CMBS, or commercial/collateralized mortgage-backed securities, is a whole world unto itself in real estate finance that revolves around the bundling and packaging of pools of real estate loans that are then marketed for sale. Before these pools are sold, if the loan pool is large enough, it is legally separated into tranches (slices), which are ownership claims on the cash flows of a certain level of seniority, each of which is given a security credit risk rating, just like a corporate bond. This allows the overall CMBS offering to appeal to a more diverse set of buyers with different risk profiles.
The tranche that has the residual (last) ownership claim on cash flows is often marketed as “unrated” (shown as “UR” in the Figure below), and sits at the bottom of the stack. Due to its highest risk (first-loss position after equity) among the group, this tranche will be priced the lowest and thus have the highest targeted IRR (overall yield). The IRR assumes repayment of principal in full, however, and this unfortunately does not always come to pass.
A certain percentage of borrowers within the pool of loans will likely default by not repaying their loan principal in full or at all. When a CMBS offering is put together and offered to the market as a tradable, SEC-regulated security, this disclosure is made and buyers of the securities make their purchases with open eyes relative to default risk.
The way CMBS securities work is that holders of the most junior tranche will take the loss first, and if the loss exceeds the principal amount of that most junior tranche, holders of the second most junior tranche will take the loss next, and so on up on the stack. You can simulate various levels of default in the interactive spreadsheet template below (change the percentage value in cell c11), which you are free to download and repurpose by clicking on the download icon.
The Linneman textbook does a phenomenal job of teaching CMBS and frankly, every other facet of the commercial real estate business. It can be purchased here.