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Commercial mortgage-backed securities are a type of investment where the income comes from mortgage payments. The mortgages are for commercial real estate, such as office buildings and factories, rather than residential properties. This theoretically lowers the risk to investors, as commercial mortgage borrowers are less likely than residential borrowers to repay loans early.
A mortgage-backed security involves mortgage lenders, such as banks, selling off the rights to receive repayments on multiple loans. These loans are then packaged together so that each investor has a share in an overall package that covers multiple mortgages. The aim of this is to reduce the risk to investors from individual borrowers defaulting on the mortgage. The packaging technique means a particular default only has a small effect on the overall repayment income, and this small effect is in turn shared out among many investors. There are some drawbacks though; the packaging means it can be more difficult to accurately assess the overall risk of the loans taken as a whole.
One of the most significant differences between commercial mortgage-backed securities and residential mortgage-backed securities involves the issue of prepayment. When a mortgage borrower pays back the outstanding balance early, the total income to the lender is less. This is because, despite early redemption penalties, the lender still loses out on future interest payments, which can often exceed the loan amount itself. With a mortgage-backed security, this loss is borne by the investors, who get less of an income than expected.
In the United States at least, commercial mortgages are generally more likely to have steep penalties for prepayment, making borrowers less likely to take up this option. In some cases, the borrower may even be prevented from repaying the loan early under any circumstances, or may be locked in for a certain number of years before being eligible to repay early. These restrictions thus lower the risk of prepayment-related losses by investors in commercial mortgage-backed securities.
In some cases, commercial mortgage-backed securities may benefit from the underlying mortgages having a defeasance clause. This means that the borrower cannot simply pay cash to pay off the loan earlier. Instead, the borrower must supply the lender with a security product to the equivalent value, usually in the form of treasury bills or notes. The investors will then get an interest in these securities, which gives a very reliable and steady income. In some cases, defeasance is not mandatory for the borrower, but rather an alternative to paying off the loan early in cash.
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