Commercial Real Estate Finance Blog

Volatility in the credit markets continued across the board this past week due to the ongoing sub-prime woes and worldwide credit liquidity issues As a result, CMBS (Commercial Mortgage Backed Securities) spreads widened dramatically over the last couple of months, and, in particular, over the last few weeks. Commercial Mortgage Backed Securities (CMBS) are derived from pools of commercial real estate loans. The securities are sliced and diced into multiple tranches. Recently, increased levels of subordination (the highest risk tranche that is the first to absorb losses) have been required by both the rating agencies and the AAA buyers and therefore overall yields climbed. However, AAA buyers are also demanding enhanced spreads. In addition, many bond investors seem to be fleeing to Treasuries as a “safe haven” and therefore liquidity is drying up and the remaining investors can easily demand greater yields. Fortunately, treasuries have trended down recently helping offset some of the spread “pain.” Underwriting standards have tightened dramatically over the last couple of months and gone are the days of 10-year interest only periods and underwriting to projected cash flow. Real estate investors should tread cautiously over the next few months as only the better quality deals that are priced right and underwritten to normal parameters will be financeable in the CMBS space. In fact, some CMBS lenders have closed shop, at least for now, as the market is too unpredictable and they’re unwilling to absorb losses for loans that are priced incorrectly. Alternatively, borrowers should consider other forms of financing. Balance sheet lenders offer a viable alternative now that benchmark spreads for CMBS financing are in the 200 basis points over range. Further, those financing with balance sheet lenders will obtain a more flexible structure compared to CMBS structures. Credit market volatility will likely remain for some period of time and only highly experienced borrowers, or those with advisors with strong and deep experience in the world of commercial real estate finance, should attempt to navigate on their own. Comments and/or calls are welcome.

“Tranche” is actually a French word meaning “slice” or “portion”. In the world of investing, it is used to describe a security that can be split up into smaller pieces and subsequently sold to investors.

Mortgage-backed securities (MBS), such as a collateralized mortgage obligation (CMO), can often be found in the form of a tranche. These securities can be partitioned based on their maturities and then sold to investors based on their preferences.

For example, an investor might need cash flows in the short term and have no desire to receive cash in the future. Conversely, another investor could have a need for cash flows in the long term but not right now. To take advantage of this selling situation, an investment bank could split some security or asset, such as a CMO, into different parts so that the first investor receives the early cash flows of a mortgage and the second investor has the right to receive the latter cash flows. With the creation of these tranches, a security or issue that was once unattractive may enjoy some new found marketability.

Commercial mortgage-backed securities (CMBS) are a type of bond commonly issued in American security markets. They are a type of Mortgage-backed security, but are backed by mortgages on commercial rather than residential real estate. CMBS issues are usually structured into multiple tranches, similar to CMOs rather than typical residential passthroughs.

Many American CMBS demonstrate less prepayment risk than other types of MBS thanks to the structure of commercial mortgages. Commercial mortgages often contain lockout provisions after which they are often subject to defeasance, yield maintenance and prepayment penalties to protect bondholders.