What is Securitization?
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. In contrast, many, but not all HUD multifamily loans and Fannie Mae/Freddie Mac multifamily loans are securitized.
What are the Benefits of Securitization?
Securitization has a variety of benefits, but these benefits aren’t always clearly apparent to the borrower. In fact, securitization mainly benefits lenders, as they can remove most or all of a borrower’s debt from their balance sheets once they have sold it on the secondary market, reducing the amount of risk they carry and permitting them to make more loans. This can increase liquidity in the market, which (albeit somewhat indirectly) can make it easier for commercial real estate borrowers to get loans in the first place. In addition, that increase in market liquidity may also bring down interest rates for borrowers— though this isn’t necessarily a clear cause and effect relationship.
What are the Drawbacks of Securitization?
The main drawback of securitization comes in the form of increased prepayment penalties. When a commercial real estate loan is no longer held by a lender, and is instead held by investors, those investors have purchased the debt as an income-generating asset, and expect to receive the income they’ve been promised. They don’t have a personal relationship with the borrower (as a local bank or lender might) and have no incentive to cut them a break if they wish to repay the loan early. For borrowers, that means high prepayment penalties and strict rules about how and when loans can be repaid. In many cases, securitized debt won’t just incur a high prepayment penalty, it will often have to be repaid via the process of defeasance.
Defeasance involves replacing the remaining amount of debt with securities (such as U.S. treasury bonds) that will provide the investor an equal or greater amount of income over the remaining term of the loan. Defeasance can be expensive and time consuming— and, in most cases, borrowers will have to hire an outside expert in order to make sure that the process goes without a hitch.
In addition, another drawback of securitization is the fact that it is much harder for borrowers to get any form of assistance if their property goes through a financial rough patch and they have trouble repaying their loan. As previously mentioned, securitized loans are no longer owned by the original lender, and, especially if the loan is packaged with hundreds (or thousands) of other commercial loans, there is little incentive for investors, servicers, or others to provide any kind of relief for a borrower.