For those who own or manage income-producing properties, CMBS loans may be a sound financing choice, but beware. These attractive commercial real estate loans have some challenges that borrowers should be informed of prior to the execution of any loan documents.
A CMBS loan in long form is called a Commercial Mortgage Backed Securities loan. Simply put, it is a commercial mortgage loan that lenders originate to be securitized or sold on the secondary market. After issuance, the CMBS loan is transferred from the lender to a REMIC trust (“Trust”) that is created to carry out the securitization process. The loan is pooled together with other similar loans and the Trust assesses the loan value based on factors affecting the performance of the loan and the expected yield. The pooled loans are then divided into bonds, and the Trust issues a series of bonds available for purchase by investors. The proceeds from the sale of the bonds are used to pay off the lender, and are expected to generate profits for the classes of bondholders during the loan term.
Since the 2008 recession, CMBS loans have been gradually re-entering the market. These loans are only made available to developed income producing properties such as hotels, office buildings, residential communities, retail plazas, warehouse facilities, hospitals and other commercial properties. Borrowers find CMBS loans very attractive for three primary reasons: (1) large loan amounts; (2) lower interest rates; and (3) non-recourse terms (with exceptions commonly called the “Bad-Boy Carveouts”).
What does this mean for borrowers? More money is available to invest with minimal personal risk to ownership. How? The property asset is the collateral for the loan and not the borrower’s personal finances or investments. Generally speaking, CMBS loans are structured with terms favorable to borrowers with stabilized and developed commercial properties. However, there are disadvantages to these loans that borrowers need to know in order to minimize unexpected and onerous loan terms.
The most prominent flaw is there is limited opportunity for negotiation of the loan terms, commencing with the term sheet. While the term sheet may not be binding once signed, most of the terms are not negotiable. This is because the majority of the terms provided are the material terms all loans in the Trust are required to have in order to attract participating investors and meet the rules of the Trust.
The loan must contain certain required terms such as loan-to-value ratios, occupancy requirements, minimum gross income, defeasance, financial reporting, separateness covenants, server selection and reserve accounts, to name a few. If the loan documents do not contain key terms requested by the Trust, the loan is not able to be securitized. Therefore, if the term sheet contains terms the borrower is not likely able to achieve, the borrower should attempt to negotiate the removal of those terms during the early stages to save time and money unnecessarily spent moving towards executing a loan agreement with unattainable commitments.
Next, another downside of CMBS lending is the fact that a borrower’s relationship with the lender terminates once the loan is securitized which makes loan modifications for curing of defaults or any other reason not easy to achieve. In a traditional mortgage loan, a borrower can contact the lender and propose modifications to the loan agreement. With CMBS loans, that direct relationship with the originating lender, who you may have a favorable relationship with, is eliminated.
Immediately after closing, a third party master servicer services the loan and collects loan payments. In the event of a default, a different party known as a special servicer steps in to resolve the default. All of this means your friendly banker who may have issued the loan to you cannot help in post-closing loan modifications.
To minimize the likelihood of the initiation of a special servicer whose main purpose is to strictly enforce the terms of the loan, it is critical for the borrower to identify what situations may arise that may affect the performance of the loan and the property, and try to negotiate solutions for these possible events early on during the loan agreement process. This will provide guidance to all relevant parties on how to resolve as many predictable events as possible and reduce some uncertainty for the borrower.
Another drawback to entry into CMBS loans are the ever-changing loan requirements based on market conditions and federal regulations. Recent trends include stricter underwriting procedures, mandatory use of a single-purpose entity, reduced number of available loans, increased obligations on the loan originators, increased financial reporting requirements, and regulatory changes. Be aware of CMBS market trends and identify how the changes may impact your current investments and future CMBS lending opportunities. The CMBS loan terms previously granted may not be available on future loans.
Having recently closed multiple CMBS loans, I have witnessed the positive and the negative side of securitized loans. I recommend all commercial real estate owners, developers and investors who are considering obtaining a CMBS loan make sure to retain legal counsel with the following attributes:
1. Is well informed of the securitized lending terms and how they differ from traditional mortgage loans;
2. Can identify which terms are negotiable;
3. Knows the differences between single-member and multi-member ownership requirements;
4. Understands the functions of a single-purpose entity and an independent director; and
5. Knows how to navigate post-closing issues with master and special servicers.
Taking these steps should ensure the borrower is able to focus on the benefits CMBS loans can generate for investment in the property, and not be hindered or discouraged by its loan requirements. Look for my next blog in the CMBS series spotlighting the Bad Boy Carveouts.
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