When learning about commercial loans, there are two main types investors should be familiar with: portfolio loans and CMBS loans. A portfolio loan is a mortgage loan that is retained by the original lender for the life of the loan, as opposed to being sold on a secondary market. A commercial mortgage backed security (CMBS) loan is a mortgage loan that is pooled together with other loans and transferred to a trust. Investors are able to purchase bonds from the trust that vary in yield and payment duration according to the risk taken on by the investor.
CMBS loans are attractive to investors because there is less risk of pre-payment compared to other mortgage investments. This is because commercial mortgages generally have fixed-term loans. These loans also offer flexibility of risk and reward for the investors, as they can chose the bonds based on the yield they want to receive. Investors receive a return on their investment each month when the interest received from all the pooled loans is broken down and paid out to each individual investor. The investors with the highest-rated bonds are paid first, and then the next-highest, and so-on. This method of payment is referred to as the “waterfall.”
There is a risk with commercial mortgage-backed securities, just like with any investment. Investors who chose the higher-risk bonds can benefit the most, as long as the borrower doesn’t default on their loan. However, when borrowers default, investors incur a loss. With lower-risk bonds the investor absorbs only the interest payments, and not the principal. This translates to a lower rate of return, but less risk for loss.
CMBS loans are attractive to borrowers because they are often available at lower rates than a traditional commercial loan. However, these loans do carry a high pre-payment penalty and have less flexibility for borrowers in paying off the loan. CMBS financing is beneficial to the mortgage industry as a whole, because it increases the available income to everyone involved. This is due to the structure of the security, where the bonds backed by the loans can be worth more than the sum of the loans themselves.
CMBS loans offer benefits to the lending institution, the borrower, and the investor. They allow investors to take calculated risks with a higher pay-off than government bonds and a lower risk than real estate investment trusts. They allow lenders to offer more loans by passing the cost on to investors, thus increasing the amount of funding available. Finally, they help borrowers by giving them easier and more affordable access to funds.