Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Commercial Mortgage-Backed Security (CMBS)

What it is:

A commercial mortgage-backed security (CMBS) is a fixed-income security, typically in the form of a bond, which uses commercial real estate loans as collateral.

How it works (Example):

A CMBS is comprised of numerous commercial mortgages of varying terms and values, such as multi-family dwellings, commercial real estate, etc. Unlike a residential mortgage-backed security (RMBS), a CMBS offers reduced pre-payment risk, since the term on commercial mortgages is generally fixed.

Investors who hold a CMBS receive, as payment, the interest and principal repayments on these mortgages. Therefore, investors principally take on the borrower's risk of default (non-repayment). Unlike residential mortgage-backed securities, however, a CMBS does not present pre-payment risk to the holder, since commercial mortgage loans are set at a fixed term.

Similar to collateralized mortgage obligation mortgage obligations (CMO), the mortgages that back the securities are classified into tranches of risk. This allows investors to purchase a CMBS that fits their risk preference. Higher tranches (usually designated as A) have a higher rate of return because they receive both interest and principal payments, but also have a greater amount of risk (if the borrower can't make the payments, the investor gets nothing). Lower tranches (usually designated as B, C, or even D) carry lower risk at a lower rate of return because they absorb only interest payments on mortgages with shorter terms to repayment.

Why it Matters:

A CMBS presents a reduced-risk alternative to a RMBS, since prepayment risk is nearly eliminated. Moreover, the CMBS is a way for lending institutions to reduce risk and increase lending power by packaging outstanding debt receivables, such as mortgages, into potentially profitable securities that can be purchased by investors.