CMBS

A CMBS pools loans secured on commercial property — offices, shopping centres, hotels, warehouses, apartment blocks — and sells the cash flows as tranched bonds. The machinery is the same as residential MBS; almost everything else is different.

• Far fewer loans. A residential pool holds thousands of small mortgages; a CMBS deal might hold forty large ones, with the top ten dominating. Diversification is thin and one property can matter.
• Loans are usually non-recourse. The lender's claim is against the building and its rent, not against the borrower's other assets. If the property fails, the borrower can hand back the keys.
• Prepayment is mostly prohibited. Residential borrowers refinance freely; commercial loans carry lock-outs, yield maintenance and defeasance. The cash flows are far more predictable — but the credit risk is far more concentrated.

The result is a bond that behaves less like a mortgage portfolio and more like a leveraged claim on a small number of buildings.

The two numbers that decide everything

• LTV measures the equity cushion beneath the loan. A 60% LTV survives a 40% value decline before the lender is impaired.
• DSCR measures whether the rent covers the interest. Below 1.0 the property does not pay its own debt, and the borrower is funding it from elsewhere or not at all.
• These are the commercial-property cousins of the cap-rate arithmetic: net operating income over value is the cap rate, and when it falls below the loan rate the equity is being consumed.

The structure

The B-piece buyer is a genuine feature of this market: a specialist who takes first loss, does property-level diligence, and can typically kick loans out of the pool before closing. Their presence is a real alignment mechanism, and it is exactly what the 2008 residential machine lacked.

The maturity wall, not the default rate

Commercial mortgages are typically interest-only or lightly amortising with a large balloon at maturity, usually five to ten years in. The borrower never intends to repay from cash flow; they intend to refinance. That makes the credit event refinancing failure rather than missed payments:

• A loan can pay perfectly for its whole term and default at maturity because no lender will write a new loan at the property's current value and today's rates.
• This creates a dated, forecastable wall of risk — the maturity schedule is public — which is why CMBS analysts talk about vintages and maturity years rather than about default probabilities.
• Rate increases hit twice: they cut the property's value (a higher cap rate discounts the same rent to less) and raise the new loan's cost. Both squeeze the refinancing at once.

Special servicing and the extend-and-pretend question

• Troubled loans transfer to a special servicer, who can modify, extend or foreclose. Their incentives are set by the servicing agreement and rarely align perfectly with every tranche.
• Senior and junior holders want opposite things. A junior tranche prefers extension — time creates the chance of recovery. A senior tranche often prefers a prompt sale that returns principal. This conflict is structural and is fought in every distressed deal.
• Extensions delay loss recognition. Whether that is prudent workout or denial is only knowable afterwards, which is precisely why reported delinquency rates lag economic reality in this market.

Sector risk is the modern story

Property type dominates outcomes to a degree that surprises bond investors: post-2020, office and older retail have faced structural demand declines while industrial and apartments held up. A pool's property-type mix is a bigger driver of its risk than its average LTV, and single-asset single-borrower deals — increasingly common — remove diversification entirely in exchange for transparency about exactly which building you own.

The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.