Commercial mortgage-backed securities involve mortgages for commercial real estate, reducing risk for investors as commercial borrowers are less likely to pay off loans early. Bundling loans reduces risk from individual borrower default, but makes overall risk assessment more difficult. Commercial mortgages have heavy prepayment penalties, reducing risk for investors. Foreclosure clauses can provide reliable income for investors.
Commercial mortgage-backed securities are a type of investment where income comes from mortgage payments. Mortgages are for commercial real estate, such as office buildings and factories, rather than residential property. Theoretically, this reduces risk for investors, since commercial mortgage borrowers are less likely than residential borrowers to pay off their loans early.
A mortgage-backed security involves mortgage lenders, such as banks, selling the rights to receive repayments on multiple loans. These loans are bundled so that each investor has a share in an overall package that covers multiple mortgages. The goal of this is to reduce the risk to investors from individual borrowers defaulting on the mortgage. The bundling technique means that a particular default has only a small effect on the overall redemption income, and this small effect is in turn shared among many investors. However, there are some drawbacks; the bundling 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 prepays the outstanding balance, the total income for the lender is less. This is because, despite the early repayment penalties, the lender still misses out on future interest payments, which can often exceed the loan amount. With a mortgage-backed security, this loss is borne by investors, who earn less income than expected.
At least in the United States, commercial mortgages are generally more prone to heavy prepayment penalties, making borrowers less likely to take this option. In some cases, the borrower may even be prevented from repaying the loan early under any circumstances, or may be locked up for a certain number of years before being eligible to repay it early. Therefore, these restrictions reduce the risk of prepayment-related losses for investors in commercial mortgage-backed securities.
In some cases, commercial mortgage-backed securities may benefit from the underlying mortgages that have a foreclosure clause. This means that the borrower cannot simply pay cash to pay off the loan early. Instead, the borrower must provide the lender with a security product of equivalent value, usually in the form of bills or treasury notes. Investors will earn an interest in these securities, which provides a very reliable and constant income. In some cases, discharge is not mandatory for the borrower, but rather an alternative to paying off the loan early in cash.
Smart Asset.
Protect your devices with Threat Protection by NordVPN
