Because of their unique terms, CMBS loans can be an attractive option for certain borrowers. But because their structures are more complex than traditional loans, it is important to understand the upside, and potential downside, of choosing to take one out when investing in commercial real estate. This article explains what CMBS loans are and the advantages and disadvantages they have compared to traditional loans.
What is a CMBS Loan?
Unlike traditional loans, a CMBS loan is not designed to be originated and then serviced as a stand-alone loan. Instead, once a CMBS loan has been made to a borrower and secured by a first priority mortgage, it is packaged with other loans and then sold by conduit lenders, commercial banks and investment banks on the secondary market in a process known as securitization.
A commercial mortgage backed security offers an investor an ownership in a pool of real estate assets. Numerous loans are pooled and then transferred to a trust, the trust then issues a series of bonds. The bonds (aka tranches) vary in yield, duration and priority and, therefore, risk. Investors, such as pension or hedge funds, then invest in a bond of their choosing, based on their appetite for risk. Thus, the purpose of a CMBS loan is to generate returns for investors and the loan documentation is designed to manage the investment—and hedge risk.
Once a CMBS loan is sold, the borrower works with a servicer rather than the original lender. A servicer is an institution that works for the benefit of the trust and its investors (i.e. the “certificate holders”) in the administration of the CMBS loan. The CMBS loan is initially serviced by a master servicer according to both the loan terms of the underlying loan documents and a Pooling and Serving Agreement (a “PSA”). The PSA sets forth the responsibilities of each servicing entity associated with the trust and how each servicing entity must operate. The functions of a master servicer include collecting payments from borrowers, providing mortgage performance reports to investors, advancing funds for delinquent loans, reporting to the trustee and transferring non-performing loans to a special servicer.
A CMBS loan is generally offered for a 5, 7 or 10 year term. But because it is amortized over a longer term (generally 25 or 30 years), its terms require the borrower to make a balloon payment at maturity. Additionally, a CMBS loan may qualify for interest only payments, thus greatly lessening debt service during the life of the loan. Because a balloon payment is due at maturity, a CMBS loan is generally taken out with a plan of refinancing or selling the property when the loan matures. The risk in taking out a CMBS loan is that if the loan’s maturity coincides with a down or distressed real market, which may limit a borrower’s options if it is unable to make the balloon payment at maturity.
CMBS loans are generally structured as non-recourse loans—in the event of a loan default or foreclosure, the lender can only look to repayment of the debt from the property used as collateral for the loan and/or from cash flows derived from that property. The borrower, and any guarantors, generally have no personal liability to the lender, although CMBS loans provide for full recourse liability for certain “bad boy” acts by the borrower, such as conducting activities that result in transfers, intentional damage, harm or lack of productivity to the property serving as collateral for the loan.
Benefits
CMBS loans are attractive because the loans offer competitive, lower interest rates than traditional loans. Borrowers are able to leverage a higher value of the collateral (higher loan-to-value ratio) when determining loan amount. And because some CMBS loans also offer interest only payments during the life of the loan, it can mean lower debt service payments from the borrower, which can free up cash flow. Additionally, upfront fees charged in originating a new CMBS loan are often less than fees incurred with a traditional loan, again freeing up cash.
Additionally, if the owner/borrower wants to sell the property that has been financed through a CMBS loan, upon payment of a fee, the loan may be assumable by a purchaser, allowing the borrower to sell the property and transfer the debt to the buyer without the cost associated with finding a securing new financing. When this occurs, the buyer will generally be bound by the same terms as the original owner.
Drawbacks
Since the CMBS loan will be collateralized, the terms and structure are more complex than with a traditional loan, there is less flexibility to the borrower in negotiating the loan terms and CMBS loans are subject to a number of restrictions that may not be present with a traditional loan. For example, with a CMBS loan, a borrower’s business must have a single purpose and the borrower subject to certain single purpose entity requirements and limitations under loan documents.
CMBS loans also often prohibit secondary or supplemental financing. Because the goal of a CMBS loan is to maximize returns to investors, a borrower may also be prohibited from refinancing or prepaying a CMBS loan. Where prepayment is permitted, achieving the payoff is often complicated and expensive because prepayment penalties will be charged. A borrower may also be required to replace the property with another form of collateral in a process called defeasance. Alternatively, a borrower may be required to pay yield maintenance, which means the borrower will have to pay the difference between their current interest rate and U.S. Treasury yields. However, as noted above, the loan may be assumable by a purchaser of the property.
Additionally, a CMBS loan is serviced by a servicer according to the PSA and the loan terms of the underlying loan documents. These requirements and restrictions allow less flexibility in servicing the loan than may otherwise be permitted in the case of a traditional loan. As such, it may be very difficult for a borrower to obtain financial assistance from the master servicer that could avoid a loan default. Instead, upon the occurrence of a borrower’s default under the loan, the loan is assigned to a special servicer, whose job it is to work with the borrower to address the default. A special servicer can negotiate workouts or take defaulted properties through the foreclosure process. While a special servicer has a number of options (such as a loan modification, negotiated payoff, selling the loan or accepting a deed in lieu of foreclosure), a lender under a traditional loan has more flexibility and options for a loan workout with the borrower.
Importantly, in a CMBS loan, cash flow is subject to cash management process. Upon the borrower’s default, the special servicer takes control over the borrower’s cash flow during the default period. This can starve the asset of much needed cash flow necessary to properly run the property and lead to the necessity of the appointment of a receiver to manage the property. And because a CMBS loan is designed to protect the interest of investors, in addition to non-payment, cash sweeps or loan defaults can be triggered by failure to meet certain covenant thresholds, such as “debt service coverage ratios.” If a loan goes into default, loan fees and costs can also be more expensive than with a traditional loan—costs associated with default interest, reports for special service, special servicer fees, legal fees, loan modification fees, additional equity contributions, etc… add up quickly and are not typical in traditional loans.
In sum, CMBS loans can be an attractive vehicle for borrowers looking at financing options, as its attractive upfront fees, rates and debt service requirements make it an attractive choice. However, the downsides associated with a CMBS loan should not be ignored and potential borrowers should carefully consider their loan options before committing to a certain financing vehicle. If you have any questions about these loans, or any of the subjects touched on in this article, please reach out to Justine Lara Konicki (jlk@kjk.com, 216.736.7211) or Peggy S. Beistel (psb@kjk.com, 216.736.7207).
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