Finance  ·  Analysis

Increased Use of Subordinate Debt Poses Grave Risk for CMBS, Data Shows

A new study from Moody’s Ratings found the market contains $27 billion worth of subordinate debt on loans originated since 2014


Commercial mortgage-backed securities (CMBS) transactions that include subordinate debt in the capital stack face an increased risk of defaults and more complex workouts as billions of dollars of CMBS loans originated under lower interest rates mature into a higher interest rate landscape. 

The worrisome conclusions regarding CMBS financing come from a new report by Moody’s Ratings that studied the subordinate debt performance of both single asset, single borrower (SASB) CMBS and conduit CMBS. 

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All told, Moody’s calculated that the current CMBS landscape contains roughly $27 billion worth of loans carrying subordinate debt — both B notes and mezzanine loans — originated between 2014 and 2023. Much of that debt is likely impaired due to the altered interest rate landscape from the time of origination to its upcoming maturity. 

“The story really is how much subordinate debt is out there— it’s $27 billion,” said Darrell Wheeler, senior credit officer at Moody’s and co-author of the report. “A lot of subordinate debt became B notes after 2015, and in the 10-year loans coming due in 2025 there will be a lot of B notes for special servicers to deal with, so it’s more complicated.”

“Performance is a mixed bag,” he continued, “but we saw better performance for earlier vintage production that has matured, while the jury is still out for stuff that matured in 2023 and 2024.” 

There are two types of subordinate debt, B-notes and mezzanine financing. An A-note is a senior (i.e. larger) mortgage loan, while the B-note is subordinate to this amount and is directly secured by a first lien on the underlying collateral. Moreover, the B-note lender receives payments only after the A-note’s debt is fulfilled, and typically has little to no control of the outcome of any defaults, including ones initiated by the B-note side. 

Mezzanine debt is secured by the equity interest of the borrower, rather than the property. During a default, the mezzanine lender forecloses on the borrower’s position and becomes the borrower in the capital stack – this lender only receives payments once the senior and B-note lenders are fulfilled. 

The issue at stake today is that CMBS deals originated over the last decade increasingly used subordinate debt to finance transactions, and now that the nation has entered a period of high interest rates and increasing CRE distress, those CMBS loans with more subordinate risk are more likely to default, according to Moody’s. 

Among $164.9 billion of SASB deals carrying $10.8 billion in subordinate debt Moody’s has rated since 2016, 15.6 percent of loans with subordinate debt have defaulted, compared to 6.5 percent of SASB loan defaults without subordinate debt; among the $355.9 billion of conduit deals carrying $27.7 billion in subordinate debt Moody’s has rated since 2016, 11.6 percent of loans with subordinate debt have defaulted, compared to 7.9 percent of loans without that debt. 

“As interest rates increased post-2022, this extra subordinate leverage has contributed to several 2023 defaults,” wrote Wheeler. “SASBs have shorter mortgage terms than conduit loans, exacerbating their rate vulnerability.”

This rate vulnerability has been dangerously augmented by an expansion of total leverage in the SASB space: Of the $47.8 billion of SASB loans originated between 2016 and 2023 that had $10.8 billion of subordinate debt, Moody’s found that Moody's loan-to-values increased 28 percentage points to a stunning 143 percent. 

If that’s not enough, Moody’s warns that conduit loan performance is likely to begin experiencing difficulties within the next year, as well, as the majority of post-2014 conduit issuance used mortgage B-notes to structure the subordinate debt rather than mezzanine debt financing. 

“It really started in 2013, but by 2015 they were doing more subordinate debt in the format of B notes than in mezzanine notes, and with B note your additional debt is secured by the property,” explained Wheeler. 

Typically mezzanine debt had been used to finance conduit CMBS, but by 2015 that equation had flipped: A/B note structures created $2.8 billion in B-note debt, while mezzanine loans produced only $1.3 billion in debt. The evolution away from mezzanine loans to B-note loans held outside CMBS trusts will complicate workouts during defaults, as co-defaults of the A/B-note split initiate a complex special servicer dance not sparked by traditional mezzanine loan defaults. 

“As those B-notes start to mature, a default on the B-note is also default on the A-note, and the servicer has to work out the loan with the interest of the A and B note in mind,” explained Wheeler.  

Between 2015 and 2023, loans with B-note subordinate debt reached $13.7 billion while loans with mezzanine subordinated debt came out to $7.1 billion. 

“As these conduit loans start maturing in 2025, their servicers will have to maximize workout strategies for both the A-notes and B-notes, and in some cases the B-note holders will control the special servicer’s actions,” Moody’s notes. 

While performance for pre-2015 vintage conduit CMBS with subordinate debt has been strong – the 76 percent refinance rate is almost identical to the 77 percent refinance rate for conduits without subordinate debt – that pattern is expected to change as post-2015 conduit CMBS matures into a higher interest rate environment. 

Moody’s calculated that $2.6 billion of maturing conduit loans originated in 2014 and 2015 had average coupons of 4.6 percent and 4.1 percent, respectively, but those same borrowers will need to refinance their A-note and subordinate debt into mortgage rates as high as 7.5 percent 

“They will have to reduce the securitized mortgage proceeds to meet a 1.2X DSCR threshold,” Moody’s writes. “Thus, the increased use of B-notes after 2015 may cause a reduction in the number of quick resolutions with low losses for conduit loans with sub debt.” 

Finally, the refinancing risk is exacerbated by the increased leverage that borrowers used when financing their subordinate debt CMBS transactions, one that could make prepayments difficult as debt service declines. 

“For vintages that have not yet fully matured, the prepayment rate for conduit loans originated from 2014 through 2023 with sub debt is 17 percent, slightly higher than the 13 percent for those without sub debt,” wrote Moody’s. “But now with the increase in interest rates since 2022, this trend will likely reverse and prepayments will decline for loans that have subordinate debt.”

Overall, Moody’s isn’t optimistic on the fate of CMBS workouts. 

“As the majority of CMBS 2.0 conduit loans have yet to mature in the high-rate environment, subdebt will play a greater role in maturity default resolutions over the coming few years,” wrote Moody’s. “The inability to dismiss B-notes during a foreclosure will lead to longer, more complex conduit loan workouts as 2025 approaches.” 

Brian Pascus can be reached at