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CMBS
Introduction
Commercial mortgage

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Preferred by real estate developers
Given their key role in financing commercial real estate projects, CMBS tend to be
preferred by real estate because it can provide liquidity to both lenders and investors.
CMBS provide more liquidity and capital to banks and lenders, who can avail
themselves of more capital to provide more loans (ALICO Capital n.d.).
Structure

CMBS are a group of loans of differing sizes, property type (all commercial), locations
and bundled together in a portfolio. Once these loans are bundled together, trusts
securitize these portfolio of loans, providing bonds with different maturity and yields.
These bonds are offered as securities to various investors including institutional.
Tranching

Securitization of loans refers to the process whereby trust converts the commercial
mortgage portfolio loans into bonds which can be purchased. Once the portfolio of
diverse commercial mortgage loans have been securitized, they are then categorized
into a few so-called tranches (i.e. categories) by credit rating agencies. The CMBS are
organized into these segments (tranches) depending on their level of potential default
risk. The ratings can be anywhere between AAA ( Investment Grade) to DDD

(Unrated/junk). There are usually a number of tranches in a CMBS bond, containing
both investment grade and junk tranches to ensure that risks presented by the lowest
ranking ones are vitiated by the higher ranking tranches.

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Yield

One key feature of such CMBS securities are the higher yields they offer to the
investors and lenders. Unlike other types of securities such as government bonds and
corporate bonds, commercial mortgage-backed securities tend to higher yields to the
investors, which is why they are often preferred over government and corporate bonds
(Fidelity Institutional Asset Management, 2017).

Primary investors

Those investing in CMBS often tend to include pension funds, insurance companies,
and commercial banks, all institutional investors. Investors in CMBS tend to be such
institutions and trusts because of the the complexity such bonds present.

Risks

Like other types of securities such as corporate bonds, CMBS also entail a few risks for
the investors. The underlying borrowers in a CMBS can default on their principal and
interest payments, presenting financial loss to those who have invested in such
securities (Principal Real Estate Investors, n.d.). The level of loss in cases like this
depends on a number of variables such us the market condition and underwriting
standards. Nevertheless, the main risks posed to the value of CMBS are declines in the
value of real estate, declines in the number of occupants, myriad macroeconomic
conditions, and others. Identifying such risks in advance and ensuring that those
investing in CMBS are familiarized with them, credit rating agencies calculate the level
of risk and returns. Real estate market conditions can either negatively or adversity

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affect the value of CMBS (Routledge A and Litan, R, 2014). The paradigm of such
weakness was in 2009, when mortgage-backed securities defaulted as a result of a
subprime loan crisis.

How do rating agencies rate the returns on CMBS?

The default risk of CMBS necessitate that investors have a clear information as to the
credit quality, or a credit rating from a bond rating agencies. There are a number of such
agencies which undertake such CMBS rating. These agencies include Standard & Poor,
Kroll Bond, Moody’s and Fitch Ratings (US Securities and Exchanges Commission,

2016).. Credit ratings are denoted in AAA (high credit quality) to DDD (in default). The
methods employed by RAs to assess the returns on CMBS vary depending on a
number of factors. For instance, in Europe, the CREs tend to employ a varied method,
while for the US market, there is a different criteria. This paragraph will analyze the
criteria used by Moody’s and S&P’s. Following the 2008 financial crisis, and how AAA
rated securities and bonds defaulted on, RAs have come attack opprobrium over their
methodologies and criteria. Therefore, RAs have come to to overhaul how they assess
and evaluate CMBS following the mortgage crisis of 2008. The updated methodologies
used by each RAs will be analyzed below.

Generally, credit rating of CMBS is a multifaceted procedure, which entail three prongs.
These prongs are property level analysis, loan level analysis and portfolio level
analysis (Thakor A, and Boot A ,2008). These so-called prongs will be analyzed in turn.

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First, rating agencies (RAs) assess the underlying commercial property, which is tied to
the CMBS. This is also referred to as property level analysis. Analyzing the collateral
property is the considered the first step in rating such CMBS. Standard & Poor,
considers such analysis central to how it rates CMBS returns (2012). While analyzing
the market conditions in real estate, the RAs also pay key attention the supply/demand
dynamics in that particular real estate market.

While performing property level analysis, most RAs either rely on the net cash flow
(NCF) or the net operating income (NOI) of the collateralized property. However,
Moody’s rely on NCF in assessing the CMBS on a property level (Moody’s, 2000). To
derive NCF from the collateralized properties, the agencies rely on a number of
variables, including from base rent and expenses, to occupancies and overheads. Once
stabilized NCG has been derived, RAs apply stabilized capitalization rate to the NCF.
Capitalization Rate = Net Operating Income / Current Market Value

Loan Ration Rate is key in assessing value of collateralized commercial property in
CMBS bonds. Therefore, once the capitalization rate has been derived, the LTV (loan to
ratio rate) rate is obtained by RAs.

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Amount of Loan
LTV = _________________________________
Capitalized Market Value
Following determining LTV, Debt-Service Coverage Ratio (DSCR) is used to measure
the amount of cash flow a lender has to pay off financial obligations. Various RAs take
this into consideration in the property level analysis. However, as with property
valuation, there is no uniform method of calculating DSCR, which is why different RAs
use different methods to calculate. For example, Moody’s, one of the big three credit
rating agencies, computes two types of DSCRs, stressed and actual.
Relying on the DSCRs, and LTV, RAs identify necessary credit support adjustment.
The second prong of rating a CMBS is loan level analysis, as mentioned above. When
analyzing the loan itself, RAs considers DSCR, Capitalization Rate and the property
type. The type of property is also an important factors when RAs assess the loan level
analysis. For instance, Moodys rates in the this hierarchy as such:

● Multifamily
● Anchored Retail
● Industrial
● Unanchored Retail
● Office
● Hotel

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Previous borrower behavior is often considered key in predicting the future behavior of
such borrower. Moreover, the quality of information furnished by the bond issues to the
rating agency (RA) plays a key role in assessing the loan risks during portfolio level
analysis. Therefore, while analyzing on the loan level, RAs consider borrower quality,
amortization, floating rate loans, and cross collateralization. Should there be volatility
as to the floating rate loans, the RAs render credit enhancement modifications to
compensate for the potential loss floating rate loans entail (Standard & Poor’s 2012).
The third and last prong is portfolio level analysis of CMBS. The RAs will focus on the
information quality, portfolio diversity and issues pertaining to legality and structure of
the portfolio bonds. The more diverse the pool of loans, the less risks are associated
with the CMBS issues derived from such portfolios (Thakor A, and Boot A ,2008).

Therefore, risks can be mitigated by diversifying the portfolio. Some RAs consider
economic diversity as well, which evaluates the transactions’ susceptibility to be
influenced by different sectors of the economy.

Moreover, legal issues as to the issuer of CMBS bonds are also analyzed and factored
into the overall rating procedure. For instance, Moody’s considers the level of
involvement of the issues in bankruptcy matters, stressing a true sale from the issuer to
the CMBS seekers in securitization (Moody’s, 2000).

Conclusion

Overall, it is evident that commercial mortgage-backed securities are basically a type of
bond with distinct features. Moreover, as analyzed above, they tend to offer better yields

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over Treasury bonds, luring more investors, institutional and individual. Once loans
have been securitized and issues as bonds by Trusts, rating agencies (i.e. RAs)
perform evaluations, which vary between RAs, to give each CMBS tranche a credit
score. Such rating, as analyzed above, involved a number of specific methods,
depending on the RAs.

Reference

● ALICO Capital, n.d., WHAT IS CMBS? Commercial Mortgage-Backed Securities,
ALICO Capital, accessed 10 December, 2017 <http://www.alicocapital.us/whatis-cmbs/>
● Lemke, Lins and Picard, 2017 ‘Mortgage-Backed Securities’, Thomson West

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● Fidelity Institutional Asset Management, 2017., High Yield CMBS, Fidelity
Investments, accessed 10 December, 2017
>https://institutional.fidelity.com/app/proxy/content?literatureURL=/9863425.PDF
● Routledge A and Litan, R, 2014, A Real Fix for Credit Ratings, Economic
Studies at Brookings,
● accessed 7 December 2017 <https://www.brookings.edu/wpcontent/uploads/2016/06/real_fix_for_credit_ratings_litan.pdf>
● US Securities and Exchanges Commission, 2016, Annual Report on Nationally
Recognized Statistical Rating Organizations, US Securities and Exchanges
Commission, accessed 7 December 2017 <https://www.sec.gov/files/2016-
annual-report-on-nrsros.pdf>
● Thakor A, and Boot A ,2008, Handbook of Financial Intermediation and Banking,
Elsevier
● Moody’s, 2000, Moody’s Approach to Rating U.S. CMBS Conduit
● Transactions.
● Principal Real Estate Investors, n.d. Important Information and Risk Factors,
Principal Real Estate, accessed 10 December 2017
<http://www.principalcef.com/risk-factors.php>
● S&P Credit Rating Service- Ratings Direct 2012, European CMBS Methodology
And Assumptions, Standard & Poor’s, accessed 8 December 2017
<www.maalot.co.il/publications/MT20150111122815.pdf>


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