What Are CMBS Loans – Conduit Loans?
For the Commercial real estate investor that is looking for a large commercial loan, you may be asking- What are CMBS Loans? and What are Conduit Loans? A CMBS loan is one of the most common investment options; they’re also referred to as conduit loans. They give commercial real estate (CRE) investors a chance to fund commercial properties of all sorts. Although these loans have been around for some time now, a majority of investors still don’t understand what these conduit loans are and the way they work. When dealing with small banks, this is usually an issue since most of them don’t offer CMBS loans.
At Neal Business Funding, we provide information on a wide range of topics concerning CRE borrowers, including sponsors, investors, and developers. In this article, we’ll take a closer look at how CRE borrowers can select CMBS/Conduit loans to fund CRE projects. In contrary to traditional commercial mortgage, conduit loans are usually packaged and sold to interested investors on another market; this process is called securitization. For this reason, these loans act differently compared to a standard commercial real estate loan.
Exactly What Are CMBS Loans?
A CMBS loan is a CRE type of loan that is usually secured by a commercial property’s first position mortgage. Conduit loans are an excellent option for CRE investors and are generally packaged, pooled, and sold by a syndicate of banks, commercial banks, investment banks, and conduit lenders (like us). These loans are kept in a separate trust to act as insurance for a mortgage-backed security. They’re often more preferred than traditional commercial mortgage loans by borrowers who are interested in higher leverage with reduced fixed rates; this is because they seem to be a good deal with minimal risk.
CMBS loans are typically non-recourse with basic bad-boy carve-outs. A majority of these loans consist of a fixed interest rate that’s amortized more than a 25-30-year period. Some, however, offer as low as a 10-year amortization. More often than not, a balloon payment is needed at the end of the term.
Who Needs Conduit/CMBS Loans?
Conduit/CMBS Loans are accessible for income-producing properties such as office buildings, retail properties, industrial buildings, hotels, self-storage facilities, and multifamily properties. Any company out there looking to invest in CRE projects can apply and should consider CMBS loans as a choice for their finance.
How Conduit/CMBS Loans Work
CMBS loans are well-known for their great benefit in their flexible and convenient underwriting guidelines. Unlike traditional loans, conduit loans are readily accessible for new CRE investors and don’t include high scrutiny or restrictions. For those investors who are unable to meet the harsh conventional liquidity and probable net worth minimums, they can opt for a conduit loan and receive the financing they require without all the risks; quite often with better rates and terms.
Commercial lenders have significantly increased due to the ease with which investors can receive finance through conduit loans. What makes CMBS loans even more appealing is their low fixed interest rates. For a significant return on investment without having to go through the scrutiny that comes with traditional loans, most CRE investors are considering CMBS loans for the recapitalization of existing investments or their next venture.
CMBS Loan Underwriting Parameters
Conduit loans are common with most CRE investors due to their forgiving underwriting parameters. Most CRE investors can receive these CMBS loans even if they don’t satisfy the typical demands requested by a local savings bank. There are two underwriting parameters governing conduit loans: the loan to value ratio (LTV) and the debt service coverage ratio (DSCR). The DSCR is the ratio of the total operating income to the gross annual debt. It’s usually determined solely by the specific lender and differs based on the level of risk connected with the property. For instance, offices are generally viewed as less risky compared to land investments by most CMBS lenders.
On the other hand, LTV is the ratio of the net sum of money borrowed to the commercial property’s value. The loan’s value is determined by an independent third-party appraisal company and the lender. LTV guidelines depend on the lender’s amount of risk; the lower the risk, the higher the LTV.
The REMIC Connection
The legal framework of securitized conduit loan pools is explicitly a real estate mortgage investment conduit (REMIC). So what makes a CRE loan a conduit loan is that it strictly follows the REMIC tax rules for pass-through entities. REMIC pass-through entities are generally trusts that don’t pay income taxes. Instead, they pass taxes, expenses, and income, through to interested investors who purchase conduit loans. The investors price these loans depending on the pass-through taxation of the particular pooled conduit loans. As a result, CMBS loans must adhere to REMIC regulations.
Pros of CMBS Loans
CMBS/Conduit loans usually have lower interest rates in comparison to traditional commercial mortgages, and a majority of them have fixed interest rates. Generally, the interest rate will depend on a U.S. Treasury rate with a margin. The margin will be affected by the strength of your business, the value of the property you intend to buy, and your creditworthiness.
Another thing that is appealing about this type of loans is that many are non-recourse and assumable. When a loan is said to be “non-recourse,” it implies that a borrower isn’t personally accountable for the repayment of the loan. It also means that there will be no need for you to make a personal guarantee after you take out the loan. The major exception to this is what is called “bad-boy carve-outs.” It implies that in case you deliberately cause harm to the conduit lender, property, or investors, you could end up being personally liable.
What’s more, most of these loans are entirely assumable. In case you plan to sell the property, whoever you sell to can take over the loan for you, freeing you from any kind of obligation on loan. Some conduit lenders, however, charge a certain fee for authorizing the loan to be assumed by some other borrower. Loan assumption usually occurs when the property loan has a below-market interest rate since it assists the buyer in saving money on funding the property.
One disadvantage with CMBS loans is that borrowers usually have less flexibility in bargaining loan terms. The reason behind this is that the trust managing the securitization of the loans must adhere to certain tax laws. Another drawback, after signing the necessary loan documents, borrowers have minimal recourse to alter features or terms of the loan, unless the specific loan is in default. All borrowers should keenly consider any future funding requirements or requirements for the property they’re buying before they can think about taking out a conduit loan.
CMBS Loans vs. Traditional Commercial Mortgages
Since these loans are usually pooled together and then sold to investors, they tend to behave a bit differently in comparison to a traditional commercial real estate loan. The key differences that every single borrower should understand are how prepayment of the loan works and the specific parties that will be associated in managing that loan.
When it comes to a traditional commercial mortgage, the cost of a prepayment penalty is often computed as a percentage of the interest lost. For instance, the prepayment penalty on an SBA 504 loan is equal to the entire annual interest, if you choose to prepay in the first year. For the following year, the expected prepayment penalty will be approximately 90% of the annual interest. Therefore, if the annual interest received in the second year of that loan is $10,000, then the prepayment penalty of that loan would be $9,000. On a CMBS loan, however, the prepayment is usually done through either yield maintenance or defeasance.
Once you receive a mortgage, the property’s lien will be released after the mortgage is repaid. In case you wish to pay off your particular mortgage as soon as possible, you’ll bring upon yourself a prepayment penalty. Since conduit loans are typically packaged and sold to interested investors, prepayment isn’t always a choice. Some conduit lenders, instead, request borrowers to follow a process called defeasance to release the property’s lien. Once you defease a certain loan, you will require to put up new security to replace the property. Although it isn’t technically prepayment, defeasance is a technique that allows borrowers to release their property from the particular outstanding lien. For such a case, bonds are almost always the new collateral.
After you defease your loan, it will remain outstanding. However, the property will be freed from the owner, and borrowers can then either refinance or sell the property. The new collateral that is in bonds will require to generate sufficient interest to cater for all future loan payments; or else, you might have to incur a penalty. In general, you can’t defease a CMBS loan for the first two years of that loan.
Generally, yield maintenance is a type of prepayment penalty that a conduit lender will request if the borrower wishes to pay off his or her loan early, or wants to refinance the loan for a significantly reduced interest rate. Once a borrower prepays a certain loan, the conduit lender will cut all the future interest payments. More often than not, lenders request prepayment penalties to recover some of the lost interest and to discourage borrowers from refinancing or prepaying a loan.
The main objective of yield maintenance is to allow the investors to earn their initial yield, the interest you were incurring on loan. Yield maintenance also focuses on enabling the conduit lender to reinvest the cash returned from the borrower, with an additional penalty payment, into bonds or some other investments and to acquire the same cash flow like the loan had not been paid off early.
The conduit lender will then determine how much extra money they require from the borrower to recoup the gap. The actual calculation takes the remaining loan payments’ present value and multiplies the exact number by the difference between the interest rate of the loan and comparable U.S. Treasury bonds’ interest rate. The resulting number will be the amount incurred as a prepayment penalty. More often than not, prepayment penalties can be very high. Since the lender is assured of receiving the whole loan interest, you can typically receive a better loan interest rate with yield maintenance.
Since a CMBS loan is usually pooled with other loans, kept into a trust and sold to interested investors, there will be some change in the loan servicing and administration. After your loan has been securitized, there will be no more need for you to work directly with a conduit lender. As an alternative, the loan will be placed in a REMIC trust, and you’ll have to deal with a commercial mortgage servicer, often known as a “Master Servicer.” Based on what happens to the loan, there are other trust players that you might interact with.
– Master Servicer – If you’re a borrower, a Master Servicer is a person who you’ll make payments to. Basically a commercial mortgage servicer, the Master Servicer manages all the routine servicing of the loan. Apart from collecting payments, this involves managing any escrow accounts, reviewing requests from various borrowers, inspecting the property, and coming up with financial statements for those loans. At other times, a Master Servicer might subcontract these duties to either a Primary or Sub Servicer.
– Special Servicer – In case you fail or stop making payments on your specific loan and it gets into default, a Special Servicer will be given this job. The Special Servicer can work together with you to alter or modify the loan to achieve the investors’ best interest. That may include foreclosing on the property, forgiving or deferring fees or interest, changing loan terms, assumption of the loan, or permitting the substitution of collateral. In case the loan is issued to a Special Servicer, it will be necessary to perform an appraisal, usually done at the expense of the borrower.
Even though there are other trust players, they’re not parties that you will generally engage with as a borrower. Every single responsibility and role will be put down in a Pooling and Service Agreement (PSA) that are usually signed during the formation of REMIC trust. Since each PSA will be distinct, there is much of standardization across them because of the tax laws regulating the trust. That means that you have less room left to bargain the terms of your loan, particularly when set side by side to a traditional real estate loan. A few examples of restrictions that might be in your loan agreement are outlined below:
– Secondary funding on the property might be prohibited
– You might not be permitted to defease the loan before the first two years are over
– Generally, your business requires to be a single-purpose body that’s bankruptcy-remote
– A majority of loans include a “lock-out period” during which you aren’t permitted to make any prepayments
Commercial mortgage-backed security loans provide both significantly low-interest rates, as well as lax underwriting parameters to commercial real estate investors. What’s more, they are also an attractive choice since they are both non-recourse and wholly assumable.
It’s prudent that borrowers think very keenly about their financing requirements and the requirements of the property during the loan’s life before agreeing to a CMBS loan. Any kind of feature or flexibility you require must be clearly shown in the loan documents. After the signing of documents and the formation of trust, you will not be in a position to make any considerable changes to the loan terms, only if the loan is in default. Neal Business Funding provides real-time access to comprehensive property information that lenders, business owners, and commercial real estate experts require in today’s competitive marketplace.