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Leveraged Breakdowns

CMBS Basics, Part Two

Commercial Mortgage Backed Securities (CMBS) play a significant role in providing liquidity to the commercial real estate market. In many ways, CMBS issuance is a bellwether for the overall health and liquidity in the commercial real estate market. During the Great Recession, CMBS lending essentially stopped for several years, and the first issuers back into the market were watched closely to gauge the health of the market. As you are searching for your first real estate private equity job, never underestimate the value of a history lesson. Understanding some of the background of these concepts can help you impress your interviewer during a real estate private equity interview.

Key Features of CMBS

CMBS loans are similar to conventional bank loans in many ways, but there are a few key differences. First, CMBS loans are usually non-recourse. Well, sort of. Non-recourse means that there is no person or company providing an unlimited repayment guaranty, which commercial banks and private equity lenders normally do require. CMBS loans do require, however, a guaranty against fraudulent acts, willful misconduct, negligence, etc. This type of guaranty goes by many different names, such as a springing guaranty, carveout guaranty, bad acts guaranty, or a bad boy carveout. The idea is that there is no repayment guaranty as long as there are no bad acts. If there are bad acts involved in the management of the property and repayment of the loan, then the person signing the guaranty is then legally obligated to repay the loan.

The non-recourse nature of CMBS lending is very attractive to borrowers for two reasons: First, the owner doesn’t have personal liability for the debt if something goes wrong; and second, carveout guarantees don’t have to be disclosed to other lenders because they don’t fit the definition of a “contingent liability.”

Another distinguishing feature of CMBS is the term. Most loans in the portfolio will have a 10-year maturity, which is often longer than what most conventional banks prefer. The longer term is attractive to investors because it assures them of a coupon for a longer term, and the borrowers like it because it allows them to lock in their borrowing cost for a longer duration. The downside for borrowers, however, is that the loans carry prepayment language, called defeasance (you can find a detailed explanation of defeasance here).

Changes Since the Great Recession

In the aftermath of the residential mortgage backed securities meltdown in 2008, several changes were implemented with regard to SEC oversight of the CMBS market. The Dodd-Frank Wall Street Reform and Consumer Protection Act (referred to as “Dodd-Frank”) requires (among other things) that firms issuing CMBS must “retain an economic interest in a material portion of the credit risk for any asset that it transfers, sells, or conveys to a third party.” Previously the issuer could package the loans, issue the bonds, and when they were sold, the issuer was out of the deal. Arguably this left the issuer with no incentive to ensure the long-term success of the issuance. Now the issuer must stay in the deal in a meaningful way.

Many REPE firms will use CMBS loans to finance their asset purchases. The non-recourse nature and the longer fixed rate durations fit well with firms’ investment strategy. Your real estate private equity job as an analyst will more than likely require LBO models that incorporate CMBS financing. Knowing a thing or two about the CMBS industry will help you think and talk like an insider, which will help you stand out in a crowded real estate private equity interview process. Good luck, and keep learning!

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