February 28, 2005

Commercial Financing and Waterfalls in Commercial Mortgage Backed Securities

The Waterfall Determines Which Investor in a Commercial Mortgage Backed Security Gets Paid First

When commercial mortgage loans are securitized, they are assigned to a trust that assembles these commercial loans into a large pool of around $1 billion. The trust then sells bonds backed by the commercial loans in this pool.

But not every investor (bond buyer) gets the same yield. A nervous insurance company may be willing to accept a much lower yield in return for the right to be the very first lender to receive his principal and interest in the event of a shortfall. This Nervous Nellie insurance company may buy some of the AAA-rated bonds (the lowest risk "tranche").

A more aggressive bank may be willing to take more risk in return for a higher yield. This bank may buy some of the AA-rated bonds and would be second in line to be paid in the event of a shortfall.

The process continues until only the very risky "B-piece" remains. The bonds in the B-piece tranche are typically unrated, but they may offer a yield as high as 16% to 20%! Of course, if there are any losses in the pool, the first class of bonds to take the hit will be B-piece.

The procedure that describes which investor gets paid all of his principal and interest first, and then who gets paid second, third, fourth, etc., if there is any money left over, is known as the waterfall.

A waterfall can get quite convuluted in a structured financing deal where there is a mezzanine loan and some preferred equity behind a conduit (CMBS) loan. The rents come in from the property, and the first lender to be paid will be the conduit first mortgage.

Then the mezzanine loan piece might get paid a coupon rate of 10%. Next the preferred equity holders may be paid a 12% coupon, and then the owners may be paid up to 8% on their original downpayment, and finally any excess may be paid to the mezzanine loan lender.

The waterfall is the provision in the Intercreditor Agreement that details where the payments go.

In addition to permanent lenders, you can find numerous mezzanine lenders on C-Loans.com.