Commercial mortgage-backed securities (CMBS) are one of the many types of securitized products fixed income money managers invest in. As the name implies, CMBS are secured by mortgages on commercial properties, such as hotels, industrial buildings, multi-family housing, offices, and retail stores. Those mortgages are then bundled and transferred into a special-purpose vehicle, where the cash flows from those mortgages are divided into tranches. This creates securities with varying levels of duration, credit risk, and ratings.

CMBS are similar to the residential mortgage-backed securities market in that they can be broadly separated into two categories based on whether they are issued under a private label or they are issued by a government agency, which guarantees the mortgage’s principal and interest. The private-label CMBS market can be further broken down in to two segments: conduit and single asset, single borrower (SASB).

Origins of the CMBS Market

The modern CMBS market began in earnest after the passage of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989. That legislation was a response to the Savings and Loans Crises earlier in the decade and resulted in the creation of the Resolution Trust Corporation (RTC). To unload the insolvent thrifts’ distressed commercial mortgages, the RTC created a securitization program.

30 Years Later: Conduits and SASB

Fast forward to today and the CMBS market has grown significantly. According to the Securities Industry Financial Market Association (SIFMA), at the end of 2018, there were $543 billion CMBS outstanding, with conduit and SASB bonds comprising roughly 90% of the total.

This market is still small relative to the fixed income universe and as a result plays a minor role in broad market indices. Prior to the 2008 Financial Crisis, conduit CMBS dominated the market. However, since 2010, SASB bonds’ popularity and issuance levels have grown significantly. As of year-end 2018, there were $137 billion outstanding versus $354 billion in conduits.

Key Distinctions

As the moniker single asset, single borrower implies, these bonds are backed by a single loan. In contrast, conduit bonds are generally larger and collateralized by many loans on a mix of property types from varying geographic regions. SASB collateral types can be broken down further into single asset and single borrower. Single asset refers to bonds where the collateral is a loan on a single commercial real estate asset, while single borrower refers to a portfolio of assets held by the same borrower.

CMBS are typically issued by a trust with a real estate mortgage investment conduit (REMIC) structure that permits cash flow to be distributed to investors without mandatory tax withholdings. The securities are generally held by institutional investors including asset managers, banks, hedge funds, and insurance companies. The tranches within each deal are designed to appeal to different types of investors based on their unique needs and risk tolerance levels. The higher-rated tranches that come with more credit enhancements and shorter expected maturities typically are more suitable for bank customers and conservative investment vehicles, the tranches with longer expected maturities are for insurers, and the riskier tranches are generally the purview of hedge funds. Due to regulations stemming from the Dodd-Frank Act following the 2008 Financial Crisis, the company performing the securitization is now required to retain 5% of the risk for a period of five years.

Conduit issues generally exhibit a set of similar characteristics. The deal sizes are often close to $1 billion and are collateralized by mortgages on properties representing a diverse range of commercial subsectors. They usually contain roughly 50 to 100 loans that range in size from $1 million to $100 million, with the top 10 largest loans in each deal representing around 50% of the collateral balance. The majority of the underlying mortgages have a term of 10 years with fixed rate, monthly payments. The mortgaged properties are typically fully leased (or close to it) and have stable cash flow profiles.

In contrast, SASB issues can vary greatly from one deal to the next. The underlying loan can be either a fixed or floating rate and can come with maturity terms that reflect the norm in whatever commercial subsector the collateralized property happens to belong to. It is not uncommon for floating-rate deals to have a short initial maturity with up to five, one-year extension options. These terms of these options also vary by deal. There are sometimes, but not always, interest-rate increases and/or one-time extension fees payable to investors as compensation for the optionality. The overall breakdown of fixed versus floating rate formats is approximately 60% and 40%, respectively, but that preference has changed over the past couple of years. In the 2017 to 2018 period, over 70% of newly issued SASB bonds had floating rate coupons. This includes office collateral that is traditionally financed with a fixed-rate mortgage.

Certain types of collateral tend to appear with greater frequency among the different types of CMBS issues based on their underlying characteristics. The most significant discrepancies are in retail and hotels sector, which represent significantly larger portions of newly issued conduit and SASB bonds respectively. There is also stark contrast between the two largest types of CMBS issues when it comes to structural composition. These differences allow for these products to be suitable for a range of investors based on individual needs.