Commercial Mortgage-Backed Securities (CMBS)

Commercial mortgage-backed securities (CMBS) are secured by mortgages on commercial properties rather than residential real estate. They're effectively the backbone of commercial property financing. A CMBS can provide liquidity to real estate investors and commercial lenders alike.

CMBS aren't standardized, so there are a lot of details associated with them that can make their valuation difficult. But CMBS provide a lower degree of prepayment risk when compared to a residential mortgage-backed security (RMBS) because commercial mortgages are most often set for a fixed term.

CMBS take the form of bonds. Commercial mortgage loans act as the collateral, with principal and interest passed on to investors. The loans are typically contained within a trust, and they're highly diversified in term, property type, and amount. The underlying loans that are securitized into CMBS include those for properties such as apartment buildings and complexes, factories, hotels, office buildings, office parks, and shopping malls, often within the same trust.

CMBS require a wide range of market participants, including investors, a primary servicer, a master servicer, a special servicer, a directing certificate holder, trustees, and rating agencies. Each of these market participants has a different role to ensure that the CMBS perform properly.

CMBS are bucketed into various tranches or blocks of assets. CMBS generally have three or four tranches, even though they're customized. Tranches are typically ranked from senior–or highest quality—to lower quality.

The highest quality tranches will receive both interest and principal payments and have the lowest associated risk. The securities are structured so the tranches take on more risk and are designed to absorb most of the potential losses that can occur as the tranches go down in rank.

The lowest tranche in a CMBS structure will contain the riskiest loans of the portfolio and possibly speculative loans. This securitization process is important for both banks and investors. It allows banks to issue more loans in total, and it gives investors easy access to commercial real estate while giving them more yield than traditional government bonds.

Typically, only very wealthy investors invest in CMBS because there aren't many options here for the average investor. It's difficult to find mutual funds or exchange-traded funds that solely invest in the asset class, although many real estate mutual funds invest a portion of their portfolio into CMBS.

As of December 2016, the SEC and FINRA have introduced new regulations that mitigate some of the risk of these securities by creating margin requirements for covered agency transactions, including collateralized mortgage obligations.