S.E.C. Real Estate Observer

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The lending sources for commercial real estate loans are commercial banks, thrifts, insurance companies, private investors and mortgage brokers. Mortgage brokers package loans for institutional lenders; hold mortgages in their own portfolio or package loans for commercial mortgage backed security (CMBS) issuers. The CMBS loans or commercial mortgage backed security loans are known as Wall Street money, conduit loans or securitized loans. These terms are interchangeable.

Characteristics of a CMBS loan:

While terms can vary the following is a list of the most common traits:

1. Fixed Interest rate: The interest rate is usually fixed for the entire term of the loan. The rate is tied to an index with the same term as the due date on the mortgage. Based on the risk of your property, you are quoted a spread such as 250 basis points over the 10 year treasury. This means the interest rate on your loan will be 2.5% higher than the interest rate of the 10 year treasury note on the day you lock the rate. The standard indexes used are LIBOR, 5 or 10-year treasury notes or the 11th district cost of funds.
2. Long amortization periods: The loans are generally amortized over 20 to 40 years. Monthly payments are low with the entire balance due and payable at the end of 5 or 10 years.
3. Non-recourse loans: Liability is limited, to environmental, financial management, taxes and fraud. These are called “carve outs” and a credit worthy entity will need to guarantee the lender against default under these items.
4. Transferable: The loans are generally transferable with the payment of one point and a serious credit check. Often to assume the loan requires greater credit worthiness than to originate the loan. The survey will need to be updated and the tenants may be required to sign new estopple letters. If interest rates have increased since the origination date the interest may be increased. Because of lender policies, some of the loans are very difficult to assume.
5. The loan is underwritten by the income or cash flow from the property. Debt service ratios vary with product type, but are a minimum of 1.25. Properties are underwritten to vacancy rates that are higher than the market is experiencing. Do not expect the underwriter to use a 95% occupancy rate. Since the security is an income stream, conduit loans are not available for development projects.
6. Reporting requirements: The underwriter wants to see cash flow, and this does not end once you have signed the loan. Monthly income and expense statements are common for the first year. Then reporting is quarterly. Loans require notice if a tenant moves and another tenant leases the space, and leases can be subject to approval by the lender.
7. Reserves: CMBS services escrow for taxes, insurance, repairs, tenant improvements and leasing commissions.

Getting the loan:

The cost of getting a CMBS loan is high. Packaging loans to become securities brings “Wall Street” legal fees. The survey has to be to higher standards than required by conventional lenders. The environmental inspection is done by an “approved” firm that may be out of state, so you will incur travel expenses. Structural and site inspections are required. The lender requires a single asset entity to hold title.

Unless you are dealing directly with an issuer, the mortgage broker has no real authority. The mortgage broker and the lender have a contract that states the lender is not bound by any statement made by the loan broker. The loan broker’s job is to only report the latest offering. Since the mortgages are being packaged for a sale in the bond market, which is an ever-changing market, the rules can change during negotiation. The most dramatic example of this was in 1997 when the entire market dried up within a matter of days. Commitments were not honored, lenders disappeared and borrowers sued anyone they could find.

The Underwriting Process:

Mortgage brokers gather information and forward it to the lender or issuer’s underwriting department. An issuer funds the loan. At time of closing, the borrower is called on the phone by the lender to confirm the lending rate. The call is usually a conference call among the lender, the borrower and the borrower’s attorney. The phone call is taped and reviewed by a securities compliance officer. A security is formed when commercial loans are deposited into a trust.

The issuing entity reduces risk by creating a pool that has diversity both by geography and product type. This diversity prevents the entire pool from being subject to idiosyncratic risk factors, such as an earthquake in California, or an overbuilt office market in Houston, Texas.

California, Texas and New York have the highest geographic representations. Product types include retail, office, industrial, apartment, hotel/motel and general. Hotels/motels are seen as having the highest risk factors and are weighted accordingly. Apartments are the lowest risk. Pools are increasing in size and many are in excess of $1 billion.

Within the framework of a trust, the issuer creates and sells different classes of bonds or traunches of risk. The formulas to create these bonds and the models that support the ratings vary with the issuer. The entire process is a security deal and governed by the Securities Exchange Commission. All the safeguards and disclosures in the system are designed to protect the bond purchaser.

The borrower is a commodity, and is required to attest to all information provided on the real estate and the cash flows. The paper work places all the disclosure requirements of the property on the borrower and removes this risk from the issuer. The disclosure requirement often exists during the entire term of the loan. Remember these become security disclosures and can carry severe penalties for error.

The Servicing Agent:

Once the loans are in place and the bonds have been issued, the servicing agent receives payments on the loans and distributes principal and interest based on the contract governing the distribution of proceeds for this specific CMBS.

The servicing agent keeps records on the loan, oversees the escrow account, any reserve accounts and provide a budget cash flow statement for the property. Reporting statements are checked against the cash flow budget. The servicing agent schedules annual inspections of the property. The servicing agent reports to the special servicing agent.

Call Protection:

In the industry, call protection means protection of the bond investor’s return. A bond has a cost, an income stream and is due at a specific time. With these elements quantified, an investor can accurately determine the internal rate of return (IRR). Since the CMBS are sold into the bond market, the mortgages become a bond. This means they need to be paid over the entire term of the loan and not prepaid at any time prior to the maturity date. A prepayment changes the yield. Wall Street buys and sells the expectation of a specific yield over a fixed time. The yield maintenance clause and later the defeasance clauses are structures to guarantee the investor’s IRR.

Under yield maintenance, the borrower is required to make the lender whole in the event of an early payoff. This is done by calculating the present value of the income stream and the loan balance discounted by the treasury rate of the same term. The difference between this figure and the loan balance is the prepayment premium. When interest rates are falling, the prepayment premium goes up. If interest rates are constant, there is still a prepayment premium due to the spread or the basis points over the index. If interest rates have increased the issuer will need to cover his costs to reinvest the principal. Yield maintenance clauses require the borrower to pay cash to prepay the loan.

Defeasance is very similar to yield maintenance. Here the borrower actually purchases U.S. Treasury securities (strips/bills) that become the collateral for the loan, and the property is released from the debt. While yield maintenance was an accounting issue, defeasance became a legal exercise and incurred huge legal fees.

Most loans now have a prepayment lockout for the entire term of the loan or the term less 6 months. This means that if a loan is due on December 31st of 2010, the borrower can pay off the balance of the loan any time after June 30th of 2010 without incurring a penalty. This is to provide a realistic time to allow for refinance of the property and is replacing the 30-day window originally provided.

Areas to watch:

1. CMBS want insurance protection for the collateral and the cash flow. Operations interruption insurance is required, to ensure that the payments will continue in the event of a loss. Property loss is to cover the appraised value, not the loan. Co-insurance clauses are not accepted. Some of the insurance amount requirements have been relaxed since insurance companies have refused to insure structures for amounts in excess of land and structure values. This can become a particular problem on very valuable NNN retail sites where the value is in the credit of the tenant and the land.
2. Have your attorney read the insurance clauses carefully. Usually the servicer determines how insurance proceeds are allocated. Several apartment projects in Baytown, Texas, had tornado damage. The lender retained the insurance proceeds. An owner who lost roofs on 40% of his project was told that the proceeds were being applied to his loan balance. He could not put secondary financing on the building to repair the roofs, and a yield maintenance formula was being applied to his prepayment. The owner was forced to sell and lost all equity.
3. Make certain that the reporting requirements are reasonable. Do not agree to audited financials unless you are going to be able to supply them at a cost that can be supported by the project.
4. Many loans have annual inspection requirements with the borrower being responsible for the cost.
5. Getting lease approvals is inconvenient. Most lenders will agree to notice and the right to deny. Usually a 5-day period to review and reject is acceptable if the lease does not represent more than 20% of the property.
6. CMBS loans prohibit secondary financing. This becomes particularly difficult when an owner wants to sell and has a large equity. Creative methods of mezzanine lending exist, but often ownership is diluted.
7. Most real estate attorneys with general practices do not remain current in the terms and conditions of conduit lending. You need an attorney that reviews this type of loan on a very regular basis, and is experienced with the case law. For example one clause requires the guarantor to represent and warrant that the operating account will always have sufficient money to pay the note. This warranty creates a recourse loan for the guarantor.
8. Negotiate the 6-month window at the end of the term to allow for refinancing.
9. Be certain to initial the bottom of each page of every document you sign. Small specific details can become very important when loans are being put into portfolios. This insures that you get the terms you signed at closing.

The Future of Lending:

More lenders are adopting the securitized loan practices. Insurance companies write their loans to near conduit standards to create a secondary market in the event they need to generate liquidity. Reducing the prepayment risk on a mortgage loan also stabilizes the insurance company’s asset base. This is important for an insurance company’s rating within the insurance industry.

Commercial banks and portfolio lenders see the conduit loan standards as an opportunity to create a premium when issuers are doing a roll up and need to balance a package of loans.

New insurance products are becoming available for NNN and institutional grade properties that will allow a borrower to insure a minimum residual value loan at time of maturity. The fee associated with the residual value insurance prohibits marginal properties from participating.

The New REO:

The loan servicer reports to the “special servicer.” This individual or office has the final authority in loan disposition. The “special servicer” is an underwriter for the higher-grade bonds or traunches. In the event of a default, the special servicer covers a short fall in payments. This office determines if a loan will be foreclosed. It has the authority to negotiate a sale, a buy out or a work out of the loan. After a foreclosure a subsidiary entity holds title during an REO period. Unlike commercial bankers the special servicer does not need to meet federal bank or thrift regulator requirements in the disposition of real estate owned. The office is autonomous within the limits of the organization. Opportunity purchasers and listing agents should be getting to know these folks.