Commercial real estate lending can be a complicated concept to understand, especially for the novice investor. Most individuals in the industry are familiar with the traditional methods of lending and debt; however, as a developing investor, it is important that you understand the depths of the debt market for commercial real estate. With that in mind, we are going to review the CMBS market and CLO market – two concepts within the debt world that may assist you in growing your portfolio and your wealth.
The CMBS market is an acronym for commercial mortgage-backed securities, and they account for approximately 2% of the total United States fixed-income market. CMBS. are defined as fixed-income investment products that are backed by mortgages on commercial properties. What exactly does that mean for you? Let’s dig in.
A CMBS loan is a great finance option for investors who are interested in holding onto their property for a long period of time. This is because of the way that CMBS loans works. When an investor seeks financing for their real estate asset, they can obtain a CMBS loan. Then, the bank that originates the loan takes it and packages it in a trust with multiple other similar loans, all non-recourse loans. They then take that package to the bond market and sell to bond holders. Bond holders will buy the packaged loans and receive a return based on the interest rate borrowers had agreed to for their original loan.
Investors using a CMBS loan to purchase real estate will benefit from lower interest rates and the ability to maximize leverage on their deal. However, the loan can provide difficulty for any investor who may be interested in selling or refinancing in the future because of the structure in which the loan is sold to bond holders.
For those interested in investing in the real estate market, the CMBS market offers investors an alternative beyond real estate investment trusts. Bond purchases can be made in the CMBS market, and investment opportunities are classified into tranches based on credit risk. The riskier loans will be placed in the lowest tranches, while the least risky loans will be placed in the higher tranches. The higher tranches usually provide lower returns while the lower tranches provide higher returns. Investors are then paid their principle plus interest accordingly when the original debt it paid. However, it is important to note that if there is a default on the loans, the higher tranches are paid in full, with interest, before the lower tranches receive any funds.
The CLO market, on the other hand, refers to the transactions associated with collateralized loan obligation (CLO). CLO is defined as a single security backed by a pool of debt. Similar to the CMBS market, a package is created out of a bundle of loans. However, a CLO is usually comprised of corporate debt that lasts around ten years. When referring to commercial real estate CLO’s though, the debt typically lasts from two to four years and is made up primarily of bridge loans. The debt differs from the CMBS market because it is recourse debt; that is, it relies on the borrower.
Similar to CMBS bonds, CLOs are also divided into tranches. These are classified according to risk. The lower the risk, the lower the return, and, just like in the CMBS market, the lower risk investors must be paid first before the higher risk investors receive their dividend. The tranches for CMBS bonds are labeled, with the lowest risk and lowest return on first: AAA, AA, A, BBB, BB, and last, equity tranche.
The creation of a CLO can be completed by a financial institution or an investor. First, the CLO manager creates a capital structure of tranches with varying risks and returns; then, they raise capital from investors who select the tranche that best meets their business model. Next, the CLO manager collects funds to purchase the loans, and last, the interest generated is used to pay the investors.
Unlike with CMBS loans, the return on CLOs can fluctuate according to interest rates because the underlying loans are subject to floating rates. However, they are intriguing to investors because they provide opportunities to invest in a managed portfolio while receiving higher returns.
A Final Note
Debt is a necessity that keeps the flow of our economy moving. There is much potential for investors who want to pursue opportunities in the CMBS or CLO markets; however, it is necessary that they understand the risks and restrictions associated to ensure that they are prepared for whatever changes in the market might be approaching. Additionally, investors should assess their risk tolerance to allow them to identify how they want to invest; consulting with a financial advisor can help investors learn more about the importance of understanding their risk adversity.
If you are curious to understand the different types of interest rates and how the effect different types of real estate loans, read this.
ALSO, watch THIS episode of The Signet Podcast with Jeff Hudson from Walker Dunlop who gives a great understanding of the nature of lending in real estate.
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