Commercial mortgage-backed securities (CMBS) are backed by a pool of commercial mortgage loans on income-producing property. Important features of a CMBS are as follows:
Debt service = annual interest payment and principal repayment
Net operating income = rental income – cash operating expenses – a non-cash replacement reserve
If DSC > 1.0, then cash flows from property are sufficient to service debt.
How to interpret DSC and LTV ratios:
The role of a credit-rating agency in the CMBS market is to give an opinion on the credit-quality of the bond and provide any enhancement to achieve a desired credit rating. For example, if specific DSC and LTV ratios are needed and those ratios cannot be met at the loan level, then subordination is used to achieve the desired credit rating.
Interest and principal repayments in a CMBS are structured as follows:
Characteristics of a CMBS Structure
In this section, we look at two important characteristics of a CMBS structure: call protection and balloon risk.
RMBS investors are exposed to prepayment risk since the borrowers have a right to prepay and are not penalized for prepayment; they have an incentive to prepay. CMBS has considerable call protection, which is protection against early prepayment of mortgage principal. The call protection comes in two forms: at the structure level and at the loan level.
Call protection at the structural level:
Call protection at the structural level comes by structuring CMBS into sequential-pay tranches, by credit rating. A lower-rated tranche cannot be paid off until the higher-rated tranches are retired. But, in the case of a default, the losses must be charged to the lowest-rated tranche first and last to the highest-rated tranche.
Call protection at the loan level:
There are four mechanisms that offer investors call protection at the loan level:
Residential mortgages are fully-amortizing loans that are fully amortized over a long period of time. Usually, there is no principal outstanding after the last mortgage payment. But, many commercial loans backing CMBS transactions are balloon loans which require a substantial principal payment on the final maturity date. If the borrower is not able to make the lump sum payment, he may ask for an extension of the loan over a period of time called the “workout period”.
Balloon risk is a type of extension risk. The risk that a borrower will not be able to make the balloon payment either because the borrower cannot arrange for refinancing or cannot sell the property to generate sufficient funds to pay off the balloon balance is called “balloon risk”.