Commercial real estate first mortgage debt is generally broken down into two basic categories:
1. Loans to be securitized or CMBS loans.
2. Portfolio loans. Portfolio loans are originated by a lender and held on its balance sheet through maturity.
In a CMBS transaction, many single mortgage loans of varying size, property type and location are pooled into a trust. The trust issues a series of bonds that vary in yield, duration and payment priority. Nationally recognized rating agencies then assign credit ratings to the various bond classes ranging from investment grade (AAA/Aaa through BBB-/Baa3) to below investment grade (BB+/Ba1 through B-/B3) and an unrated class which is usually the lowest rated bond class.
Investors choose which CMBS bonds to purchase based on the level of credit risk, yield, and terms desired. Each month the interest received from all of the pooled loans is paid out to all the investors, starting with those investors holding the highest rated bonds, until all accrued interest on those bonds is paid. Then the interest is paid to the holders of the next highest rated bonds and so on. The same thing occurs with principal as payments are received and dispersed. If there is a shortfall in contractual loan payments from the Borrowers or if loan collateral is liquidated and does not generate sufficient proceeds to meet payments on all the bond classes, the investors in the lowest bond class will incur a loss with further losses impacting more senior classes in reverse order of priority.