BUYING AND OWNING REAL ESTATE: PUBLIC DEBT

A common example of public debt is a commercial mortgage-backed security (CMBS). A CMBS is a pool of mortgage loans that are assembled by a lender, and then sold in tranches to the public market. As borrowers make their regular mortgage payments, the proceeds are pooled together and then are paid to the owners of the debt securities in a priority dictated by the rating of the security. 


The security's rating is determined by a third party rating service such as Moody's, Fitch, Standard & Poor's and Dominion Bond Rating Service. The rating process involves the agency reviewing the pool of mortgage loans, including an examination of the underlying collateral assets, to determine the quality of cash flow that is likely to be derived from those loans. 


If the loans are of a very high credit quality, a larger proportion of the mortgage pool will be assigned an AAA rating. The rating categories are consistent with bond rating categories, so for instance the A tranche is subordinate to the AAA tranche, and the buyer of the B-piece will be subordinate to all of the more senior tranches. Usually, all the holders of the more senior securities must receive their principal and interest payments before the subordinate pieces receive theirs. As such, tranches with lower credit quality are riskier, but have higher return potential.


Because each tranche of the loan pool has a different set of risks, maturity, sensitivity to changes in interest rates and return, your investment decision should be based on the type of exposure you require for your portfolio. It should also incorporate your assessment of the interest rate environment and any likely changes. CMBS securities can be purchased from a broker of such securities. It is recommended that you consult with an advisor prior to purchasing such securities because they can behave differently depending on the interest rate environment.


Source: Ian Woychuk, Investopedia.com