CMBS B-Pieces Represent Higher Risks, Higher Returns for CMBS Investors
CMBS loans, also referred to as conduit loans, are pooled together utilizing a real estate mortgage investment conduit (REMIC) and securitized in order to create bonds called commercial mortgage-backed securities. During the securitization process, these bonds are split into tranches based on risk and return.
Investment-grade commercial mortgage-backed securities are rated AAA/Aaa through BBB-/Baa3, while sub-investment grade securities are ranked BB+/Ba1 through B-/B3. These sub-investment grade commercial mortgage-backed securities are collectively referred to as the CMBS B-piece.
Investors in A-class CMBS bonds get paid first, but in exchange, are offered a lower overall return. In contrast, investors in B-piece CMBS need to wait until all A-class bondholders are repaid prior to receiving bond payments. In exchange for this risk, they receive a higher rate of return on their investment.
All of this means that if one or more CMBS borrowers go into default on their loans and the underlying properties that collateralize the CMBS loans go into default, the B-piece investors may only get paid back once the properties are foreclosed on and sold by the special servicer. In some cases, the B-piece investors may only be paid back partially. In a dire situation, the B-piece investors may not be paid back at all.
Demand for B-piece CMBS Impacts CMBS Borrowers
Since CMBS loans are pooled into commercial mortgage-backed securities and sold to investors on the secondary market, the demand for CMBS bonds greatly impacts the availability and interest-rate pricing of the underlying CMBS loans. That can make CMBS loans somewhat less attractive for commercial real estate borrowers.
Since a large amount of the CMBS bonds that are sold are actually B-pieces, the demand for higher-risk bonds, in general, whether CMBS or otherwise, has an even particularly large impact on CMBS loan pricing and availability. For example, when the Fed raises interest rates or the market, in general, appears uncertain, CMBS interest rates may rise significantly, particularly for riskier property types, such as hotels.
In addition, CMBS loan covenants, which are written into CMBS pooling and servicing agreements, may become stricter when the demand for B-piece securities decreases. This may come in the form of stricter “bad boy” carve-outs, which detail when a non-recourse CMBS loan becomes a fully-recourse financial instrument. This means that the special servicer can attempt to repossess the borrower’s personal property in the case of a loan default. Less demand for B-piece CMBS may also result in stricter prepayment penalties, whether in the form of yield maintenance or defeasance.
CMBS B-piece Securities and Risk-Retention Rules
CMBS risk-retention rules regarding CMBS B-piece securities may also have an impact on conduit loan pricing and terms. CMBS risk-retention rules, as mandated by the Dodd-Frank Act of 2010, went into effect in 2016, and require that conduit lenders keep at least 5% of commercial mortgage-backed security on their books for a pre-determined amount of time, depending on the exact risk-retention method utilized.
There are a variety of risk-retention methods that can be utilized by CMBS issuers, though all require that issuers hold onto part of the B-rated bond tranches. While issuers are generally allowed to sell some or all of the B-piece to a third-party investor, that third-party investor generally must hold onto the security for a minimum of 5-years. This stops institutions like hedge funds from actively trading B-pieces in order to achieve short-term profits.
Overall, risk-retention is intended to ensure that the lender and the investors’ interests are more aligned and that lenders do not issue high-risk CMBS loans that they believe have a high chance of defaulting.
Before risk-retention rules went into effect, conduit lenders were allowed to pass 100% of the default risk to the CMBS investors, something which likely contributed to the CMBS crisis, one component of the larger 2008 financial crisis involving defaults on hundreds of billions of dollars of mortgage-backed securities (MBS). During the crisis, CMBS borrowers defaulted on billions of dollars of loans, leading to major losses by investors.