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CMBS Primer
9/30/2024

Overview:
 

Commercial Mortgage-Backed Securities (“CMBS”) are an important component of the commercial real estate ecosystem. Their creation has dramatically increased funding availability and liquidity for commercial real estate (CRE) owners while providing investors exposure to a sector that had historically been difficult to access. CMBS are bonds backed by commercial mortgages from a diverse set of properties and geographies that, similar to other Asset-Backed Securities, allow for tailored credit, term and interest rate exposure.

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Some unique benefits include:

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  • Diversified among property types and geographies generally backed by first lien mortgages

  • Credit enhancement provides tiering that both protects more senior bonds and creates opportunity to fill various risk tolerances

  • A liquid alternative to whole loans or real estate direct investments

  • Ability to create fixed rate and floating rate exposure

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Investor types include Hedge Funds, Insurance Companies, Banks, Money Managers and Private Equity firms. Because these instruments carry various combinations of duration, risk and return to investors, they offer participants multiple ways to invest and take views on the sector to meet their unique investment mandates.

 

Origin Story:

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Commercial-Mortgage Backed Securities (“CMBS”) are bonds backed by an underlying pool of commercial mortgages that is diversified by both property type and geography. They come in various forms including Conduit, Single Asset, and Agency structures which will be discussed below. While this sector has been around for quite some time, it was the Savings and Loan Crisis of the 1980s and the resulting establishment of the Resolution Trust Corporation (RTC) that created the modern CMBS market. It was a creation of necessity to address the enormous volume of commercial mortgages on bank thrift balance sheets. By packaging the loans together and creating a bond structure that spread out the risk, the RTC was able to find investor appetite for assets that otherwise would have been very difficult to sell one by one. By the mid 2000’s, CMBS had emerged as a dominant source of financing for the commercial real estate (CRE) market.

 

Trade Mechanics:
 

CMBS trades in Over-the-Counter (OTC) markets which simply means the securities trade directly between individuals rather than via a centralized exchange. In many cases the securities clear via DTC which serves as a clearinghouse ensuring confidence in the settlement process. The business of sourcing investments and accessing liquidity makes personal relationships a vital part of OTC markets.

 

Primary Participants:
 

There is a vibrant ecosystem that is intended to create a feedback loop from origination to successful sale of CMBS in the primary market to secondary market trading. Investor appetite and demand ultimately drive the loan pool characteristics which are constantly updated. Borrowers, Originators, Issuers, Regional Broker Dealers, and Investors all play a part in the functioning of the market.

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Borrowers/Sponsors – Borrowers come in all shapes and sizes depending on the size of the commercial real estate they are looking to finance. These range from small businesses that may own a single strip mall in the Midwest to large, global real estate companies who own millions of square feet of office space. These CRE owners have various financing options to choose from including traditional banks, insurance companies, REITs, and CMBS origination platforms - all of which compete for their business.

 

Originators – CMBS originators operate much like any other financial institution offering financing with the nuance that these loans are intended to land in a mortgage pool rather than on a bank or insurance company balance sheet.

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The process is largely the same as any other financing avenue – there are underwriting guidelines that must be met in order for the borrower to successfully receive financing. These Originators are in constant communication with their investment bank colleagues to ensure the origination mandate is aligned with ultimate investor appetite of the CMBS bonds downstream.

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Investment Banks – Large Investment banks are generally responsible for originating and aggregating commercial mortgages into a pool, creating securities backed by this pool (CMBS), and selling these securities in the new issue market. These investment banks also serve an important role in maintaining a functional secondary market for CMBS by employing traders to actively trade and make markets.

 

Regional Broker Dealers – There are dozens of smaller broker dealers that are often referred to as “Regional BDs” who serve an important role in rounding out the liquidity for the CMBS market. They often fill in the cracks from what inevitably is missed by the much larger, major investment banks “Majors” who tend to cater to the largest customers and investors.

 

Investors – CMBS has historically been largely an institutional investment class. This includes pension funds, governments, sovereign wealth funds, insurance companies, banks, and investment funds. Each of these participants can either access the market directly with in-house traders who know the securities, the players, and the OTC market – or they can invest in a manager who specializes in CMBS, who in turn has a strong understanding of the ecosystem.

 

Loan Structures:

  • Balloon loans are the most common in CMBS. They are structured to have a large, required payment of remaining principal at a point in the future – often 5 or 10 years – as opposed to gradually reducing to zero. Prior to maturity, they can be interest only or amortizing.

  • Amortizing loans require payments of interest and principal over time – often 30 years – to slowly reduce the balance to zero.

 

Property Types:

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  • Office: Includes a range from small suburban offices to large skyscrapers based in major city century business districts.

  • Multifamily: Apartment buildings of all sizes

  • Retail/Mall: From class B and C malls to large lifestyle centers, strip malls, single tenant big box stores, etc.

  • Warehouse/Industrial: Distribution centers, specialty production sites, storage, etc.

  • Mixed Use: Typically, a mix of retail on lower levels and office above. Common in large buildings located in major cities.

  • Hotel/Hospitality: Ranging from small hotels to large resorts

 

Deal Structure:

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CMBS, along with other ABS, are unique in their payment structure and loss protection.

Commercial Real Estate loans make up the collateral for CMBS bonds. This pool of loans is aggregated then structured into CMBS bonds that allow investors to purchase an interest in it with varying degrees of risk and duration. This is accomplished by creating a “waterfall” (think of a series of buckets, one below the other – as one fills up the water overflows to the next bucket and so on) of both payments and loss allocations - with safer bonds being protected from loss by bonds lower in the “capital structure".

 

You can see in the below diagram, an example loan pool of $100mm is split into five bond classes which make up the capital structure. Principal payments pay sequentially top down, and losses are allocated bottom up.

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For example, the first $20mm of principal generated from the $100mm pool of loans is paid to the A Class, the next $20mm is paid to the B Class and so on. Conversely, the first $20mm of losses are allocated to the E Class, the next $20mm are allocated to the D Class and so forth – for the Class A to become impaired, the pool would have to take $80mm of losses (Classes E-B). This phenomenon is known as Credit Protection - Classes E-B protect the A Class from losses, Classes E-C protect Class B, and so on.

Loan Pool interest is used to pay bondholder interest, so everything is designed to balance out. In many structures, principal paying (P&I) bondholders, as a whole, will receive slightly less interest than is generated by the Loan Pool. The excess is paid to the Interest Only (IO) tranche. In simple terms, a Loan Pool that generates 6% interest and pays P&I bondholders 5% will have 1% left over to pay the IO Class.​​​​​​​​​​​​​​​​​​​​​​​​​​

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​​​​​​​​​​​​​​​​​​​Deal Types:

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Deal type is driven by the collateral that makes up the pool of loans. Conduit, SASB, and Agency are the three primary CMBS deal types.

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  • Conduit: Made up of a diverse pool of CRE loans spread across various property types and locations. The benefit here is gaining a broad, diversified exposure.

  • SASB: Single Asset Borrower deals use the same structural concepts explained above, but the collateral is typically a single large loan rather than a pool of many. Some investors prefer to gain exposure to specific assets they know and can underwrite in detail.

  • Agency: The collateral in Agency deals is underwritten by government agencies who provide loss protection to investors. Similar to residential agency loans, government agencies such as Ginnie Mae, Fannie Mae, and Freddie Mac provide an important role in the functioning of the commercial real estate markets.

 

Key Risks:

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  • Interest Rate: As market risk-free rates change, the value of bond coupons change as well. In a rising rate environment, fixed-rate securities will be negatively affected, and conversely, will benefit as rates fall. The effects of these moves would be further escalated based on the duration of the security. Higher duration securities would generally exhibit larger price movements based on the movement of interest rates. Floating rate securities tend to hold steadier during changing interest rate environments as they price at a spread over the risk free rate. Investors in structured credit have the benefit of choosing from both fixed and floating rate securities which allows managers to adjust interest rate exposure based on their view of future rate moves.
     

  • Credit Risk: Private label mortgages in CMBS include a component tied to borrower defaults. While there are structural elements that can help mitigate losses, managers must ultimately be able to underwrite the probability of borrower default and assess recoveries given default. A manager’s ability to underwrite loan level data is critical to its ability to successfully manage a portfolio of private label CMBS.
     

  • Credit Spread: Similar to other instruments such as municipal bonds and corporates, structured credit trades at a spread relative to risk free rates. Theoretically this spread should reflect market sentiment around the risk of default or impairment. In times of elevated volatility, these spreads tend to widen, which can affect bond values. Similarly, during times of peace, these spreads can tighten and serve as a tailwind to valuations.
     

  • Prepayment: Borrowers in CMBS may opt to prepay the loan when the contract allows it. As rates drop, bond values tend to go up, however, the likelihood of borrower prepayment should increase if it is more economical for a borrower to refinance into a lower interest rate loan. Generally, this can serve as a benefit to investors that own bonds at a discount to par, or an adverse phenomenon to investors that own bonds at a premium to par as the expected coupon stream is shortened by the pool paying down more rapidly. While each deal and loan are unique, CMBS loans tend to be structured with more defined protections – known as Call Protection - against unexpected prepayments vs residential loans. Generally, prepayments can be either a downside or upside, depending on the nature of and purchase price of the security and should be a consideration to keep in mind when selecting securities.

 

  • Liquidity: The CMBS market trades Over-the-Counter (OTC). This means that human beings actually negotiate trades as they happen rather than machines driving transactions on a centralized exchange. During times of lower volatility, liquidity may be abundant, and the depth of buyers and sellers of securities may be robust. At other times, macro forces may cause liquidity to diminish which would affect a manager’s ability to raise liquidity in an efficient manner.

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  • Structural: Losses from the entire loan pool impact the lowest CMBS tranche first and move upward once that class has suffered a full loss. For example, in simple terms, if you own the bottom tranche which is 10% of a deal, then the first 10% of loan losses would cause a full loss of investment. Alternatively, if you own a tranche higher up – with the lower tranches making up 30% of a deal, the first 30% of losses to the pool are not applied to your tranche - you are protected by the tranches below. Interest Only securities are often tied to specific P&I tranches of a deal and are impacted in tandem. These phenomena are known as structural leverage and structural protection.

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Q&A:

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Question: Why would investors purchase the E Class instead of the A Class?

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Answer: The prices, and resulting returns, for each bond class are dependent on each bond’s place in the capital structure. Investors in CMBS come in all shapes and sizes. A Classes tend to be AAA rated and are predominantly invested in by insurance companies, money managers, and others who are mandated to invest in highly rates securities. They are willing to accept a lower rate of return in exchange for added security. Those who are not constrained by investing exclusively in AAA securities are free to underwrite the loan pool to determine their ideal place in the capital structure that best rewards the added risk. Pools that are perceived to be less risky may see added demand in the lower bond classes and vice versa.

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Question: How are CMBS bonds different than traditional corporate bonds?

 

Answer: An important distinction is the collateral, or what is backing the bonds. Corporate debt tends to be “unsecured” which means in the event of a default or bankruptcy, there are no specific assets tied directly to the bonds. Unsecured corporate bondholders must get in line in the event of default to receive any remaining cash available AFTER secured holders are made whole.


Additionally, a unique characteristic of CMBS is that the loan pools are what is known as “bankruptcy remote”. This means bondholders have a direct interest in the underlying real estate tied to the loans and are not impacted by any outside events. This is a very important differentiator.


Finally, like all Asset-Backed Securities, CMBS allows investors to target a variety of cash flow profiles vs traditional corporate fixed income that simply provides an interest stream and a bullet payment at maturity. CMBS bonds have dynamic cash flows that are available in fixed and floating form as well as interest only and principal paying profiles.

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Question: I am invested directly in commercial real estate, how is this different?

 

Answer: CMBS are bonds backed by first lien interests in commercial real estate. This means that the trust is first in line to get paid in the event of a default. Any equity in the property would first have to be wiped out before the first dollar of loss would hit a bondholder. 
 

Question: What is the difference between Principal paying bonds and Interest Only bonds?


Answer: Principal paying CMBS perform just like a traditional bond – they pay timely interest and, ultimately, the principal balance. Interest Only bonds (IOs) provide a stream of interest payments only and are more similar to an annuity – the value is derived by the coupon and the length of expected payments. Generally speaking, the longer the IO is expected to cash flow, the more valuable it is.

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General Disclosures

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This presentation provided by Peak53 Partners, LP (“Peak53”) has been prepared solely for informational purposes and may not be relied on in any manner as legal, tax or investment advice or as an offer to sell or the solicitation of an offer to buy an interest in any fund, including Peak53 Structured Opportunities Fund, LP (the “Fund”), which can only be made by a private placement memorandum (the “Memorandum”) that contains important information about each fund’s risks, fees and expenses. In the case of any inconsistency between the descriptions or terms in this document and the Memorandum, the Memorandum shall control. Peak53 reserves the right to change any terms of the offering at any time. These securities shall not be offered or sold in any jurisdiction in which such offer, solicitation or sale would be unlawful until the requirements of the laws of such jurisdiction have been satisfied.

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While all the information prepared in this document is believed to be accurate, Peak53 makes no express warranty as to the completeness or accuracy of such information, nor can it accept any responsibility to update errors appearing in the document. More complete information about Peak53’s products and services is contained in the offering documents for such products and services, which are available on request. This document is strictly confidential and intended exclusively for the use of the person to whom it was delivered by Peak53. This presentation may not be reproduced or redistributed in whole or in part.

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Products managed by Peak53 are intended for sophisticated investors and the information in these materials is intended solely for “Qualified Clients” within the meaning of Rule 205-3 under the Investment Advisers Act of 1940, as amended. Any products or service referred to herein may not be suitable for any or all persons. This presentation includes “forward-looking statements” within the meaning of the U.S. Securities Act of 1933, as amended, and the U.S. Securities Exchange Act of 1934, as amended, or the “Exchange Act.” Forward-looking statements are not based on historical information and include, without limitation, statements regarding our future financial condition and results of operations, business strategy and plans and objectives of management for future operations. Forward-looking statements reflect our current views with respect to future events. The words “may,” “will,” “expect,” “intend,” “anticipate,” “believe,” “project,” “estimate” and similar expressions identify forward-looking statements. These forward-looking statements are based upon estimates and assumptions made by us or our officers that, although believed to be reasonable, are subject to certain known and unknown risks and uncertainties that could cause actual results to differ materially and adversely as compared to those contemplated or implied by such forward-looking statements.

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All forward-looking statements involve risks, assumptions and uncertainties. You should not rely upon forward-looking statements as predictors of future events. The occurrence of the events described, and the achievement of the expected results, depend on many events, some or all of which are not predictable or within our control. Actual results may differ materially from expected results. These risks, assumptions and uncertainties are not necessarily all of the important factors that could cause actual results to differ materially from those expressed in any of our forward-looking statements. Other unknown or unpredictable factors also could harm our results. All of the forward-looking statements we have included in this presentation are based on information available to us on the date of this presentation. We undertake no obligation, and specifically decline any obligation, to update publicly or revise any forward-looking statements, whether as a result of new information, future events or otherwise. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this presentation might not occur.

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The strategies described or contemplated herein are subject to a variety of risks and there can be no assurance that the investment objectives will be achieved or that the strategies described will be implemented. The strategies described or contemplated herein are not “conservative”, “safe” or “risk-free”. Loss of principal may occur. Economic, market and other conditions could also cause the Fund to alter its investment objectives, guidelines, and restrictions. Any projections, outlooks or assumptions are subject to change and should not be construed to be indicative of actual events which will occur. Please review the Fund’s private placement memorandum for an explanation of other risks.

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