Commercial Loans Blog

The Problem With Securitized Commercial Loans

Posted by George Blackburne on Thu, Jan 7, 2016

Trophy.jpgYears ago the interest rates on commercial loans offered by life insurance companies were much-much-MUCH lower than those offered by any other commercial lender.  By the way, in commercial real estate finance (CREF), life insurance companies are known as life companies.

Man, if you could obtain a commercial loan from a life company, you were sitting in clover.  Your interest rate would be almost 80 basis points (0.80%) lower than a commercial loan from the next best lender.  On a loan of $10 million, that's real money.  The problem, of course, is that only the top 2% of all commercial loans can qualify for a life company loan.  I blogged on this reality recently.

Then, about 15 years ago, Wall Street figured out how to securitize commercial loans.  Here's how the process works.  The money center banks - huge banks like Bank of America, Wells Fargo Bank, J.P. Morgan Chase - and the conduits would originate about $1 billion worth of commercial first mortgages on the four major food groups: multifamily, office, retail, and industrial properties.  These mortgages would then be sold to a trust, and the trust would then issue bonds to the investing public backed by the commercial loans held by the trust.  These bonds were known as commercial mortgage-backed securities (CMBS's).

 

Ugly.jpg

 

Now we come to the key step.  These CMBS bonds would then be rated according to risk by one of the rating agencies, like Fitch, Moody's, Standard & Poors, a new rating agency named Kroll Bond Ratings, and Morningstar.  Once rated, many of these CMBS bonds become eligible for purchase by pension trusts.  Yummy.  Pension trusts love-love-love investment grade CMBS bonds, and therefore the yields that the underwriters have to offer in the marketpace to sell these bonds is super-low, often less than 3%.

Free List of 3,159 Commercial Lenders Sort By Your Own Criteria

Bottom line, when commercial loans are securitized, they can be sold off at really low interest rates.  Hooray!  Now we have a true competitor to the life companies.  Conduits today are offering large commercial loans today (1/7/16) at around 4.125%, only about 25 to 35 basis points higher than the low rates offered by life companies.  More importantly, the loan does not have to be absolutely perfect.  The building can be a little older.  The property could be in a smaller city.  The location doesn't need to be the single best location in the city.  Conduits can make loans in secondary locations.  Not every car driving by has to be a Lexus or a Mercedes.  CMBS lenders (money center banks and conduits) make about 23% in dollar volume of all commercial loans today.

By the way, a conduit is defined as a specialized kind of mortgage company that originates large, plain vanilla commercial mortgages for their eventual sale to a CMBS trust.  The word "conduit" is short for real estate mortgage investment conduit (REMIC).

 

Great_Ideas.jpg

 

Now we are finally able to discuss the point of today's training article.  There is a big problem with securitized commercial loans.  Securitized commercial loans include the CMBS loans being made by conduits, the subprime commercial loans made by Bayview Financial in the early 2000's, and the non-prime commercial loans being made by Velocity and Cherrywood today. The good news is that these securitized commercial loans have a very low interest rate and very low monthly payments.

The problem with securitized commercial loans is that they burden the borrower's commercial property for ten years - making the property difficult to sell and economically impossible to refinance.

Here's why: The buyers of commercial mortgage-backed bonds are insistent that these bonds have a fixed interest rate. The reason why is because life insurance companies and defined benefit pension plans need to know exactly what they are going to earn, so they can be sure that they have enough dough to meet their actuarial projections (a certain number of people die or retire every year).

Therefore securitized commercial loans have enormous prepayment penalties (sometimes almost impossible to believe). To make matters worse, they all prohibit junior financing

Let's suppose a borrower accepts a $6.8 million securitized commercial loan on a $10 million building. Six years later, the building is worth $13 million. Did you know that a prospective buyer would have to put $6.2MM (48%) down!  Remember, the seller is not allowed to carry back a second mortgage.  The purchase has to be cash-to-loan.  In other words, the buyer has to put enough money down so that there is only a first mortgage.

The alternative is equally unattractive.  The seller could simply suck it up and pay the prepayment penalty on his existing first mortgage.  But the problem here is that defeasance prepayment penalties are enormous.  In our example here, the seller might have to pay a $1.2 million defeasance prepayment penalty.

Either way - trying to sell a property when the buyer has to put 48% down or making the seller pay a $1.2 million prepayment pealty - yikes!

I would argue that bank commercial loans - or even private money commercial loans with no prepayment penalty - are much better than securitized commercial loans.  The interest rate and monthly payments will admittedly be higher, but at least the seller is not tied to a chair.

 

Apply For a Commercial Loan to Blackburne & Sons

 

Commercial mortgage training

 

Submit Your Loan to 750 CommercialLender

 

Topics: Securitzied commercial loans