How CMBS Loan Origination Works
CMBS loan origination occurs when a lender processes a potential borrowers’ loan application and determines whether they will be approved for a loan. This generally involves credit checks, background checks, a financial analysis of the subject property, and the reviewing of third-party reports, like the property appraisal and a phase 1 environmental inspection (ESA). Sometimes, this will involve the use of a commercial mortgage broker, which intermediates between the borrower and the lender in order to help facilitate the approval process and obtain optimal terms for the borrower.
If a borrower is approved, the second part of the origination process involves transferring the loan into a REMIC (real estate mortgage investment conduit), a special purpose vehicle (SPV) used to pool the loan with other loans to create a commercial mortgage-backed security, which is then sold to investors on the secondary market.
These mortgage pools are generally broken up into tranches based on credit risk, with the highest-ranked CMBS tranches (AAA-Aaa) providing the lowest risk and lowest percentage return for bondholders, and the lowest-ranked tranches (BB+/Ba1-B-/B3) providing the highest risk and highest percentage returns for bondholders. The lower-ranked tranches are not considered “investment grade” securities, and, these bondholders must wait until the investors in the higher tranches have been fully repaid before getting compensation.
CMBS Origination Begins With Underwriting
The main players in the CMBS origination process are underwriters, who will analyze the loan for its potential credit risk and determine the terms at which the loan may be offered to the borrower. This involves:
A review of the property financials, including cash-flow, vacancy/occupancy rates, and current tenant leases, with a focus on the credit scores of current tenants (particularly for properties with few tenants).
Conducting a credit check and a background check on the borrower.
Examining the borrower’s biography, personal financial statement (PFS), and real estate experience, including the submission of an SREO (schedule of real estate owned), which represents other real estate assets that the borrower currently owns.
Reviewing local market data.
Analyzing third-party reports, including:
Appraisal by a certified appraiser to determine property value
Phase I Environmental Inspection
Phase II Environmental Inspection (if contamination is found in Phase I).
Determining annual required replacement reserves for the potential borrower, which may be estimated at a per-unit cost for multifamily properties, or a PFS (per square feet) costs for commercial properties.
Determining the potential prepayment terms for the loan, typically yield maintenance or defeasance, as well as the lockout period in which the loan cannot be prepaid.
After incorporating all of this information, the underwriter will determine whether the loan will be approved, and, if so, the term, interest rate, and LTV at which it will be approved. The loan terms may be up for negotiation, which may often include the borrower and the loan broker or advisor attempting to achieve higher leverage, lower interest rates, or lower lender fees for the transaction.
While underwriting for conduit loans is certainly comprehensive, it should be noted that the underwriting standards for these loans are significantly less stringent than for multifamily agency loans from Fannie Mae and Freddie Mac, HUD multifamily loans, and many bank loans. These loans often require a sponsor or key principal to have a net worth of 100% of the loan amount, a credit score of 680+, and (sometimes) significant real estate experience.
CMBS Origination and Loan Defaults
Loan default is the biggest risk for CMBS lenders, as it will impact the borrower reputationally and financially, as lenders are now required to hold on to 5% of every CMBS loan they issue on their balance sheet. This is referred to as risk retention and was mandated by the Dodd-Frank Act of 2010 in order to prevent CMBS lenders from issuing overly-risky loans that are highly prone to default.
As part of today’s CMBS origination and underwriting process, underwriters may look at statistics of which CMBS loans have defaulted in order to avoid approving loans with these same types of characteristics. They may also use statistical software to assist in this process. For example, statistics may show that property types like malls and office buildings with a high amount of soon-to-expire leases may be more prone to default, and may avoid originating these loans, or at the very least, will only approve these loans at lower leverage and if they have a very high DSCR (debt service coverage ratio).
CMBS Origination and Arm’s Length Transactions
According to federal regulations, CMBS lenders may not have any significant legal relationship with the borrower, servicer, or special servicer of the loan. This means that transactions must be “arms-length” to prevent any type of collusion, such as giving more favorable (but riskier) terms to a borrower that has a business relationship with the lender. Therefore, the originator has a legal obligation to ensure that there are no untoward relationships that could impact the origination, securitization, or servicing of the loan, as these could have a significant negative impact on the CMBS investors.
CMBS Origination and Legal Costs
In addition to the costs of third-party reports and lender fees, CMBS borrowers will generally have to pay steep lender legal fees, generally, far more than the fees for the agency, bank, life insurance, or HUD loans. This is due to the complex nature of CMBS underwriting, the more complex non-recourse carve-outs that CMBS loans carry, and the exact specifications of the loan servicing agreement, particularly in regards to what will happen if the loan is sent to a special servicer in the case of loan default.
CMBS legal fees generally cost $15,000 for loans under $5 million. Legal fees may spike to $30,000 for more sizable transactions, and may even stack up to $100,000 plus for particularly large loans, such as CMBS SASB (single asset, single borrower) transactions for loans between $200 million and $1 billion+.