another risk is prepayment risk, the risk that borrowers will prepay their loans, reducing the expected cash flows to investors. For example, refinancing, home sales, or other factors can cause prepayments. When borrowers prepay their loans, investors lose the interest they would have received for the remaining loan term.
  • Finally, there is the risk of default, which is the risk that borrowers will default on their loans, resulting in investors' losses. Defaults can occur for various reasons, such as economic downturns or changes in the borrower's financial situation. When a borrower defaults, the investor may receive a partial amount of principal and interest owed, leading to a loss on the investment.

Because there is a lot of uncertainty in the economy, it's even more critical for investors to consider these risks when investing in RMBS and to diversify their investments to manage risk. Additionally, investors should carefully analyze the underlying loans' credit quality and the securities' structure to understand the potential risks and rewards of RMBS investing.

Understanding commercial mortgage-backed securities

Conduit lenders, SPVs that securitize commercial mortgages, usually issue CMBS. They purchase a portfolio of commercial mortgages from banks or other financial institutions, bundle them into securities, and sell them to investors as bonds. These bonds are divided into tranches with varying risk levels.

The equity tranche is the riskiest and has the highest yield, while the AAA tranche is the least risky and has the lowest yield.

CMBS are regarded as secure investments because the loans that support the securities are generally given to creditworthy and prominent borrowers. Nevertheless, there are still risks involved.

  • Interest rate risk refers to the possibility that changes in interest rates can affect the value of the CMBS. For example, when interest rates rise, the value of the CMBS may decline. On the other hand, if interest rates drop, the value of the CMBS may increase.
  • Prepayment risk is another potential threat that investors should be aware of. This risk refers to the possibility that borrowers will repay their loans ahead of schedule, which can affect the cash flow of the CMBS. For example, if many borrowers decide to prepay their loans, investors may not receive the expected returns from their investments. Additionally, prepayment risk can affect the price of the CMBS.
  • Default risk refers to the possibility that borrowers default on their loans, leading to investor losses. If a borrower defaults, investors may lose some or all of their investment. The risk of default is typically higher for lower-rated tranches of CMBS, which offer higher returns but carry greater risk.

Consider these when making investment decisions, and consider diversifying your portfolio to mitigate them.

Understanding CMBS loans

CMBS loans (conduit loans) have recently become a popular choice for commercial real estate financing. These loans are combined with similar loans and converted into bonds that can be sold to investors on the secondary market. CMBS loans are popular due to their relaxed credit requirements. They generally have fixed-rate terms of 5, 7, or 10 years.

  • These loans offer several advantages, such as flexible underwriting guidelines, fixed-rate financing, full assumably, and the potential for higher investment yields for both lenders and bondholders.
  • Furthermore, CMBS loans offer relatively high leverage—typically up to 75% for most property types and sometimes up to 80% in specific scenarios. CMBS loans also have competitive interest rates that are more favorable than comparable bank loans.
  • Another good thing about CMBS loans is that they allow cash-out refinancing, which benefits businesses that want to extract equity from their commercial properties to fund renovations or expand their core business. They also enable investors to choose which tranche to purchase, allowing them to work within their risk profiles.
  • Moreover, they are available to many borrowers, including those who may not qualify for traditional loans due to poor credit, previous bankruptcies, or strict collateral requirements. Moreover, CMBS loans are non-recourse, which means that in case of default, the lender cannot seize the borrower's personal property to pay off the debt.
  • Lastly, CMBS loans are assumable, making it easier for a borrower to transfer ownership of the property before the end of their loan term.

These features make CMBS loans an attractive option for investors seeking higher yields with flexible underwriting guidelines and a broad range of potential borrowers.

CMBS loans can fund various commercial real estates properties, such as retail, office, and mixed-use properties. Among these, retail properties are the most popular choice for CMBS lenders because they generally have well-established, long-term anchor tenants and are managed by professional organizations.

Office assets are also commonly financed by CMBS loans and can be used to acquire, refinance, or extract equity from Class A and Class B office properties.

In recent years, mixed-use properties have become increasingly popular among CMBS lenders, as these properties offer diverse tenants and potential revenue streams.

CMBS loans can be used to finance anything from small apartment buildings with a few commercial tenants to large complexes that include living spaces and a variety of commercial establishments, such as retail stores, restaurants, or entertainment businesses.

When considering whether to approve a CMBS loan, lenders generally evaluate two primary metrics: DSCR and LTV. They also examine debt yield, which measures how long it would take for the lender to recover losses if the property was foreclosed.

Although CMBS loans mainly focus on income, lenders typically require a borrower to have a net worth of at least 25% of the entire loan amount and liquidity of at least 5% of the loan amount. The underwriting process is the most time-consuming part of CMBS origination.

The method evaluates a borrower's credit risk by requiring third-party reports such as appraisals and environmental assessments, checking credit history, net worth, and commercial real estate experience.

While CMBS loans have less strict requirements for credit, net worth, and experience compared to bank or agency loans, it's still helpful for borrowers to have good credit and commercial real estate experience.