Commercial mortgage-backed securities (“CMBS”) loans and balance-sheet loans are not created equal. While there are many similarities between the two types of loans, the differences are material and important. Identifying and understanding these differences and the ways in which they may impact a borrower is essential to providing effective borrower representation.1
CMBS Loans Overview
CMBS loans are typically non-recourse loans that materially comply with a standardized set of requirements (e.g., single-asset borrower) and have a term of five, seven, 10 or (rarely) 15 years. The loans may provide post-closing advances for value-add opportunities (e.g., tenant improvements), but the vast majority of principal is advanced at the closing of the loan. Thus, construction loans and loans involving significant redevelopment funded by the lender are not securitized.2
Each CMBS loan bears a fixed interest rate.3 A borrower is required to make a monthly payment of principal and interest, generally based on an amortization schedule of 25–30 years; however, some loans will include an interestonly period at the start of the term. As such (and assuming no defaults), the timing and amount of each loan payment throughout the term is ascertainable when the loan closes.
In a CMBS transaction, multiple individual commercial mortgage loans are pooled together with other commercial mortgage loans and transferred to a trust, typically a passthrough entity (not subject to tax at the trust level) known as a real estate mortgage investment conduit (“REMIC”).4 The trust issues a series of bonds (also referred to as certificates), which are segregated into different classes (also called tranches). These bonds all relate to the same pool of mortgage loan collateral but may vary in yield, duration and payment priority.5 Nationally recognized ratings agencies (e.g., Moody’s Investor Service, Fitch or Standard & Poor’s) will assign a credit rating (which may fall anywhere in the spectrum between unrated and investment grade) to each bond.6 The bonds are then sold on a public exchange.
Once the CMBS loan is transferred to the trust and securitized, the loan is serviced in accordance with the applicable loan documents and a Pooling and Servicing Agreement (“PSA”). Each trust has its own PSA, containing a unique set of terms. The PSA governs the allocation and distribution of loan proceeds and losses to the bondholders. It also describes how the loans are to be serviced and includes guidance to ensure that the trust continues to comply with the REMIC provisions in the tax code.
The pool of loans is not serviced by the trust but by two servicers, a master servicer and a special servicer. The master servicer is the primary servicer. Its duties are limited to routine matters (e.g., reviewing financial reports, preparing reports to investors and confirming satisfaction of disbursement conditions).7 The special servicer addresses loan prepayments, defaults and any other matters that diverge from the express terms of the loan documents (e.g., lease that does not meet leasing requirements).8 One key difference between portfolio loans and CMBS loans is the servicing. Each portfolio lender applies its own individualized servicing standards to each of the loans it holds. A CMBS servicer acts in accordance with the specific PSA applicable to all of the loans in the pool it governs. It is worth noting that while there are variances in the obligations of a servicer under a PSA, for the most part, the practices and procedures are standardized to meet REMIC requirements and to protect the bondholders.
Commercial mortgage lenders are attracted to the CMBS market because the aggregate value of the bonds backed by a pool of loans are generally worth more than the sum of the value of all of the loans, enabling the lender to profit off of the arbitrage.9 The securitization market also has enabled lenders to finance assets that would not otherwise be eligible for a lender’s balance-sheet. It is also much easier for a lender to sell the bonds than it is for the lender to sell individual mortgage loans.
Investors who buy the bonds are attracted to the certainty of a pre-determined income stream. The diversity among the securitization certificates, including with respect to monthly payment amounts, duration of payments and risk of non-payment, also enables an investor to match the investor’s specific needs to the bond’s income stream. The public market makes trading the certificates quick and simple, effectively turning illiquid assets into liquid investments.
Advantages and Disadvantages of CMBS Loans from the Borrower’s Perspective
A borrower is often drawn to a CMBS loan for the following reasons:
- Lower Interest Rates. CMBS loans typically have lower interest rates than balance-sheet loans for several reasons. First, there is less risk (and thus a lower return) in a diversified pool of securitized mortgages because the losses from a single defaulted loan may be offset by the strength of the remaining loans in the pool. Second, the original lender earns fees and other income, including premium payments by investors for bonds in specific tranches, from the sale of the loan at securitization, thus increasing the lender’s return on investment beyond that it would receive if its only income were debt service payments. Third, the enhanced liquidity and structure attracts a broader range of investors to the commercial mortgage market, resulting in lower interest rates than balance-sheet loans. The delta between the interest rate on a CMBS loan and a balance-sheet loan is less significant when interest rates are low because the benefits to CMBS lenders are compressed; however, as interest rates rise, the delta becomes increasingly significant.
- Higher Overall Loan-to-Value (“LTV”) Ratio. A balance-sheet lender is often prohibited by its own institutional policies or regulatory requirements from lending more than 70 percent of the appraised value of the property.10 A CMBS lender is not typically bound by the same type of institutional policies and regulatory requirements because it is not holding the loan for its own account. It is not uncommon to see a CMBS loan with an LTV of 80 percent or, particularly in combination with a mezzanine loan, even higher.11
- Increased Availability of Capital. There are clear limitations on the amount of capital that a balance-sheet lender can advance because it must reserve against each loan that it holds on its books.12 These limitations on the aggregate capital that a balance-sheet lender can lend cause the lender to be more selective about the loans that it will make. In contrast, a CMBS lender sells each loan (other than the five percent it is legally required to retain13), freeing up its capital and allowing it to continue originating loans. With the notable exception of the 2008–2010 time period, there has been a virtually unlimited supply of capital in the CMBS market.
A borrower often focuses on the lower interest rate and higher LTV offered by a CMBS loan and fails to appreciate the following disadvantages, which have proved themselves to be problematic for many borrowers:
- No Continuity of Lender. A CMBS lender is not a “relationship lender.” Its relationship with a borrower is purely transactional. Once a loan is securitized, the original lender (or, if the original lender becomes a servicer, the original lender’s personnel) ceases its involvement with the loan. The borrower must now deal with a master servicer and special servicer, each appointed by the securitization trust and with whom the borrower has no pre-existing relationship.
- Master Servicer. One of the principal obligations of the master servicer is to enforce the loan documents.14 The master servicer has no incentive, and strong disincentive, to vary from the express terms of the loan documents. This is true even when circumstances clearly necessitate a liberal reading or modification of the loan documents.
- Special Servicer. Unlike the master servicer, the special servicer has broad (but not unlimited) power to make decisions that go beyond, or conflict with, the terms of the loan documents as long as the special servicer honors it fiduciary obligation to act in the best interest of the bondholders.15 The special servicer receives most of its income from the fees that it charges a borrower to address a particular request.16 If the circumstances of a loan require multiple and extensive interactions with a special servicer, the fees that a borrower pays to the special servicer may negate the benefits that the borrower receives from the lower interest rate. It is worth noting that a borrower can often achieve greater responsiveness and flexibility from a special servicer by increasing the amount of fees it pays.
- Minimal Structuring Flexibility. The goal of a CMBS lender is to close and securitize the loan as quickly as possible. During the securitization process, a CMBS lender will be required to certify that, except as otherwise noted, each of the loans meets the CMBS requirements. Any loan that diverges from the CMBS requirements may slow, or even derail, the securitization process. In order to avoid this situation, CMBS lenders frequently respond to a borrower’s requests for changes in structuring or changes to the terms of the loan documents by saying “We cannot make that change. CMBS rules prohibit it.” Frequently the foregoing statement is inaccurate. There are definitely borrower requests that cannot be accommodated if the loan is to be securitized (particularly as it relates to the REMIC rules), but more often than not, there are no legal reasons that a CMBS lender cannot accommodate the borrower’s request. Rather, the CMBS lender is trying to avoid a situation in which it is required to note the matter as an exception on its certification. Accordingly, CMBS lenders are often unwilling to address a borrower’s legitimate requests and concerns. Any borrower that wants to effectively negotiate with a CMBS lender should take the time to understand which variances from a lender’s standard policies and loan documentation will require the lender to make a disclosure during the securitization process and which variances are legally prohibited.17
- No Unplanned Future Advances. Real estate projects are not static, and sometimes unanticipated problems arise. While a portfolio lender is reluctant to advance proceeds to a borrower beyond the amount of the original commitment, a portfolio lender may agree to do so if it believes that an infusion of capital will stabilize the project. For example, if the sole tenant at the project files for bankruptcy and rejects its lease during the bankruptcy proceedings, revenues from the property will cease. This situation is problematic for both borrower and lender. If the borrower then procures another tenant willing to pay a reasonable amount of rent, but the borrower does not have enough money to pay for all of the tenant improvements necessary to get the new tenant in place, a portfolio lender might agree to make additional loan advances (above and beyond the original loan commitment) for this purpose. In the CMBS context, once a loan has been securitized, additional loan funds cannot be advanced because there is no lender available to advance them. There are only the servicers and the bondholders, neither of which has the requisite authority (or, with respect to the servicers, source of funds) to make any additional advances.18
- Rating Agency Confirmations. The need for a borrower to conform to CMBS requirements does not end when the loan closes and continues through the full repayment of the loan. Certain actions, even if expressly permitted by the terms of the loan documents (e.g., loan assumption), are conditioned upon the borrower receiving a confirmation from a rating agency that the action in question will not cause a downgrade to the credit rating of the securities issued in the securitization. A borrower will incur additional fees and expenses in obtaining a rating agency confirmation, and these costs are in addition to the fees that the borrower pays to the servicers. Much like the servicing fees, the costs of a rating agency confirmation can reduce the benefits that a borrower receives from a lower interest rate.
- Securitization Indemnification Liability. One typical CMBS requirement mandates that the borrower indemnify the lender from liability under Rule 10b-5 of the Securities Exchange Act of 1934 for any misstatements in information or disclosures to investors, rating agencies or other parties to the securitization.19
- Lack of Confidentiality. CMBS bonds are publicly traded, and investors in the securities are provided with an opportunity to review loan files and disclosure statements before purchasing the bonds.20 The information provided to potential investors includes financial information about the borrower, its parents and sponsors, as well as third parties such as tenants and property managers.21 A borrower should not have any expectation of confidentiality in light of the broad dissemination of information. If confidentiality is important to the success of the underlying property (e.g., a single-tenant data center) or a borrower (e.g., highprofile individual), then a CMBS loan may not be a good option for that borrower.