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Understanding CMBS Tranches
Commercial mortgage-backed securities are often split into different tiers based on the different levels of risk and return. These tiers are known as tranches. This article explores the basics of CMBS tranches.
What are CMBS Tranches?
Image by Lukas Blazek via Unsplash
Commercial mortgage-backed securities are a group of commercial real estate loans that are pooled together and securitized to be sold on the secondary market. These CMBS loans are then split into different tiers based on the different levels of risk and return. These tiers are known as tranches.
There are many different CMBS tranches that are typically classified into two major categories — investment-grade CMBS, and sub-investment-grade CMBS. Investment-grade CMBS tranches comprise the AAA/Aaa through BBB-/Baa3 rated securities, while the BB+/Ba1 through B-/B3 ranked securities make up the sub-investment-grade tranches. In the industry, sub-investment grade CMBS tranches are collectively referred to as CMBS B-pieces.
Why CMBS Tranches Matter
With commercial mortgage-backed securities, the least risky loans are considered the highest-rated and are placed in the highest tranches. Conversely, the riskiest loans are the lowest rated and are placed within the lowest tranches. The higher tranches of CMBS typically offer lower interest rates for investors, but with lower possible returns — the lower tranches, on the other hand, offer higher interest rates for investors, but with higher potential returns.
In the case of a default on one or more of the loans bundled in a commercial mortgage-backed security, investors of the highest tranches are first to be fully paid off, with interest, further decreasing potential risk. Investors in lower-rated CMBS tranches, which includes all of the B-piece CMBS, may receive a higher return — but do not receive funding in the event of a default until after the A-class CMBS investors are fully repaid.
CMBS Risk-Retention Rules
Instituted by the Dodd-Frank Act of 2010 and first enforced in 2016, CMBS risk-retention rules dictate that lenders must hold onto at least 5% of the commercial mortgage-backed securities they issue — including a portion of the B-piece tranches. Risk-retention rules were implemented to ensure that CMBS lenders' interests remain aligned with the interests of the investors, and to effectively steer them away from offering loans to investors who may turn out to be unable to pay them back. Prior to the introduction of these rules, CMBS lenders could, and sometimes did, transfer 100% of their risk from their CMBS loans to commercial real estate investors — many analysts agree that such actions played a large role in the CMBS market crisis back in 2008-2010.
Related Questions
What is a CMBS tranche?
A CMBS tranche is a tier of commercial mortgage-backed securities (CMBS) that are split into different levels based on the different levels of risk and return. These tranches are typically classified into two major categories — investment-grade CMBS, and sub-investment-grade CMBS. Investment-grade CMBS tranches comprise the AAA/Aaa through BBB-/Baa3 rated securities, while the BB+/Ba1 through B-/B3 ranked securities make up the sub-investment-grade tranches. In the industry, sub-investment grade CMBS tranches are collectively referred to as CMBS B-pieces. Higher tranches will generally offer interest rates (and lower returns for investors), while lower tranches offer higher interest rates (and higher potential returns for investors).
Sources:
What are the different types of CMBS tranches?
CMBS tranches are typically classified into two major categories — investment-grade CMBS, and sub-investment-grade CMBS. Investment-grade CMBS tranches comprise the AAA/Aaa through BBB-/Baa3 rated securities, while the BB+/Ba1 through B-/B3 ranked securities make up the sub-investment-grade tranches. In the industry, sub-investment grade CMBS tranches are collectively referred to as CMBS B-pieces.
Source: Understanding CMBS Tranches and CMBS are Split Into Tranches Based on Credit Risk
How do CMBS tranches affect commercial real estate financing?
CMBS tranches affect commercial real estate financing by providing investors with different levels of risk and return. The highest-rated, least risky loans will be placed in the highest tranches, while the lowest-rated, riskiest loans will be placed in the lowest tranches. Higher tranches will generally offer lower interest rates (and lower returns for investors), while lower tranches offer higher interest rates (and higher potential returns for investors). In the case of a default on one or more loans in a commercial mortgage backed security, the highest tranches must be fully paid off, with interest, before the lower tranches will receive any funds.
Source: cmbs.loans/blog/cmbs-tranches and www.multifamily.loans/apartment-finance-blog/understanding-cmbs-tranches
What are the risks associated with CMBS tranches?
CMBS tranches are divided into different levels of credit risk, with the highest tranches offering lower interest rates and lower returns for investors, and the lowest tranches offering higher interest rates and higher potential returns for investors. However, in the case of a default on one or more loans in a commercial mortgage backed security, the highest tranches must be fully paid off, with interest, before the lower tranches will receive any funds. Additionally, CMBS risk-retention rules dictate that lenders must hold onto at least 5% of the commercial mortgage-backed securities they issue — including a portion of the B-piece tranches. Risk-retention rules were implemented to ensure that CMBS lenders' interests remain aligned with the interests of the investors, and to effectively steer them away from offering loans to investors who may turn out to be unable to pay them back. Source 1, Source 2.
How do CMBS tranches affect the pricing of commercial real estate loans?
CMBS tranches affect the pricing of commercial real estate loans by offering different interest rates and potential returns for investors. The highest tranches offer lower interest rates and lower returns, while the lowest tranches offer higher interest rates and higher potential returns. In the case of a default on one or more loans in a commercial mortgage backed security, the highest tranches must be fully paid off, with interest, before the lower tranches will receive any funds. Source 1 and Source 2.
What are the benefits of investing in CMBS tranches?
Investing in CMBS tranches offers a variety of benefits. The highest tranches (lowest risk, highest quality credit rating) typically offer lower interest rates and lower returns for investors, while the lower tranches generally offer higher interest rates but with higher potential returns for investors. In the event of a default on one or more loans bundled in a commercial mortgage-backed security tranche, the highest tranches must be fully paid off, with interest, before the lower tranches can receive any funds. This further decreases potential risk for investors in the highest tranches. Investors in lower-rated CMBS tranches, which includes all of the B-piece CMBS, may receive a higher return — but do not receive funding in the event of a default until after the A-class CMBS investors are fully repaid. Source 1, Source 2