Conduit loans are loans used to purchase commercial property. However, unlike a traditional commercial mortgage, these loans are packaged and sold to investors on the secondary market in a process known as securitization. Due to this, these loans behave differently than a standard commercial real estate loan.
- Conduit/CMBS Loans Explained
- Conduit Loans vs. Traditional Commercial Mortgages
Conduit/CMBS Loans Explained
When you get a traditional commercial real estate loan, you approach a lender, receive funds and pay the loan back to the lender over the course of several years. However, when you get a conduit loan, the loan will be packaged with other commercial mortgages into a trust, known as a Real Estate Mortgage Investment Conduit (REMIC), and sold on a secondary market to investors. This is a process known as securitization, and this is why these loans are also referred to as commercial mortgage-backed security (CMBS) loans. After your loan is sold to investors, this will change some aspects of how the loan will be administered and who you will deal with when making payments or changing the loan.
Most conduit loans have a balloon payment at the end of a five or 10 year term. However, the monthly payments follow a 20 or 30 year amortization period. This means that the monthly payment will be equal to what you would pay if the loan had a 20 or 30 year term, but you will pay off the loan in five or 10 years instead. The last payment on the loan will be the balloon payment where you pay back the remaining principal and interest.
|Average Terms and Features|
|Minimum Loan Amount||$1 - $2 million|
|Loan-to-Value Ratio||60% - 75%|
|Interest Rates||3.5% - 5.3%|
|Loan Term||5 - 10 years|
|Amortization Period||20 - 30 years|
Conduit loans normally have lower interest rates when compared to traditional commercial mortgages, and most have fixed interest rates. The interest rate will generally be based on a U.S. Treasury rate plus a margin. For example, if the current 10-year U.S. Treasury rate is 2.13% and the margin is 2.00%, the interest rate on your loan would be 4.13%. Your creditworthiness, the value of the property you’re purchasing and the strength of your business will all affect the margin.
Another thing that is attractive about these loans is that most are non-recourse and assumable. A non-recourse loan means that a borrower is not personally responsible for repayment of the loan. This means that you won’t have to make a personal guarantee when you take out the loan. The main exception to this is what is known as “bad boy carve outs”, meaning that if you intentionally cause harm to the property, conduit lender or investors, you could become personally liable.
Secondly, many of these loans are fully assumable. This means that if you decide to sell the property, the buyer can take over the loan for you, releasing you from any obligation on the loan. However, some conduit lenders charge a fee for allowing the loan to be assumed by another borrower. Loan assumption normally occurs when the loan on the property has a below market interest rate, as it helps the buyer save money on financing the property.
One downside to conduit loans is that borrowers generally have less flexibility in negotiating loan terms. This is because the trust overseeing the securitization of the loans must comply with certain tax laws. In addition, once the loan documents are signed, borrowers have little recourse to change terms or features of the loan (again due to the tax laws governing the trust), unless the loan is in default. Borrowers should carefully think about any future financing needs or needs for the property they're purchasing before they take out a CMBS loan.
Conduit/CMBS Loans vs. Traditional Commercial Mortgages
Because these loans are pooled together and sold to investors, they behave a little differently than a traditional commercial real estate loan. The main differences that borrowers should know about are how prepayment works and the parties who will be involved in managing the loan.
On a traditional commercial mortgage, a prepayment penalty is usually calculated as a percentage of the interest lost. On an SBA 504 loan, for instance, the prepayment penalty is equal to 100% of the annual interest if you prepay during the first year. For the second year, the prepayment penalty will be 90% of the annual interest. So if the annual interest paid during the second year of the loan is $10,000, the prepayment penalty would be $9,000.
However, on a conduit loan, prepayment is normally done through either defeasance or yield maintenance.
When you get a mortgage, whether a residential or commercial one, the property you’re purchasing is used as collateral to secure the loan. If you can’t make payments on the mortgage, your lender has the right to keep or foreclose the property (this is what is known as a lien). The lender will either hold the property until you can repay or sell the property to recoup some of their money.
For a traditional mortgage, the lien on the property will be released once the mortgage is repaid. If you want to pay off your mortgage early, you will incur a prepayment penalty. Because conduit loans are packaged and sold to investors, prepayment is not always an option. Instead, some conduit lenders require borrowers go through a process known as defeasance to release the lien on the property. When you defease a loan, you will need to put up new collateral to replace the property. Defeasance is not technically prepayment, but it is a way for borrowers to release their property from the outstanding lien. In this case, the new collateral is almost always bonds.
When you defease your loan, the loan itself will remain outstanding, but the property will be freed from the lien (borrowers can then sell or refinance the property). The bonds used as the new collateral will need to generate enough interest to cover all future payments on the loan; otherwise, you may have to pay a penalty. Typically, you cannot defease a conduit loan for the first two years of the loan.
Yield maintenance is a form of prepayment penalty that a lender will charge if the borrower wants to pay off his loan early or refinance the loan for a lower interest rate. When a borrower prepays a loan, the lender will lose out on future interest payments. Lenders charge prepayment penalties to recoup some of this loss interest and dissuade borrowers from prepaying or refinancing a loan.
The purpose of yield maintenance is to let the investors earn their original yield (which is the interest you were paying on the loan). The goal of yield maintenance is to allow the conduit lender to reinvest the money returned from the borrower, plus a penalty fee, into bonds or other investments and receive the same cash flow as if the loan hadn’t been paid off early.
The lender will calculate how much additional money they need from the borrower to make up this difference. The actual calculation takes the present value of the remaining loan payments and multiplies this number by the difference between the loan’s interest rate and the interest rate of comparable U.S. Treasury bonds. This number will be the amount owed as a prepayment penalty.
Yield maintenance prepayment penalties can be very high. However, because the lender is guaranteed to receive all of the interest on the loan, you can usually get a better interest rate on loans with yield maintenance.
Because a conduit loan is pooled with other loans, placed into a trust and sold to investors, the servicing and administration of the loan will change a little bit. Once your loan has been securitized, you won’t be working directly with a lender anymore. Instead, the loan will be in a REMIC trust, and you will work with a commercial mortgage servicer, referred to as a “Master Servicer”. There are other players in the trust that you may interact with, depending on what happens to the loan.
Master Servicer: As a borrower, this is who you will make payments to. The Master Servicer is a commercial mortgage servicer that manages all the day-to-day servicing of the loan. Beyond collecting payments, this includes managing any escrow accounts, inspecting the property, reviewing requests from borrowers and creating financial statements for the loans. In some cases, a Master Service may subcontract these responsibilities to a Primary or Sub Servicer.
Special Servicer: If you stop making payments on your loan and it goes into default, it will be given to a Special Servicer. The Special Servicer can work with you to modify or change the loan as long as it is in the best interest of the investors. This includes changing the loan terms, deferring or forgiving interest or fees, foreclosing on the property or allowing a substitution of collateral or the assumption of the loan. If the loan is transferred to a Special Servicer, an appraisal will need to be performed (often done at the borrower’s expense).
There are other players in the trust, but these are not parties that you will typically interact with as a borrower. All of these roles and responsibilities will be outlined in a Pooling and Service Agreement (PSA) that is signed when the REMIC trust is formed. While each PSA will be unique, there is a lot of standardization across them due to the tax laws governing the trust. This means that you have less room to negotiate the terms of your loan, especially when compared to a traditional commercial real estate loan.
Some examples of restrictions that may be in your loan agreement are listed below:
- Your business generally needs to be a single-purpose entity that is bankruptcy remote. Single-purpose entities are normally incorporated as limited companies or limited partnerships.
- Secondary financing on the property may be prohibited.
- Many loans come with a “lock-out period” during which no prepayment is permitted.
- Defeasing the loan within the first two years may not be permitted.
We recommend borrowers think very carefully about their financing needs and the needs of the property during the life of the loan before agreeing to a conduit loan. Any feature or flexibility you need should be clearly indicated in the loan documents. Once the loan documents are signed and the trust is formed, you will not be able to make any significant changes to the loan terms unless the loan is in default.