The Unique Aspects of CMBS Loans: APrimer for Borrower’s Counsel
Susan J. Booth*
The author of this article discusses some of the primary differences between commercialmortgage-backed securities loans and balance-sheet loans. Although the two types ofloans are more similar than different, the differences are material and important. Identify-ing and understanding these differences and the ways in which they may impact a bor-rower is essential to providing effective borrower representation.
Commercial mortgage-backed securities(“CMBS”) loans and balance-sheet loans arenot created equal. While there are manysimilarities between the two types of loans,the differences are material and important.Identifying and understanding these differ-ences and the ways in which they may impacta borrower is essential to providing effectiveborrower representation.1
CMBS Loans Overview
Generally
CMBS loans are typically non-recourseloans that materially comply with a standard-ized set of requirements (e.g., single-assetborrower) and have a term of five, seven, 10or (rarely) 15 years. The loans may providepost-closing advances for value-add op-portunities (e.g., tenant improvements), butthe vast majority of principal is advanced atthe closing of the loan. Thus, constructionloans and loans involving significant redevel-
opment funded by the lender are notsecuritized.2
Each CMBS loan bears a fixed interest rate.3
A borrower is required to make a monthly pay-ment of principal and interest, generally basedon an amortization schedule of 25–30 years;however, some loans will include an interest-only period at the start of the term. As such(and assuming no defaults), the timing andamount of each loan payment throughout theterm is ascertainable when the loan closes.
In a CMBS transaction, multiple individualcommercial mortgage loans are pooled to-gether with other commercial mortgage loansand transferred to a trust, typically a pass-through entity (not subject to tax at the trustlevel) known as a real estate mortgage invest-ment conduit (“REMIC”).4 The trust issues aseries of bonds (also referred to as certifi-cates), which are segregated into differentclasses (also called tranches). These bondsall relate to the same pool of mortgage loan
*Susan J. Booth is a partner in the Los Angeles office of Holland & Knight. The author thanks Dora de la Rosa, anassociate at the firm, for her significant contributions to this article.
collateral but may vary in yield, duration andpayment priority.5 Nationally recognized rat-ings agencies (e.g., Moody’s Investor Service,Fitch or Standard & Poor’s) will assign a creditrating (which may fall anywhere in the spec-trum between unrated and investment grade)to each bond.6 The bonds are then sold on apublic exchange.
Once the CMBS loan is transferred to thetrust and securitized, the loan is serviced inaccordance with the applicable loan docu-ments and a Pooling and Servicing Agreement(“PSA”). Each trust has its own PSA, contain-ing a unique set of terms. The PSA governsthe allocation and distribution of loan proceedsand losses to the bondholders. It also de-scribes how the loans are to be serviced andincludes guidance to ensure that the trustcontinues to comply with the REMIC provi-sions in the tax code.
The pool of loans is not serviced by the trustbut by two servicers, a master servicer and aspecial servicer. The master servicer is theprimary servicer. Its duties are limited to rou-tine matters (e.g., reviewing financial reports,preparing reports to investors and confirmingsatisfaction of disbursement conditions).7 Thespecial servicer addresses loan prepayments,defaults and any other matters that divergefrom the express terms of the loan documents(e.g., lease that does not meet leasingrequirements).8 One key difference betweenportfolio loans and CMBS loans is theservicing. Each portfolio lender applies its ownindividualized servicing standards to each ofthe loans it holds. A CMBS servicer acts in ac-cordance with the specific PSA applicable toall of the loans in the pool it governs. It is worthnoting that while there are variances in theobligations of a servicer under a PSA, for the
most part, the practices and procedures arestandardized to meet REMIC requirementsand to protect the bondholders.
Commercial mortgage lenders are attractedto the CMBS market because the aggregatevalue of the bonds backed by a pool of loansare generally worth more than the sum of thevalue of all of the loans, enabling the lender toprofit off of the arbitrage.9 The securitizationmarket also has enabled lenders to financeassets that would not otherwise be eligible fora lender’s balance-sheet. It is also much eas-ier for a lender to sell the bonds than it is forthe lender to sell individual mortgage loans.
Investors who buy the bonds are attractedto the certainty of a pre-determined incomestream. The diversity among the securitizationcertificates, including with respect to monthlypayment amounts, duration of payments andrisk of non-payment, also enables an investorto match the investor’s specific needs to thebond’s income stream. The public marketmakes trading the certificates quick andsimple, effectively turning illiquid assets intoliquid investments.
Advantages and Disadvantages ofCMBS Loans from the Borrower’sPerspective
Advantages
A borrower is often drawn to a CMBS loanfor the following reasons:
E Lower Interest Rates. CMBS loans typi-cally have lower interest rates thanbalance-sheet loans for several reasons.First, there is less risk (and thus a lowerreturn) in a diversified pool of securitizedmortgages because the losses from a
single defaulted loan may be offset bythe strength of the remaining loans in thepool. Second, the original lender earnsfees and other income, including premiumpayments by investors for bonds in spe-cific tranches, from the sale of the loan atsecuritization, thus increasing the lender’sreturn on investment beyond that it wouldreceive if its only income were debt ser-vice payments. Third, the enhancedliquidity and structure attracts a broaderrange of investors to the commercialmortgage market, resulting in lower inter-est rates than balance-sheet loans. Thedelta between the interest rate on aCMBS loan and a balance-sheet loan isless significant when interest rates arelow because the benefits to CMBS lend-ers are compressed; however, as interestrates rise, the delta becomes increasinglysignificant.
E Higher Overall Loan-to-Value (“LTV”)Ratio. A balance-sheet lender is oftenprohibited by its own institutional policiesor regulatory requirements from lendingmore than 70 percent of the appraisedvalue of the property.10 A CMBS lender isnot typically bound by the same type ofinstitutional policies and regulatory re-quirements because it is not holding theloan for its own account. It is not uncom-mon to see a CMBS loan with an LTV of80 percent or, particularly in combinationwith a mezzanine loan, even higher.11
E Increased Availability of Capital. Thereare clear limitations on the amount ofcapital that a balance-sheet lender canadvance because it must reserve againsteach loan that it holds on its books.12
These limitations on the aggregate capital
that a balance-sheet lender can lendcause the lender to be more selectiveabout the loans that it will make. Incontrast, a CMBS lender sells each loan(other than the five percent it is legallyrequired to retain13), freeing up its capitaland allowing it to continue originatingloans. With the notable exception of the2008–2010 time period, there has been avirtually unlimited supply of capital in theCMBS market.
Disadvantages
A borrower often focuses on the lower inter-est rate and higher LTV offered by a CMBSloan and fails to appreciate the following dis-advantages, which have proved themselves tobe problematic for many borrowers:
E No Continuity of Lender. A CMBS lenderis not a “relationship lender.” Its relation-ship with a borrower is purelytransactional. Once a loan is securitized,the original lender (or, if the originallender becomes a servicer, the originallender’s personnel) ceases its involve-ment with the loan. The borrower mustnow deal with a master servicer andspecial servicer, each appointed by thesecuritization trust and with whom theborrower has no pre-existing relationship.
† Master Servicer. One of the principalobligations of the master servicer isto enforce the loan documents.14 Themaster servicer has no incentive,and strong disincentive, to vary fromthe express terms of the loandocuments. This is true even whencircumstances clearly necessitate aliberal reading or modification of theloan documents.
The Unique Aspects of CMBS Loans: A Primer for Borrower’s Counsel
† Special Servicer. Unlike the masterservicer, the special servicer hasbroad (but not unlimited) power tomake decisions that go beyond, orconflict with, the terms of the loandocuments as long as the specialservicer honors it fiduciary obligationto act in the best interest of thebondholders.15 The special servicerreceives most of its income from thefees that it charges a borrower to ad-dress a particular request.16 If the cir-cumstances of a loan require multipleand extensive interactions with aspecial servicer, the fees that a bor-rower pays to the special servicermay negate the benefits that the bor-rower receives from the lower inter-est rate. It is worth noting that a bor-rower can often achieve greaterresponsiveness and flexibility from aspecial servicer by increasing theamount of fees it pays.
E Minimal Structuring Flexibility. The goalof a CMBS lender is to close and securi-tize the loan as quickly as possible. Dur-ing the securitization process, a CMBSlender will be required to certify that,except as otherwise noted, each of theloans meets the CMBS requirements.Any loan that diverges from the CMBSrequirements may slow, or even derail,the securitization process. In order toavoid this situation, CMBS lenders fre-quently respond to a borrower’s requestsfor changes in structuring or changes tothe terms of the loan documents by say-ing “We cannot make that change. CMBSrules prohibit it.” Frequently the foregoingstatement is inaccurate. There are defi-
nitely borrower requests that cannot beaccommodated if the loan is to be securi-tized (particularly as it relates to theREMIC rules), but more often than not,there are no legal reasons that a CMBSlender cannot accommodate the bor-rower’s request. Rather, the CMBS lenderis trying to avoid a situation in which it isrequired to note the matter as an excep-tion on its certification. Accordingly,CMBS lenders are often unwilling to ad-dress a borrower’s legitimate requestsand concerns. Any borrower that wantsto effectively negotiate with a CMBSlender should take the time to understandwhich variances from a lender’s standardpolicies and loan documentation willrequire the lender to make a disclosureduring the securitization process andwhich variances are legally prohibited.17
E No Unplanned Future Advances. Realestate projects are not static, and some-times unanticipated problems arise. Whilea portfolio lender is reluctant to advanceproceeds to a borrower beyond theamount of the original commitment, aportfolio lender may agree to do so if itbelieves that an infusion of capital willstabilize the project. For example, if thesole tenant at the project files for bank-ruptcy and rejects its lease during thebankruptcy proceedings, revenues fromthe property will cease. This situation isproblematic for both borrower and lender.If the borrower then procures another ten-ant willing to pay a reasonable amount ofrent, but the borrower does not haveenough money to pay for all of the tenantimprovements necessary to get the newtenant in place, a portfolio lender might
agree to make additional loan advances(above and beyond the original loan com-mitment) for this purpose. In the CMBScontext, once a loan has been securi-tized, additional loan funds cannot beadvanced because there is no lenderavailable to advance them. There areonly the servicers and the bondholders,neither of which has the requisite author-ity (or, with respect to the servicers,source of funds) to make any additionaladvances.18
E Rating Agency Confirmations. The needfor a borrower to conform to CMBS re-quirements does not end when the loancloses and continues through the fullrepayment of the loan. Certain actions,even if expressly permitted by the termsof the loan documents (e.g., loan as-sumption), are conditioned upon the bor-rower receiving a confirmation from a rat-ing agency that the action in question willnot cause a downgrade to the credit rat-ing of the securities issued in thesecuritization. A borrower will incur ad-ditional fees and expenses in obtaining arating agency confirmation, and thesecosts are in addition to the fees that theborrower pays to the servicers. Much likethe servicing fees, the costs of a ratingagency confirmation can reduce thebenefits that a borrower receives from alower interest rate.
E Securitization Indemnification Liability.One typical CMBS requirement mandatesthat the borrower indemnify the lenderfrom liability under Rule 10b-5 of the Se-curities Exchange Act of 1934 for anymisstatements in information or disclo-
sures to investors, rating agencies orother parties to the securitization.19
E Lack of Confidentiality. CMBS bonds arepublicly traded, and investors in the se-curities are provided with an opportunityto review loan files and disclosure state-ments before purchasing the bonds.20
The information provided to potentialinvestors includes financial informationabout the borrower, its parents and spon-sors, as well as third parties such as ten-ants and property managers.21 A bor-rower should not have any expectation ofconfidentiality in light of the broad dis-semination of information. If confidential-ity is important to the success of theunderlying property (e.g., a single-tenantdata center) or a borrower (e.g., high-profile individual), then a CMBS loan maynot be a good option for that borrower.
Negotiating the CMBS Loan
Many of the representations, covenants andagreements in a CMBS loan mirror thosecontained in a balance-sheet loan. This articlefocuses on material differences between thetwo loans that may create problems for aCMBS borrower.
General Matters
In a CMBS loan, the originating lender, withwhom a borrower may have had an ongoingbusiness relationship, ceases to be involvedonce the loan is securitized, and ongoing loanmatters will be handled by the master serviceror the special servicer. Many borrowers findtheir interactions with CMBS servicers to bevery frustrating because of long delays in re-sponses (or no response at all), the need for
The Unique Aspects of CMBS Loans: A Primer for Borrower’s Counsel
the borrower to pay additional fees to receivea response, and the borrower’s perceived (orreal) lack of reasonableness by the servicer.In order to minimize these frustrations, a bor-rower will want to reduce as much as possiblethe number of situations that require thelender’s approval or otherwise necessitateinteraction between the borrower and aservicer.
A borrower also should use extra care toensure that the loan covenants are specific,tied directly to the property or a loan party andare capable of performance, in accordancewith a strict reading of their terms. Loan cove-nants that are overly broad may have unin-tended consequences. For example, a strictreading of a covenant to the effect that, “Bor-rower shall not Transfer any Collateral withoutthe prior written consent of Lender,” meansthat a borrower will breach the covenant (andperhaps trigger liability for a guarantor) if theborrower allows tenants to take candy from adish in the lobby. While this is clearly not theintent of the provision, a borrower should notrely upon a servicer for a reasonable interpre-tation of the provision. A borrower would bebetter served by modifying the sample provi-sion to exclude transfers of property of minimalvalue.
Loan Payments
Under the CMBS framework, the masterservicer collects loan payments from each ofthe borrowers and then distributes the ap-pl icable port ion thereof to each thebondholders. In order to simplify this processand consolidate payments to the investors, allof the loans in a CMBS pool will have thesame due date for debt service payments.22
The actual payment date will vary among
securitization pools. A CMBS lender also willreserve the right in the loan documents tounilaterally change the payment date at anytime prior to the securitization of the loan sothat the lender has the flexibility to move theloan to a different securitization than it initiallyintended. A CMBS lender will not provide aborrower with any notice or right to cure a debtservice payment because doing so wouldmean payments on the various loans in asecuritization pool would be made on differentdays, which is an unacceptable result.
A CMBS loan often requires a borrower topay interest before it accrues, and even if theborrower repays the loan in full on the matu-rity date, the borrower will be required to payinterest on the loan past the maturity date. Forexample, debt service payments might be dueon the 10th day of each month, but the inter-est accrual period will run from the 15th day ofa calendar month through the 14th day of theimmediately following month. Each payment,including the payment due on the maturitydate, must include interest for the entire inter-est period (i.e., through the end of the interestaccrual period, in the example, the 14th day ofa month). The original lender may actually beentitled to receive the “excess” interest.23 Aborrower should be aware that although it iscommon in CMBS loans for each interest pe-riod to extend beyond the applicable paymentdate, a CMBS loan does not have to bestructured in this manner. Instead it can bestructured like a typical portfolio loan in whichinterest is paid in arrears (e.g., the interest pe-riod is a calendar month and payment is dueon the first day of the immediately succeedingcalendar month). The only requirement ap-plicable to the interest period in a CMBS loanis that all of the loans in the pool have the
same interest period.24 As a practical matter,this means that a CMBS lender may be unwill-ing to accommodate a borrower’s request forthe interest period to end prior to the paymentdate. A borrower should identify the paymentdates and interest period in the term sheet toavoid an unpleasant surprise.
SPE Requirements
CMBS loans are generally nonrecourse(other than traditional carveouts). If a loangoes into default, the property and the cashflow therefrom are the lender’s primary (andgenerally only) source of repayment. CMBSinvestors and rating agencies want the loanstructure to minimize potential disruptions inproperty cash flow. One means of accomplish-ing this is to isolate the real property fromother assets by requiring that the borrower bea single-purpose entity (SPE), holding a singleasset, in order to minimize the risk that theborrower files for bankruptcy as well as therisk of other disruptions in cash flow unrelatedto the loan and the asset.
Like CMBS lenders, balance-sheet lenders’loans also typically require a borrower to bean SPE; however, a CMBS lender’s SPErequirements are often more extensive andstringent than those of a balance-sheet lender.
A borrower should be aware that many ofthe SPE covenants in CMBS loan documentsare overbroad and may encompass items thatdo not relate to SPE matters. It is essentialthat a borrower review each of these itemsvery carefully to ensure that it can be fullycompliant with each one. One of the reasonsthat it is so important for a borrower to ensurethat it is capable of complying with the SPErequirements is that violations of SPE cove-
nants may trigger recourse liability under stan-dard CMBS loan documents. In Wells FargoBank, NA v. Cherryland Mall Ltd. Partnership,25
an SPE borrower had a loan covenant to“remain solvent.” The guarantor executed alimited recourse guaranty that triggered full li-ability to the guarantor if the borrower failed tocomply with the SPE covenants. When theborrower defaulted under the loan, the lenderforeclosed and then sought a deficiencyagainst the guarantor on the basis that theborrower’s insolvency constituted a breach ofthe SPE covenant and triggered liability underthe guaranty. The Cherryland court found infavor of the lender and held that the guarantorwas liable for the full amount of thedeficiency.26
The following is a list of CMBS requirementsthat are not typically contained in balance-sheet loans (other than those modeled off ofCMBS loan documents):
E Ownership. Except in unusual circum-stances, both the borrower and its parentmust be an SPE, and preferably in theform of a Delaware limited liabilitycompany.27
† A borrower will need an importantand intransigent reason if it wants toalter the SPE or Delaware limited li-ability requirement applicable to it orits parent. For example, in California,in order to obtain the tax benefitsfrom certain affordable housing proj-ects, the property owner must be alimited partnership, and the manag-ing general partner must be a non-profit corporation established for thispurpose.28 The foregoing structurewill not prohibit a loan from being
The Unique Aspects of CMBS Loans: A Primer for Borrower’s Counsel
securitized, but the borrower may berequired to educate the lender aboutthe reasons that the traditionalCMBS borrower structure needs tobe modified.
E Separateness covenants. A CMBS lenderimposes a number of requirements uponthe borrower to insulate it from otherentities.
† Independent Director. One of thecustomary CMBS requirements isthat the organizational documents ofeach of the borrower and its parentprovide for the appointment of oneor two (depending upon the amountof the loan) independent professionaldirectors and prohibit a voluntarybankruptcy filing and certain othermaterial actions without the approvalof the independent director.29 Theborrower is responsible for the costsassociated with retaining and main-taining the independent director.
If the amount of the loan issmall, a CMBS lender mayagree to waive the indepen-dent director requirement orat least agree that the inde-pendent director does nothave to be a “professional.”30
† Operational Matters. An SPE mustadhere to certain separateness cov-enants designed to ensure that theSPE acts as a separate entity, dis-tinct from its affiliates. These cove-nants generally include the following:(i) maintaining separate books andrecords; (ii) not comingling its assetswith those of any other entity orpermitting any other entity to access
its bank accounts; (iii) holding itselfout as a separate entity; (iv) main-taining separate financial statements;(v) filing separate tax returns; (vi)correcting any known misunder-standing as to its separate identity;(vii) maintaining an arms-length rela-tionship with its affiliates; (viii) fairlyallocating expenses shared with itsaffiliates; and (ix) using its own statio-nery, accounts, checks andinvoices.31 A borrower should care-fully review the lender’s SPE cove-nants to make sure they are entirelyconsistent with the borrower’s oper-ating practices. If there are anyinconsistencies, even small ones,then the borrower should insist thatthe covenants should be deleted ormodified as long as the changes donot violate the rating agency require-ments (as opposed to preferences).Otherwise, a borrower runs the riskof default and may create liability forthe guarantor for a violation of theSPE covenants. Some common cov-enants that may be inconsistent witha borrower’s operating practices andfor which such a borrower shouldseek (and may be able to obtain)modifications include the following:
Separate financial state-mentsE If a borrower’s assets are
included in a consolidatedfinancial statement, theborrower should be ableto revise the SPE provi-sions to ensure that aconsolidated financialstatement is permitted.
maintain separate statio-nery (and many SPEs donot), a borrower may beable to eliminate this re-quirement or at least seeklimited exceptions for rou-tine matters such asinvoices.
Conduct of business in itsown nameE It is unlikely that a bor-
rower will succeed ineliminating this require-ment altogether, but itshould be able to obtainreasonable exceptions(e.g., for business con-ducted on its behalf bythird parties, such as amanager).
Separate tax returnsE If a borrower is not legally
required to file a separatetax return, then it shouldbe able to remove thisrequirement.
No affiliate access to bor-rower’s bank accountE If a property is managed
by an affiliate of a bor-rower, the borrowershould seek an exceptionif the affiliate managerhas the right to accessany of the borrower’sbank accounts.
† Indebtedness. The SPE provisionsalso will include restrictions on in-debtedness, typically prohibiting theborrower from having any indebted-ness other than the mortgage loanand, possibly, a capped amount ofnon-delinquent trade payables.
Restrictions on indebtednessare set forth in the publishedrating agency criteria,32 so itis unlikely that a lender will
agree to remove them en-tirely; however, lenders arefrequently amenable to mak-ing reasonable modifications.E Common matters that of-
ten affect borrowers andthat lenders are oftenamenable to adding areequipment leases, en-cumbrances on title to theextent permitted by theloan documents, obliga-tions under leases (e.g.,tenant improvements)and contracts enteredinto in accordance withthe loan documents.Since each borrower’ssituation is unique, it isimportant that a borrowercarefully review the limi-tations on indebtednessto make sure any existingor potential indebtednessis identified and specifi-cally permitted.
† Solvency. The SPE provisions willinclude a covenant regarding sol-vency of the borrower.33 At one timevirtually all lenders required the bor-rower to agree that it would remainsolvent throughout the loan term.More recently, loan documents seemto be split between that covenantand one linking the borrower’s obli-gation to remain solvent to the cashflow available to the borrower fromthe real property asset.
A borrower should pay par-ticular attention to covenantsinvolving solvency, adequatecapital and payment ofexpenses. A borrower shouldtry to remove all of the cove-nants regarding borrower’scapital and its adequacy, al-though doing so may be
The Unique Aspects of CMBS Loans: A Primer for Borrower’s Counsel
difficult. Alternatively, a bor-rower should try to limit thecovenants in some way.Some examples are asfollows:E “The borrower shall not
make a distribution if theimmediate result of suchdistribution would be tocause the borrower to be-come insolvent, fail tohave adequate capital toconduct its business op-erations or pay its expen-ses when due andpayable.”
E “The borrower shall usecommercially reasonableefforts to remain solvent,maintain adequate capitalto conduct its businessoperations, and, subjectto the borrower’s rights tocontest payments underSection [XX], pay its ex-penses when due andpayable as long as cashflow is available from theProperty to do so.”
E “As of the Closing Date, itis the intent of the bor-rower to remain solvent,maintain adequate capitalto conduct its businessoperations, and pay itsexpenses when due andpayable, subject to theborrower’s rights to con-test payments under Sec-tion [XX].”
In addition to including SPE covenants inthe loan documents, a CMBS lender willrequire that the borrower modify its organiza-tional documents to incorporate the same SPEprovisions that are in the documents. In doingso, a borrower should make sure that the SPEprovisions in its organizational documentscease to be effective once the loan has beenrepaid.
Cash Management
CMBS loans almost always require someform of cash management system so that thelender can direct and control the cash gener-ated by the property even if the property isfully stabilized with a high debt coverage ratio.The cash management system is similar tothat used with portfolio loans in that there aretypically two types of accounts: a lockbox ac-count and a cash management account. Bothaccounts will be in the name of the borrower.The lender will have a first priority securityinterest in each account as well as control overeach account pursuant to a tri-party agree-ment between the deposit bank, the borrowerand the lender (a “deposit account controlagreement”).
Although the cash management structure isvirtually the same in portfolio and CMBS loans,it is important that a borrower give the structureextra scrutiny in the CMBS context. In bothcontexts, the cash is critical to the borrower’scontinued ability to operate, but in the CMBScontext, a borrower may not be able to con-vince the servicer to address any operationalissue that prevents the system from workingas the borrower and the lender intended whenthe loan was originated.
A lockbox account is an account into whichall property revenue will be deposited. Thereare three types of lockbox accounts:
(i) hard lockbox, which requires that prop-erty revenue is deposited directly into thelockbox account and/or sent directly to a postoffice box where a bank removes the checksand deposits them into the lockbox account;
(ii) soft lockbox, which allows a borroweror property manager to collect the revenue
and then requires them to deposit it into thelockbox account; and
(iii) springing lockbox, which is only acti-vated if a specific triggering event occurs (e.g.,failure to meet a debt service ratio or a defaultbeyond applicable notice and cure periods).34
Funds in the lockbox account are transferredinto a cash management account pursuant toa schedule agreed to by the parties (e.g., dailyor monthly). Like the lockbox account, thereare three types of cash management accounts:
(i) a hard cash management account,which restricts the borrower from accessingthe cash, with debt service and operatingexpense payments made directly by the ser-vicer, and any excess amounts remaining inthe cash management account;
(ii) a soft cash management account, whichrestricts the borrower from accessing the cash,but provides that excess amounts are releasedto the borrower after debt service and operat-ing expense payments are made by the ser-vicer; and
(iii) a springing cash management account,where absent a triggering event, lockbox fundsare disbursed back to the borrower withoutfirst being deposited into the cash manage-ment account.35
Since there are substantial differencesamong the various lockbox and cash manage-ment structures, it is advisable to agree uponthe structure in the term sheet. While it isclearly in the best interest of a borrower toeliminate the lockbox/cash management struc-ture altogether, it is rare that a CMBS lenderwill agree to do so. The next best option for aborrower is to have a springing lockbox ac-
count and a springing cash managementaccount. This may be possible for a stabilizedproject in which the project’s cash flowssubstantially exceed the debt and operatingexpenses, but is unlikely in other situationsbecause CMBS lenders have a strong desireto control the cash.
If a borrower is successful in persuading theCMBS lender to agree to a springing cashmanagement account, the borrower’s nextstep should be to limit the triggering events toas few as possible. A default, after the expira-tion of applicable notice and cure periods, willalways be a triggering event. It is also typicalfor the borrower’s failure to satisfy one or morefinancial covenants to be a triggering event. Itis essential that a borrower carefully reviewseach of the triggering events, especially thefinancial covenants, to ensure that it fullyunderstands how they operate and is confi-dent, at least initially, in its ability to satisfythem. A borrower should seek to avoid trigger-ing events that are beyond its control, such asthe termination or non-renewal of a majorlease, even though doing so is likely to bechallenging. A borrower also will want to makesure that the loan documents clearly state thatat such time as the triggering events are cured(e.g., financial covenants are satisfied for twoconsecutive measurement periods), thelockbox/cash management structure will revertback to its original structure (e.g., upon cure,a hard cash management structure will be-come a springing cash managementstructure).
Regardless of the type of cash managementstructure, a borrower should focus on the tim-ing of deposits, nature, amount and order ofthe payments to be made from the cashmanagement account. A borrower will want to
The Unique Aspects of CMBS Loans: A Primer for Borrower’s Counsel
ensure that the timing of the deposits from thelockbox account into the cash managementaccount syncs with the payments from thecash management account. For example, inthe first month after the loan closes, a bor-rower might find itself without any cash in thecash management account if rents are due onthe first day of each month, but the tenantshave a five-day grace period (meaning thatmany tenants will not pay until the fifth day ofa month), and the lockbox account is sweptonce a month on the first day of the month. Ifa lockbox sweep only occurs once a month,then to maximize the likelihood that sufficientcash will be available in the cash managementaccount to make the necessary payments, thecash from the lockbox account should bedeposited immediately prior to the time thatthe disbursements will be made.
Disbursements from the cash managementaccount are generally made on the day onwhich the debt service payment is due, and aborrower will not be able to change the timingof the disbursements. Disbursements from thecash management account occur in a pre-setorder commonly referenced as a “waterfall.”Typically, taxes and insurance are paid first,followed by debt service, operating expenses,capital expenses and reserves, although somelenders will move debt service lower in thewaterfall.
The amount of each disbursement is usuallytied to the amount set forth in a budget ap-proved by the lender. Frequently, loan docu-ments fail to address what happens if theactual expenses exceed the budgeted amount.A borrower should make sure that there is amechanism for it to access cash (assuming itis available) to address budget overages. Forexample, during the construction of a tenant
improvement, a borrower will need to pay itscontractors on a monthly basis, so it will wantto be able to get disbursements from the cashmanagement account throughout the courseof construction rather than waiting until theimprovements are completed. The importanceof understanding the operation of the cashmanagement system and its consistency withthe way in which a borrower operates ismagnified if a hard cash management accountis in place. This is because if a borrower needsfunds that cannot be disbursed from the cashmanagement account, then the borrower’spartners or members will need to contributeequity if the expenses are to be paid. It is im-perative that, whatever the structure, a bor-rower has the right to receive periodic reportsof the activity in each of the accounts so itknows what is happening and is not relying onthe servicer to provide it with information.
In addition to negotiating the structure of thecash management system, a borrower shouldidentify both the lockbox bank and cashmanagement bank at the term sheet stage.Frequently, a borrower will want a local bankto be designated as the lockbox bank forreceipt of checks to minimize any delays inthe receipt of funds (e.g., designating a bankwith offices only in New York instead of a Cal-ifornia bank to receive rent checks from a proj-ect in California could result in unnecessarydelays).
In selecting a lockbox bank and cash man-agement bank, one of the matters that a bor-rower should consider is whether its desiredbank has an existing relationship with theCMBS lender. Negotiating deposit accountcontrol agreements can be costly because thelockbox/cash management bank is reluctant tomake changes to its form, and the CMBS
lender has a set of requirements that must besatisfied.36 The process will be much more ef-ficient and less expensive if the designatedlockbox/cash management bank has recentlyentered into a deposit account control agree-ment with the CMBS lender. Additionally, aborrower should seek to minimize the mini-mum balance requirement for both the lockboxaccount and the cash management account.
Reserves
CMBS loans virtually always require a bor-rower to establish reserve accounts. Commontypes of reserves include real estate taxes, in-surance premiums, repairs and maintenance,tenant improvements, capital expendituresand, less frequently, operating expenses. It isnot uncommon for the amount of the reservesrequired in CMBS loans to exceed those inportfolio commercial loans.37 Accordingly, aborrower should focus on the impact that thereserves will have on its cash flow and abilityto satisfy financial covenants.
It is judicious for a borrower to make surethat the material reserve requirements are setforth in the term sheet. Among the key itemsfor a borrower to consider are the following:
E Amount of the Reserves. The amount ofcertain reserves (e.g., deferred mainte-nance items) may be ascertainable atclosing, but other items may be subjectto change in the future (e.g., tax and in-surance reserves). A borrower will wantto make sure that the lender is requiredto act reasonably in determining theamount of monthly reserve deposits.Also, a borrower should try to negotiate acap on certain reserves (e.g., leasing andcapital expenditures) so that the borrower
will not be required to make deposits intothe reserve throughout the loan term butonly until the reserve reaches a specifiedlevel.
E Use of Reserve Amounts. While reservesare typically designated for certain pur-poses, a borrower should seek to havethose purposes broadly construed. Forexample, a leasing reserve typically cov-ers leasing commissions and tenantimprovement costs; however, a borrowermay incur additional costs related to theleasing of space, such as marketing costsand free rent. Assuming that the ad-ditional costs are reasonable, a borrowershould be entitled to request reimburse-ment for them.
E Release from the Reserves. Since thefunds in a reserve account are of novalue to a borrower unless it is able toaccess them, a borrower should payclose attention to the conditions to dis-bursement from each of the reserves.Ideally, there will be very few releaseconditions, and they all will be objective(i.e., not allow the servicer to exercisediscretion). In particular, a borrowershould make sure that amounts can bereleased to pay third parties directly whendue rather than to reimburse the borrowerat the end of a project.
E Direct Payments by Lender. If a lender isdisbursing money directly to itself so thatit can pay a third party (e.g., taxes), aborrower should request that the lendernotify the borrower prior to making thedisbursement (so that the borrower canconfirm that there are sufficient funds inthe account to cover the disbursement)
The Unique Aspects of CMBS Loans: A Primer for Borrower’s Counsel
and, at least 10 days before the paymentis due, provide the borrower with evi-dence of the payment. It is worth notingthat even if the lender agrees to the fore-going, a servicer may not actually sendthe required notices. A borrower alsoshould make sure that it will not be indefault under the loan documents (andthat no liability will accrue to a guarantor)if the lender fails to make payments whendue.
Financial Reporting and Confidentiality
Prior to a securitization, the CMBS lenderwill have to provide financial informationregarding each loan to the rating agency andthe investors.38 Following the securitization,the master servicer will be required to preparefinancial reports on the loan to the investors.39
Additionally, the securitization trust, as the is-suer of the securities, is itself obligated tomake reports under securities law andregulations.40 It is not surprising, then, thatCMBS lenders typically require that a borrowerprovide more extensive financial informationthan a portfolio lender requires. A borrower’sability to negotiate changes to the nature andtiming of the financial reports that it provideswill be limited to changes that will not adverselyimpact the financial reports that the other par-ties need to provide.
Another distinct attribute of the financialreporting covenants in a CMBS loan is thatthe information will not be confidential. In somecircumstances (e.g., a borrower is a party to aconfidentiality agreement with a tenant), it maybe problematic for information reported by theborrower to become public. In limited in-stances and if there is an important reason, aborrower may be able to impose some minimal
limitations on the dissemination of the infor-mation that it provides to the lender as long asthe borrower does not attempt to restrict thedissemination of information that is legallyrequired to be provided under the securitieslaws. If a borrower needs more than a minimalamount of information to be held in confidence,then a CMBS loan may be difficult for it toobtain.
Other than confidentiality, the considerationsfor a borrower in a CMBS loan, as they relateto financial reporting, are similar to those in aportfolio loan and include the following:
E Consistency with Operating Practices. Ifa borrower’s operating practices (e.g.,loan documents require that borrower’sfinancial statements be delivered within90 days after the end of borrower’s fiscalyear, but borrower does not prepare itsfinancial statements until 10 days afterthe end of its fiscal year) do not conformwith the reporting requirements, then itshould seek to modify the loan docu-ments so that they match the borrower’soperating practices.
E Closing Financial Statements. A borrowershould seek to include language in theloan documents to the effect that thefinancial reports submitted by the bor-rower in connection with the originationof the loan are in form and substance ap-proved by the lender.
E Event of Default. A borrower should re-strict the lender from declaring an eventof default as a result of the borrower’sfailure to deliver financial information untilafter the borrower has received noticeand an opportunity to cure.
During the most recent downturn, manylenders (both portfolio and CMBS) had dif-ficulty obtaining current financial informationfrom borrowers under defaulted loans. In re-sponse, many lenders now impose some formof monetary penalty (e.g., an increase in theinterest rate) upon a borrower who fails toprovide timely financial information. CMBSlenders often take it one step further by impos-ing full recourse liability upon a guarantor for afailure to comply. A borrower should try to elim-inate the carveout for financial reportingfailures, or at a minimum, move it “above theline” so that the guarantor is only liable forlosses actually incurred by the lender as aresult of the non-compliance. And, even if thelender will not agree to provide the borrowerwith notice and a cure period before declaringan event of default, the borrower should insistthat the lender be required to provide the bor-rower with notice and an opportunity to curebefore recourse is triggered against theguarantor.
Securitization Indemnity
CMBS loan documents contain an indemnityfrom the borrower (and usually the guarantor)for all claims and liabilities relating to thesecuritization.41 Typically, this indemnity isextremely broad in the scope of the mattersthat it covers. This is one area in which alender is generally reluctant to make changes;however, the depth and breadth of a bor-rower’s potential liability is so significant that aborrower would be remiss if it did not attemptto limit the reach of the indemnity. First, a bor-rower should seek to incorporate “standard” li-ability exclusions (i.e., limit damages to actual(not punitive, special, consequential or exem-plary) damages and costs and expenses toout-of-pocket costs and expenses). Second, a
borrower should be sure that the indemnityexcludes not just gross negligence and willfulmisconduct of the lender, but also that of theservicers, the securitization trust, the invest-ment banks and any other persons that arenot affiliates of the borrower. Finally, a bor-rower should seek to limit its liability to mat-ters arising directly from a breach of its obliga-tions under the loan documents. For example,if a borrower knowingly provides a lender withfalse information and then represents to thelender in the loan documents that the informa-tion is true and correct, it is reasonable for aborrower to be liable for any losses sustainedby the lender in relying on that information. Incontrast, if the borrower makes a disclosure tothe lender, and the lender fails to make a sim-ilar disclosure in the securitization process,then the lender, and not the borrower, shouldbe liable for the error. Similarly, if the lendermakes a mistake in the information that itsubmits (e.g., a typo in the financial cove-nants), the lender should be liable. While lend-ers are very reluctant to make changes to thesecuritization indemnity, reasonable limitationscan be negotiated. The importance of limitingthe indemnity is magnified if liability extendsnot just to the borrower, but also to theguarantor.
Duplicative Covenants
For some reason CMBS loan documentsfrequently contain an express covenant to theeffect that a borrower will perform all of itsobligations under the loan documents and an-other covenant to the effect that a borrowerwill make all of the payments it is required tomake under the loan documents. Covenantsof this nature may appear innocuous, simplyrequiring a borrower to do what it has alreadyagreed to do, but they are dangerous for a
The Unique Aspects of CMBS Loans: A Primer for Borrower’s Counsel
borrower. They have the effect of eliminatingany notice and cure periods that are applicableto the underlying covenants. A borrower shouldinsist on removing these duplicat ivecovenants. A lender has no reasonable basison which to object because the covenants areduplicative. If the lender insists on retainingthe covenants, then a borrower should addlanguage to make it clear that any notice andcure periods applicable to the underlying cov-enant are not superseded.
Consents
The CMBS loan documents are living docu-ments that control the actions of a borrowerfor a period of many years. As discussedabove, it may be difficult for a borrower toobtain timely consent from a servicer. Accord-ingly, a borrower under a CMBS loan shouldbe wary of any matter in the loan documentsthat requires the lender’s consent regardlessof how straightforward the matter may appearto be.
Since it is in a borrower’s best interest tominimize the number of matters that requirethe lender’s consent, prior to entering into theloan documents, a borrower should try to an-ticipate, to the best of its ability, changes thatmight occur in the borrower’s operations andin the loan collateral. If the borrower is able toidentify potential changes with some specific-ity (e.g., converting a portion of the projectfrom big box retail into medical office) then theloan documents can grant the borrower an un-equivocal right (i.e., no lender consent re-quired) to make such changes as long as theborrower satisfies certain objective criteria.
Some areas to target in limiting consent arethe following:
E Leasing. With respect to leasing, it isrecommended that a borrower seek ex-ceptions to lender consent for leasingactivity that: (i) does not relate to a majorlease; (ii) conforms to objective leasingparameters specified in the loan docu-ments; (iii) was specified in the loandocuments; or (iv) does not require theborrower’s consent, approval or agree-ment under the terms of a lease (i.e., atenant’s exercise of a lease renewal orexpansion).
E Alterations. CMBS loan documents typi-cally require a borrower to obtain thelender’s consent for alterations (i) thatcould have a material adverse effect onthe borrower or the loan collateral, (ii)whose cost exceeds a specified altera-tions threshold, (iii) that are structural innature, or (iv) that reduce the property’srentable square footage.
† A borrower probably will not be ableto completely eliminate any of theforegoing requirements, but a bor-rower should try to limit them asmuch as possible. Additionally, aborrower should make sure that theloan documents clearly state that thelender’s consent is never requiredfor (i) restoration of the property toits original condition following a ca-sualty or condemnation; (ii) anyalterations required under leasespermitted by the loan documents; (iii)alterations required under reciprocaleasement agreements or other re-corded documents permitted by theloan documents; (iv) alterations nec-
essary to comply with applicable law,and (v) alterations necessary to re-spond to imminent life or safety is-sues at the property.
E Transfers of Equity Interests. It is verypossible that one or more of the holdersof direct or indirect equity interests in bor-rower or guarantor could change over thecourse of the loan. This is especially trueif one of the owners has a limited lifespan(e.g., private equity fund). Any change inthe aggregate ownership of the borrowerthat, following loan origination, exceeds49 percent could jeopardize the REMICstatus42 so a borrower will never succeedin getting a CMBS lender to waive itsconsent rights to such a transfer; how-ever, a borrower should seek to persuadethe lender to waive its consent rights fortransfers of smaller percentages of inter-ests, transfers by non-controlling partiesand transfers among member/partnersprovided that such transfers comply withspecified conditions, which might includenotice to, but not consent of, the lender.
E Change in Guarantor. If one or more ofthe loan guarantors is an individual, thenit is foreseeable that the guarantor coulddie or become incompetent during theloan term. Even if the guarantor is not anindividual, it could cease to satisfy anyfinancial covenants applicable to it. Ac-cordingly, a borrower should negotiatefor the right to substitute a replacementguarantor at any time (and as manytimes) throughout the loan term as longas the replacement guarantor satisfiesthe conditions listed in the loandocuments.
If a borrower does need the lender’s consentfor a matter, the borrower faces two majorobstacles: responsiveness andreasonableness. As discussed above, it canbe very difficult for a borrower to receive atimely response from a servicer to the bor-rower’s request for approval. Many borrowershave found themselves forced to choose be-tween (1) moving forward on a matter withoutthe lender’s consent in breach of the loandocuments, and (2) waiting for the lender’sconsent at the risk of a losing a clear value-add opportunity (e.g., a new lease). It may bepossible for a borrower to expedite a responseby paying a servicer an additional fee, but thiscan be expensive and may only make sensein limited instances. A better approach is for aborrower to insist that the lender agree to re-spond to requests within a specified time-frame and also agree that the failure to timelyrespond shall be deemed approval to therequest.
Most lenders are well aware of the problemsthat borrowers have encountered in obtainingresponses from servicers. These lenders arenot excited by the prospect of deemed ap-proval, but many will agree to it (at least incertain instances) provided that the borrowerprovides the lender with at least two noticesbefore the “deemed approval” becomeseffective. An example of language that alender may accept (although a lender is likelyto limit it to certain matters, such as leaseconsents, rather than applying it to all mattersrequiring consent under the loan documents)is the following:
With respect to matters requiring Lender’sconsent under this Agreement or any of theother Loan Documents, if Lender fails to re-spond to a request for Lender’s consent withinten (10) days after Lender’s receipt of Bor-
The Unique Aspects of CMBS Loans: A Primer for Borrower’s Counsel
rower’s first request for consent together withall information reasonably required by Lenderto review the request, Borrower may deliver asecond request for such consent and, providedthat such second request contains a bold face,conspicuous legend at the top of the first pagethereof to the effect that ‘IF YOU FAIL TO RE-SPOND TO THIS REQUEST FOR CONSENTIN WRITING WITHIN FIVE (5) DAYS, YOURCONSENT SHALL BE DEEMED GIVEN,’ andLender fails to respond to such request forconsent five (5) days after Lender has receivedfrom Borrower such second request, Lendershall be deemed to have given such consent.
It is very possible that even if a borrowersucceeds in getting a lender to agree to re-spond within a specified time period, the bor-rower will want a response even faster; how-ever, it is unlikely that the borrower willconvince a CMBS lender to shorten its re-sponse times in the same way that a portfoliolender might.
In addition to time delays, any consent thatpermits a lender to use its discretion, evenreasonable discretion, can be problematic.Servicers are frequently conservative whenexercising discretion. A borrower should en-deavor, wherever possible, to eliminate anysubjectivity in the lender’s approval rights, butit is unlikely that a borrower will succeed in ty-ing all of a lender’s consent rights to objectivecriteria. If the lender does have discretion ingranting consent, then prior to requestingconsent, a borrower should review the PSA sothat it understands the servicing standards ap-plicable to the servicer as well as any otherconditions of the consent.
Rating Agency Confirmation
The credit ratings that a rating agency as-signs to the bonds at the time of the securitiza-tion are premised on the assumption that thecredit quality of the loan pool will not changesignificantly after the securitization occurs.43
Under certain circumstances, which will bespecified in the PSA,44 a borrower will berequired to deliver a confirmation from the rat-ing agency to the effect that the requested ac-tion will not cause a downgrade of any of thebond class ratings. Items that frequentlyrequire rating agency confirmation include achange in property manager, consummation ofdefeasance, a loan assumption, a transfer ofmore than 49 percent of the aggregate director indirect equity interests in a borrower fol-lowing the origination of the loan and subordi-nate financing. If the loan is large, there maybe additional matters that require rating agencyconfirmation, including an increase or de-crease in cash flow from origination, fluctua-tions in occupancy levels, significant changesin market rents, a transfer to a special servicer,defeasance or loan repayments.45 In process-ing requests for confirmation, the ratings agen-cies work with the servicer and will not interactdirectly with the borrower.
Rating agency confirmations can be expen-sive and time consuming. A borrower shouldseek to limit requirements for obtaining them.A borrower also should try to ensure that theloan documents make clear that any ratingagency confirmation requirements only apply ifthe loan is included in a securitization at thetime in question and that a rating agencyconfirmation will be deemed granted if the ap-plicable rating agency waives, declines, re-fuses to review or fails to timely respond.
Modifications
One of the reasons that CMBS loans arebest suited for stabilized properties is the exis-tence of limitations on the extent to which aCMBS loan can be modified after it closes. If asingle CMBS loan in a loan pool fails to comply
the REMIC may incur numerous adverse con-sequences, including the imposition of a 100percent prohibited transactions tax on any gainand the loss of its status as a REMIC.47 Ac-cordingly, any “significant modification,” asdetermined by the REMIC rules, of a CMBSloan is prohibited.48
Not every matter that constitutes a modifica-tion of the loan from a legal perspective isconsidered to be a loan modification in theCMBS world. Examples of changes to a CMBSloan that do not constitute “modifications”include the following:
(i) changes that occur automatically pursu-ant to the original terms of the loan docu-ments;
(ii) the substitution of a new obligor on anonrecourse loan;
(iii) changes in the timing of loan paymentsas long as such changes do not result in amaterial deferral of the originally scheduledpayments;
(iv) improvements to the mortgaged prop-erty; and
(v) minor changes to the collateral or creditenhancement.49
There are also matters that, although theyconstitute modifications of a loan, do not con-stitute a “significant modification” under theREMIC rules and are legally permitted, whichdoes not mean that they will be approved bythe lender. Examples of this type of loanmodification include:
(i) modifications occasioned by a default orreasonably foreseeable potential default;
(ii) waiver of a due-on-sale clause;
(iii) the conversion of a nonrecourse loanto a recourse loan provided that, immediatelyfollowing the conversion, the loan satisfies the“principally secured” test;50 and
(iv) a modification that releases, substi-tutes, adds or otherwise alters a substantialamount of collateral provided that, immediatelyfollowing the modification, the loan satisfiesthe principally secured test.51
There is also a category of CMBS loanmodifications that might be permitted but willnot be approved unless the borrower deliversa legal opinion to the effect that the specifiedaction does not represent a significant modifi-cation of the loan under the REMIC rulesand/or a rating agency confirmation statingthat the modification will not cause a down-grade of any of the bond class ratings.52
Examples of this type of loan modificationinclude the following: lien releases, disburse-ment of condemnation proceeds, defeasanceand loan assumptions.53
Prior to requesting any modification of theloan, it would be beneficial for a borrower toreview the PSA so that it understands how themodification will impact the bondholders.Among other things, the PSA will enable a bor-rower to identify which class of bondholderswill control the approval process, and, relatedto that, how the allocation and distribution ofproceeds and losses are divided among thebondholders. Having this knowledge in ad-vance may help a borrower determine how toapproach its request for a modification. This isparticularly true of any modification of adistressed loan in which a borrower will needto propose a modification that is beneficial to
The Unique Aspects of CMBS Loans: A Primer for Borrower’s Counsel
the class of bondholders that will need to ap-prove the modification.
Exiting the CMBS Loan
Prepayment
CMBS investors frequently purchase bondswith the expectation that the bonds will providepredictable and uninterrupted payments overthe loan term. Bond investors are willing to ac-cept tighter yields in exchange for this protec-tion, and the tighter yields result in more ag-gressive pricing to the borrowers. In order toafford the investors this protection and the bor-rowers the better pricing, many CMBS loansprohibit voluntary prepayment at any time.Even if a borrower agrees to an absolute re-striction on prepayment, it should be sure thatthe restriction terminates at least 60, butpreferably 120 days (a CMBS lender is unlikelyto agree to more than 120 days), prior to thematurity date. Otherwise, a borrower will facethe difficult task of ensuring that any refinanc-ing or repayment of the CMBS loan occursexactly on the maturity date if it wants to avoidthe event of default, default interest and latefees that typically accompany a payment madeafter the maturity date.
Defeasance
If a loan prohibits prepayment, then defea-sance is usually the only option available to aborrower if it needs to repay the loan inadvance of the maturity date (e.g., in connec-tion with a sale of the property or refinance ofthe loan).
Defeasance is the process by which asecuritization trust releases the real propertycollateral from the loan and in exchangereceives a pledge of government securities
(e.g., U.S. treasury bills).54 The governmentsecurities are specially selected to generatecash flow that mirrors the amount and timingof the loan payments exactly so that there isno interruption or change in the amount andtiming of the payments that any investorreceives.
In connection with the defeasance, a newly-formed special purpose entity, commonlyreferred to as the successor borrower, will as-sume the borrower’s obligations under the loandocuments, and the original borrower andguarantors will be released from their respec-tive obligations under the loan documents(other than the typical liabilities that survivethe repayment of a loan). Effectuating thedefeasance is complicated and precise work.It is also time-consuming and may take 30days (or more). There are various consultantswho specialize in defeasance, and it is advis-able for a borrower to retain one to handle theprocess.
Defeasance can be an expensive process.In addition to buying the substitute govern-ment securities, a borrower will incur numer-ous other costs and fees, including the costsof forming the new special purpose entity andthe fees of attorneys, accountants, the defea-sance consultant and the servicers. If a bor-rower wants to reduce these costs, it shouldpay close attention to the defeasance provi-sions in the loan documents and take the timeto negotiate them before the loan closes.
Lenders are often amenable to modificationsof the defeasance provisions as long as thefundamental framework remains unchanged.There are several changes that a borrowercan make to the defeasance provisions thatwill significantly improve its position without
altering the fundamentals that are a lender’sconcerns. First, a borrower should make surethat any duplication of payments is eliminatedfrom the loan documents. Second, a borrowershould seek to minimize the notice that it mustprovide prior to defeasance (while remainingcognizant of the time it will actually take theborrower to accomplish the securitization).Third, a borrower will benefit from ensuringthat the terms of the defeasance in the loandocuments grant the borrower the followingrights:
(i) the right to purchase substitute treasurysecurities that make payments through theearliest date for prepayment without a penalty(e.g., 90 days prior to the maturity date) ratherthan through the loan maturity date;
(ii) the right to select the substitute securi-ties; and
(iii) the right to designate the successor tothe borrower.
A borrower should be aware that the REMICrules prohibit defeasance until after the secondanniversary of the issuance of the securitiza-tion of that REMIC.55 This means that for aminimum of two years after a loan closes, aborrower will have an absolute lockout onprepayment regardless of the circumstances.
Yield Maintenance
Although CMBS lenders generally prefer toeliminate any right that a borrower has toprepay the loan, a borrower may be able tonegotiate a prepayment right. Any prepaymentright will come at a cost to a borrower. First, aborrower will be required to pay a yield main-tenance fee to compensate the lender (or, inthe CMBS context, a bond investor) for the
loss in yield and the disruption of the incomestream that an investor will incur if the loan isprepaid. Second, since a bond investor willwant a higher yield to compensate it for therisk that its payment stream will be interrupted,in addition to a yield maintenance fee, CMBSlenders often charge a borrower a higher inter-est rate on the loan than they would charge ifprepayment on the loan and defeasance werethe borrower’s only exit option.
Yield maintenance formulas in CMBS loansare similar to those in portfolio loans; however,CMBS lenders are often more amenable tochanges in the yield maintenance provisions(as they are with defeasance provisions) thana balance-sheet lender. A CMBS lender, unlikea portfolio lender, does not expect to be af-fected by the prepayment. Nor does a CMBSlender expect any prepayment right granted toa borrower to affect the lender’s ability to sellbonds because the bond investor will becompensated by the higher interest rate onthe loan. Accordingly, a borrower should seekto modify the yield maintenance premiums asfollows:
(i) increase the replacement rate in theyield maintenance formula, which will result ina lower yield maintenance premium;
(ii) make sure the monthly payment calcu-lations are based on an amortizing (and notinterest-only) loan so that the monthly loss inyield gradually decreases;
(iii) eliminate any floor on the interest rate;and
(iv) exclude casualty and condemnationpayments, partial prepayment resulting frompermitted lien releases, principal paydownsnecessary to satisfy financial covenants and
The Unique Aspects of CMBS Loans: A Primer for Borrower’s Counsel
prepayments during an event of default fromthe prepayments subject to the yield mainte-nance premium.
Whether defeasance or yield maintenanceis better for a borrower will depend upon vari-ous facts. Yield maintenance generally occursfaster than defeasance. A loan that prohibitsprepayment and only releases a borrower andthe collateral through defeasance generallyhas a lower interest rate than a loan thatpermits prepayment but requires payment of ayield maintenance premium.
In theory, a borrower should incur the samecost whether it elects defeasance or paymentof a yield maintenance premium because bothare intended to provide the lender with thesame amount of money as it would havereceived if the loan had not been repaid. Inreality, this is not always the case. There areminimal costs to yield maintenance beyondthe premium itself, whereas there can besubstantial costs associated with defeasancebeyond the cost of acquiring the substitutesecurities. Additionally, any material variancebetween the treasury rate and the coupon ratewill result in substantial cost differences be-tween defeasance and yield maintenance. Forexample, if the treasury rates increase signifi-cantly relative to the increase in the couponrate, then the price of treasuries will fall, and aborrower will be able to acquire the treasurysecurities necessary for defeasance at a pricethat is lower than the yield maintenanceamount. Defeasance offers a borrower agreater potential for gain or loss than yieldmaintenance.
Loan Assumption
Unlike portfolio loans, CMBS loans typically
permit the loan to be assumed under specifiedcircumstances. Depending upon the circum-stances, a loan assumption may be muchcheaper than either defeasance or prepaymentwith yield maintenance, but it will take signifi-cantly longer (easily 90–120 days, if not more)to accomplish.
CMBS lenders are more flexible in permit-ted loan assumptions than portfolio lendersbecause of the restrictions on prepayment andthe long term of the CMBS loan. CommonCMBS loan assumption requirements are thefollowing:
(i) payment of an assumption fee;
(ii) lender’s approval of the transferee;
(iii) the execution of assumption documentsby the new borrower and new guarantees bya replacement guarantor; and
(iv) the trust’s receipt of a rating agencyconfirmation.
Typically the loan assumption fee in a CMBStransaction is one percent; however, lendersfrequently agree to reduce it to 0.5 percent. Itis generally not in a borrower’s best interest toreduce the fee too much below 0.5 percent,except on a large loan. Loan assumptionsrequire a lot of time and effort by the specialservicer. If the assumption fee is too low, thespecial servicer may put the loan assumptionon the bottom of its “to do” pile, resulting indelays that are significant enough to enable aprospective buyer/borrower to walk away fromthe transaction.
In order to streamline the assumption pro-cess, a borrower should seek to include theconcept of “Qualified Transferee” in the loandocuments. A Qualified Transferee would be
an SPE that is owned or controlled by an entitythat meets specified financial conditions (e.g.,net worth and liquidity), and, depending uponthe nature of the real estate, specified experi-ence (e.g., 10 years’ experience managingresort hotels). If the new borrower is a Quali-fied Transferee, a lender may be willing towaive the assumption fee (though for thereasons noted above, payment of some fee isadvisable), lender approval and/or the require-ment for a rating agency confirmation.
It is likely that any new borrower will want tomodify certain provisions of the loan docu-ments (e.g., transfer provisions) to address itsspecific needs and sensitivities. To facilitatesuch changes, it is advisable for the initial bor-rower to ensure that the loan assumption pro-visions in the loan documents obligate thelender to permit reasonable modifications tothe loan documents provided that such modifi-cations do not constitute a “significantmodification.”
It generally takes a special servicer a sub-stantial amount of time (at least 90 days) toprocess a loan assumption, no matter howsimple the loan assumption may seem. Sinceit is very unlikely that a lender will accept a“deemed approval” for a loan assumption, aborrower should be sure that the purchaseagreement to which the loan assumption re-lates allows sufficient (ideally unlimited) timefor the lender to approve the loan assumption.The purchase agreement should also obligatethe buyer to provide any information requestedby the lender within a specified (and veryshort) time after the lender’s request.
It is not inconceivable that a property couldsell two or three times over a 10-year period.Accordingly, borrower should make sure that
there is no limit on the number of loan as-sumptions permitted during the term of theloan. Most lenders are willing to agree to this.
Mezzanine Financing
The last, and much less common, alterna-tive to defeasance is mezzanine financing. If aproperty appreciates significantly in value fol-lowing the securitization, and the borrowerwants to increase its loan proceeds, it may beable to procure mezzanine financing at a lowercost than defeasance.
Although the standard CMBS loan docu-ments prohibit mezzanine financing, manylenders will agree to permit it under certaincircumstances. Common lender requirementsare the following:
(i) the property satisfies specified financialtests (e.g., debt yield and loan to value);
(ii) the maturity date of the mezzanine loanis no earlier than the maturity date of the mez-zanine loan;
(iii) the mezzanine lender is not affiliatedwith the borrower;
(iv) the mezzanine lender executes anintercreditor agreement acceptable to thelender; and
(v) the borrower delivers a rating agencyconfirmation. It is advisable that a borroweraddress its right to obtain mezzanine financingin the term sheet.
Any borrower’s counsel who understandsthe CMBS framework, the differences betweenwhat a lender cannot do and what a lenderdoes not want to do, and the most commonproblems that arise for borrowers in a CMBS
The Unique Aspects of CMBS Loans: A Primer for Borrower’s Counsel
context is well-positioned to advise and assisther client efficiently and effectively with a loan,from the term sheet through repayment, inwhatever form that may take.
NOTES:1Many of the primary sources that dictate the
structure of CMBS loans, including publications of theCommercial Real Estate Finance Council and thenational rating agencies, are only available for purchase.This article includes many references to these publica-tions (noted in this article as only available for purchase)because the author was unable to find comparablepublicly-available resources.
2Commercial Mortgage-Backed Securities (CMBS)Finance: Overview, Practical Law Practice Note Overview(2018) (only available for purchase).
3CRE Finance Council, CRE Finance Council CMBSE-Primer: A Comprehensive Overview Of CommercialMortgage Backed Securities, § 1.11 (2015), available athttps://www.pathlms.com/crefc/courses/1226 (only avail-able for purchase).
426 U.S.C. § 860A(a); 26 U.S.C. § 860D(a).5CRE Finance Council, supra note 3, at § 1.4.6U.S. and Canadian Multiborrower CMBS Rating
Criteria (Fitch Ratings) (May 18, 2018), Appendix F, https://www.fitchratings.com/site/re/10028210; CMBS: RatingMethodology And Assumptions For Global CMBS(Standard & Poor’s, 2015) p. 1. https://www.standardandpoors.com/en_US/web/guest/ratings/ratings-criteria/-/articles/criteria/structured-finance/filter/cmbs (only availableto registered users).
7CRE Finance Council, supra note 3, at §§ 6,3, 8.3.8Id. at §§ 6.3, 8.4.9Id. at § 4.5.10Commercial Mortgage-Backed Securities (CMBS)
Finance: Overview, Practical Law Practice Note Over-view, supra note 2.
11Id.12CRE Finance Council, supra note 3, at § 3.2.13Final Rule Implementing Section 941 of the Dodd-
Frank Wall Street Reform and Consumer Protection Act(Credit Risk Retention) (Oct. 21, 2014), https://www.sec.gov/rules/final/2014/34-73407.pdf.
14CRE Finance Council, supra note 3, at § 6.3.8.3.1.15Id. at § 6.3.8.4.1.16Id. at § 6.3.8.4.3.5.3.17U.S. CMBS Legal and Structured Finance Criteria
(Standard & Poor’s, 2003) p. 32; CMBS: Rating Method-
ology And Assumptions For Global CMBS, supra note 6,at p. 4.
18CRE Finance Council, supra note 3, at § 2.7.1.19Id. at §§ 6.3.4, 6.3.5.20Id. at § 6.4.1.6.21Commercial Mortgage-Backed Securities (CMBS)
Finance: Overview, Practical Law Practice Note Over-view, supra note 2.
22CRE Finance Council, supra note 3, at § 4.2.23Id. at § 4.10.24Id. at § 1.4.25Wells Fargo Bank, NA v. Cherryland Mall Ltd.
Partnership, 295 Mich. App. 99, 812 N.W.2d 799 (2011).26Wells Fargo Bank, NA v. Cherryland Mall Ltd.
27CRE Finance Council, supra note 3, at § 3.7.2818 CCR § 104.1.29Legal Criteria for U.S. Structured Finance Transac-
tions: Special Purpose Entities (Standard & Poor’s, 2006)p. 4 (only available to registered users).
30Samuel Lichtenfeld, A Guide to CommercialMortgage-Backed Securities: What You Should Knowabout the “New” Environment, Freeborn & Peters White-paper, 6 (2014), https://www.freeborn.com/assets/white_papers/freeborn_peters_white_paper_a_guide_to_commercial_mortgage-backed_securities_0.pdf.
31Legal Criteria for U.S. Structured FinanceTransactions: Special Purpose Entities, supra note 29.
32U.S. and Canadian Multiborrower CMBS RatingCriteria, supra note 6, at p. 1–3; CMBS: Rating Methodol-ogy And Assumptions For U.S. and Canadian CMBS(Standard & Poor’s, 2012) at p. 7 (only available toregistered users).
33Legal Criteria for U.S. Structured FinanceTransactions: Special Purpose Entities, supra note 29, atp. 2.
34CRE Finance Council, supra note 3, at§§ 6.3.8.3.3.8 to 6.3.8.3.3.9; California Real EstateFinance Practice: Strategies and Forms, CEB (2018)§ 1.45; Cash Management for Commercial Real EstateLoans, Practical Law Practice Note (2018); Basics ofSecured Commercial Real Estate Financing, PracticalLaw Practice Note (2018).
35CRE Finance Council, supra note 3, at§§ 6.3.8.3.3.8 to 6.3.8.3.3.9.
36Id. at § 6.4.1.2.8.37Id. at § 3.12.4.38Id. at § 6.3.5; CMBS: Rating Methodology And As-
sumptions For U.S. and Canadian CMBS, supra note 32at p. 7.
50The principally secured test is typically tested onlyonce. 26 C.F.R. § 1.860G-2(a)(1). The principallysecured test will be deemed satisfied if the fair marketvalue of the real property securing the loan is at least 80percent of the loan’s adjusted issue price at originationor on the REMIC’s start-up day. The adjusted issue priceis generally the adjusted issue price of a debt instrumentat the beginning of the first accrual period. Id. § 1.1275-1
5126 C.F.R. § 1.860G-2(b)(3).52CRE Finance Council, supra note 3, at § 6.3.3.53Id. at §§ 6.3.8.3.3.17, 6.3.8.4.3.2, 6.5.54Id. at § 6.3.8.3.3.18; California Real Estate Finance
Practice: Strategies and Forms, supra note 34 at § 1.45;Fisch and Berg, The Role of Defeasance in Real EstateFinance, New York Law Journal, (July 8, 2015); Wein-stock, Defeasing CMBS Loan, Commercial InvestmentReal Estate (2014); Jacob and Jahnke, Putting the Feesin Defeasance, Michigan Real Property Review (Fall2008).
5526 C.F.R. § 1.860G-2(a)(8).
The Unique Aspects of CMBS Loans: A Primer for Borrower’s Counsel
