Advantages of Securitization for the Commercial and Multifamily Real Estate Industry
In the process of securitization, one or more assets is turned into a security, which can be traded on the financial markets. Mortgage debt is the most commonly securitized asset, with common securitized mortgage products including mortgage backed securities (MBS), commercial mortgage backed securities (CMBS), and commercial debt obligations (CDOs). Car loans, credit card debt, and student loan debt is also commonly securitized. In general, securitization is highly advantageous, as it makes loans more available for commercial real estate borrowers, stimulating the market-- but it has a few downsides, too.
How Securitization Works
Before we delve into the advantages of securitization, it may be beneficial to review just how the process works. Securitization begins when a company that owns debt, say, a commercial or multifamily real estate lender, will place the debt into a special purpose entity (SPE) or special purpose vehicle (SPV), which it will sell to another entity (generally an investor) referred to as the master owner. The master owner will then divide the debt into tranches (or segments) based on risk, and will sell it to investors. The riskiest tranches will generate the highest levels of income, but will be the last to be paid off if the borrower defaults on their loan. In contrast, the safest tranches generate the lowest levels of income, but will be the first to be paid off if the borrower defaults on their loan.
The Benefits of Securitization
As mentioned previously, the main benefit of securitization is the fact that it makes it far easier for a borrower to get a commercial or multifamily real estate loan. Of course, it also makes it easier for homeowners to obtain home loans, but that is beyond the scope of this article. In addition to making commercial loans more available, securitization also allows for those loans to be offered on better terms, due to the fact that risks are split between multiple investors, instead of being held by one lender.
For instance, a bank may offer a borrower a 70% LTV, 5-year full-recourse loan, while a CMBS lender might be able to offer the same borrower 75%, 10-year, non-recourse financing. And, unlike a bank, which may not be able to make too many loans at once, a CMBS lender can generally take the proceeds they gained from selling the loan, and use them to make a new loan to another borrower. However, there are some limits; due to new risk retention rules, a lender must keep at least 5% of a loan on its balance sheet, which creates an incentive for lenders to avoid making loans they know a borrower will not be able to repay.
The Downsides of Securitization
When compared to the upsides of securitization, there are relatively few downsides. For borrowers, one potential downside includes the fact that, CMBS loans are not serviced by their original lenders. Instead, they are serviced by a separate company, referred to as a master servicer. If the loan goes into default, it will be serviced by a special servicer. Both of these servicing companies hold a fiduciary duty to the CMBS investors, not the borrower, which can lead to significant challenges.
For instance, a special servicer may attempt to foreclose on a property after just one or two missed mortgage payments. In addition, CMBS loans may also be more susceptible to technical defaults due to the strict rules that arise as a result of the securitization process. Technical defaults are defaults that occur for reasons other than a borrower failing to pay their mortgage, such as signing a lease with a tenant not approved by the loan servicer, or violation a loan’s special purpose entity (SPE) provisions.
In addition, securitized loans can lead to issues with the market as a whole, though much of this risk has been reduced through tighter underwriting standards and new regulations, such as the risk retention rules mentioned earlier in this article. During the 2008 financial crisis, the CMBS market, which had grown considerably during the economic boom of the early and mid-2000s, was racked by a series of catastrophic defaults. As a result, CMBS loan origination fell to a paltry $3 billion in 2009, down from $12 billion in 2008, and $229 billion in 2007 (in contrast, 2018 CMBS origination was approximately $77 billion).