CMBS and Conduit Loans Defined and Explained
Conduit loans, which are more commonly referred to as CMBS loans, are commercial real estate loans that are pooled together and sold to investors on the secondary market. CMBS loans are sometimes referred to as conduit loans, due to the fact that they act as a conduit for investors who wish to generate income on the other side of the transaction.
Conduit Loan Benefits and Property Types
CMBS loans are highly attractive to commercial real estate investors due to the fact that they are fixed-rate, non-recourse, and fully assumable, and generally offer highly competitive interest rates. Rates are generally based on the current swap or Treasury rate plus a spread. Loan pricing can depend on a variety of factors, including leverage, DSCR, borrower quality, property type.
Unlike agency loans from Fannie Mae and Freddie Mac, which are only available for multifamily borrowers, conduit loans are available for a wide range of income-producing property types, including hotels, retail properties, industrial properties, office buildings, and even more exotic property types, like parking lots or marinas.
Conduit loans on high-quality multifamily and industrial properties are generally offered at the highest leverage and with the lowest DSCR requirements. In contrast, CMBS loans issued for riskier property types, such as hotels, typically offer lower leverage and higher DSCR requirements to compensate for the increased default risk.
CMBS and Conduit Loan Borrower Requirements
In addition to the benefits listed above, CMBS loans generally have lower borrower net worth and credit requirements than agency or bank loans. While agency loans typically require a borrower to have assets worth 100% of the total loan amount, excluding the value of their primary residence, conduit loans typically only require a borrower to have a net worth of 25% of the total loan amount, with 10% of those assets being liquid.
CMBS lenders may also be more lenient when it comes to credit score requirements, and while 660-680+ is preferred, lenders may be willing to allow for borrowers with significantly lower credit scores if the borrower has great experience, the property has a particularly high DSCR, or other compensating factors are involved.
The CMBS Loan Pooling and Securitization Process
After conduit loans are issued to borrowers, they pooled together into an entity referred to as a real estate mortgage investment conduit (REMIC), which is typically structured as a special purpose entity (SPE) or special purpose vehicle (SPV). This process of taking loans, grouping them together, and creating a new financial product is referred to as securitization. It should be noted that REMICs are generally pass-through entities, so they do not directly pay taxes; however, investors in the CMBS loans held by the REMIC will still have to pay capital gains taxes on any profits they receive from their investment.
After conduit loans are pooled together, they are then divided into tranches based on risk and return. Higher risk tranches reward investors with higher percentage return CMBS are divided into two categories; investment-grade bonds, which are generally rated from AAA/Aaa to BBB-/Baa3, and sub-investment-grade bonds, which are typically ranked BB+/Ba1 through B-/B3. CMBS bonds ranked BB+ and below are called the CMBS b-piece.
Due to risk-retention rules introduced by the Dodd-Frank Act of 2010, since 2016 CMBS lenders have been required to hold onto at least 5% of any loans they issue, generally including the b-piece securities. Prior to this, lenders could pass on 100% of the risk of any loans they issued to the CMBS investors.
This likely incentivized the reckless commercial lending practices that lead to the CMBS crisis, one part of the broader 2008 financial crisis which saw CMBS investors losing billions of dollars and CMBS lending come to a standstill.
CMBS Loans Can Be Assumed By New Borrowers
Another benefit of CMBS loans is the fact that, in most cases, they can be assumed, or taken on, by a new borrower for a small fee. This prevents the existing borrower from having to pay expensive prepayment penalties.
For new borrowers, assuming a loan can be an attractive option, particularly if the interest rate on the existing CMBS loan is lower than what they could get on the open market, particularly if the loan still has a high amount of leverage. Loan assumption can also allow a deal to close faster as it often only requires one third-party report, a property condition assessment (PCA).
Supplemental Financing for CMBS and Conduit Loans
In addition to the fact that CMBS loans can be assumed by new borrowers, in some cases, CMBS borrowers may be able to obtain additional financing on top of their conduit loan. This typically comes in the form of mezzanine debt or preferred equity. Mezzanine debt refers to second-position loans offered by a lender, typically at a higher interest rate (often 8-12%) than first-position debt.
When we say that the mezzanine loan is secondary debt, this means that, in the case of a loan default, the mezzanine lender will only be repaid once the first-position lender has been paid back in full. In contrast to mezzanine debt, preferred equity investors actually own equity in the property, but unlike the regular equity investors, their potential upside is limited to an annual percentage payment, also often between 8-12%.
When we say that their equity is preferred, it means that they get paid back first, before the regular equity investors (but after the lender) in the case of loan default. Sometimes, mezzanine lenders or preferred equity investors will receive an additional bonus payment, called an “equity kicker” if the project does particularly well, such as if it exceeds a certain IRR hurdle, say 15%. The potential to profit from an equity kicker may incentivize mezzanine lenders or preferred equity investors
Not all CMBS lenders will allow mezzanine loans or preferred equity on top of a borrower’s original loan, so any allowances for secondary financing typically need to be negotiated upfront, at the beginning of the CMBS negotiation process and will need to be written into the loan’s pooling and servicing agreement (PSA).
The specific arrangements regarding how the CMBS lender and the mezzanine or preferred investors will be repaid are governed by a secondary document, referred to as an intercreditor agreement. This agreement must be signed by both lenders in order for the loans to successfully close.
Conduit Loan Prepayment Penalties: Yield Maintenence vs. Defeasance
If a CMBS borrower wants to prepay their loan before its maturity date, they will be required to pay a prepayment penalty in one of two ways, defeasance or yield maintenance.
Defeasance is the more commonly required CMBS prepayment method and requires the borrower to purchase substitute collateral, generally in the form of U.S. Treasury bonds in order to provide the CMBS investors with the income they would have received if the borrower did not prepay their loan.
Yield maintenance, in comparison, requires the borrower to repay the entire UPB (unpaid principal balance) of their loan, in addition to all the interest income the investors would have earned if the borrower had not prepaid their loan.
Defeasance can be time-consuming and expensive, as it generally requires the use of outside consultants, including attorneys, accountants, a broker-dealer, and a specialized intermediary who will hold the new securities in an escrow account in the borrower’s name, but benefiting the CMBS investors.
Sometimes, borrowers can choose whether to use the defeasance or yield maintenance process in order to prepay their loan. Defeasance is generally a good idea when interest rates are higher than the CMBS loan’s interest rate, as the borrower will need to purchase fewer bonds to replace the investors’ income.
Defeasance is also a good idea when a borrower is allowed to substitute their loan collateral with agency bonds instead of Treasuries, as these offer higher interest rates, so fewer bonds will need to be purchased.
In contrast, yield maintenance is a good idea when interest rates are lower than the interest rate on the CMBS loan since this makes buying substitute securities more expensive.
Pros and Cons of CMBS and Conduit Loans
Now that we’ve reviewed most of the aspects of CMBS and conduit loans, let’s take a quick look at the pros and cons.
CMBS and conduit loan pros:
Non-recourse
Fully assumable
Low, fixed-rate terms up to 10-years
Amortizations up to 30-years
Available for a wide array of property types
Flexible in regards to net worth and credit score
Can finance portfolios in addition to single properties
CMBS and conduit loan cons:
High legal fees
Loans may easily go into technical default
Borrowers may not be able to make changes to their property
Special servicers can be hard to work with
Prepayment can be time consuming and expensive
In Conclusion: Conduit Loans are a Great Financing Option, But They’re Not For Everyone
CMBS and conduit loans can be the perfect option for many borrowers, particularly those who want a non-recourse loan at an attractive interest rate, or for borrowers who may not have a high net worth. However, they’re not ideal in all situations.
For example, if a borrower has a high net worth and great credit score and is looking to finance a multifamily property, they may be able to achieve better pricing and longer loan terms by taking out a Fannie Mae or Freddie Mac multifamily loan.
In addition, if a borrower wants to make improvements to their property during the life of the loan, or values a close relationship with their servicer, bank financing could be a better choice.
For especially high-quality properties, borrowers may want to consider a life company loan. In contrast, if a property is distressed, a borrower may not be able to get CMBS, bank, agency, or life company debt and may need to opt for a loan from a hard money or private money lender.
In addition, it’s important to note that CMBS loans generally aren’t available for construction projects, and may not be available for owner-occupied properties. They’re also not a great choice for borrowers who believe they may want to prepay their loan before its maturity date.