What are the Advantages of Securitization?
Mortgage debt is the most commonly securitized asset, with common securitized products including mortgage-backed securities (MBS), commercial mortgage-backed securities (CMBS), and commercial debt obligations (CDOs).
Advantages of Securitization for the Commercial and Multifamily Real Estate Industry
In the process of securitization, one or more assets are 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 are 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, five-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 violating 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).
Related Questions
What is securitization and how does it work?
Securitization is the process in which commercial or residential real estate loans are pooled together, packaged into a financial product, and sold to investors on the secondary market. Not all types of commercial real estate loans are securitized, but many are. For instance, CMBS and conduit loans are always securitized and sold as commercial mortgage-backed securities. Many HUD multifamily loans and Fannie Mae®/Freddie Mac® loans are also securitized.
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.
What are the benefits of securitization for commercial real estate?
Securitization has a variety of benefits for commercial real estate borrowers, such as increased liquidity in the market, which can make it easier for borrowers to get loans in the first place. In addition, that increase in market liquidity may also eventually bring down interest rates for borrowers. Securitization also allows for 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, five-year full-recourse loan, while a CMBS lender might be able to offer the same borrower 75%, 10-year, non-recourse financing.
What types of commercial real estate can be securitized?
Securitization is the process in which commercial or residential real estate loans are pooled together, packaged into a financial product, and sold to investors on the secondary market. Not all types of commercial real estate loans are securitized, but many are. For instance, CMBS and conduit loans are always securitized and sold as commercial mortgage-backed securities. Many HUD multifamily loans and Fannie Mae®/Freddie Mac® loans are also securitized.
In general, 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 are also commonly securitized.
What are the risks associated with securitization?
The main risks associated with securitization are increased prepayment penalties, difficulty getting assistance if the property goes through a financial rough patch, and potential technical defaults. Securitized loans are no longer owned by the original lender, and 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. 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.
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How does securitization affect the cost of capital for commercial real estate?
Securitization can have a positive effect on the cost of capital for commercial real estate borrowers. By increasing liquidity in the market, it can make it easier for borrowers to get loans in the first place, and may eventually bring down interest rates. However, securitization also comes with drawbacks, such as increased prepayment penalties and the need for defeasance, which can be expensive and time consuming.
For more information, see Securitization in Commercial Real Estate.
What are the differences between securitization and traditional financing for commercial real estate?
Securitization and traditional financing for commercial real estate differ in terms of the availability of loans, the terms of the loans, and the risk carried by the lender. Securitization makes it easier for borrowers to get a commercial or multifamily real estate loan, as risks are split between multiple investors, instead of being held by one lender. This can allow for loans to be offered on better terms, such as a higher loan-to-value ratio and longer loan terms. Additionally, 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. On the other hand, traditional financing typically involves a single lender carrying the risk of the loan, and may offer lower loan-to-value ratios and shorter loan terms.
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