Much of the growth in the number of hotel transactions and refinancings in the past 15 years was fueled by commercial mortgage-backed securities financings. In brief, issuers would pool numerous loans of varying product types and risks, obtain ratings on them from the rating agencies and then offer them for purchase to investors based on their investment criteria. CMBS became an attractive way to raise funds from investors that wanted to invest in real estate. It also was attractive from a hotel owner's perspective because the CMBS markets offered lower interest rates than were otherwise available from more traditional lenders, and they did not require unlimited personal guarantees.
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David Neff |
Now that the hotel industry and the economy are in a severe tailspin, many are taking a closer look at the CMBS structure to see what can be done both to restructure loans that become distressed as well as to purchase such loans. To figure both out, you need to know the basics of CMBS and what can and cannot be done. The following is a general overview. When a CMBS loan was originated, the borrower and lender entered into various agreements, with certain loan and security documents governing their relationship. These documents typically addressed various rating agency requirements, such as requiring the borrower to hold title to its property in a single-purpose entity and to provide a so-called "bad boy" guaranty under which the guarantor agreed to personal recourse under such circumstances as the filing of bankruptcy by or against the entity that owns the property.
After the loan was closed, it was pooled with other loans, evaluated by the rating agencies and transferred into a trust. The securitization occurred through a tax structure, which allows the trust to be treated as a pass-through entity not subject to tax at the trust level. The trust then issues a series of bonds of varying yield, duration and payment priority that get credit ratings and are purchased by investors. Monthly payments are then made to the investors based on their order of priority, with the lowest-rated bonds being in the first loss position. The rights of all the parties are set forth in a pooling and servicing agreement (PSA).
Special servicers handle default
Individual loans are serviced by a master servicer, who interacts with the borrower and coordinates the flow of payments from the borrower to the trustee for ultimate distribution to the bondholders. However, upon an imminent default or reasonable likelihood of default, the loan will subsequently be transferred to a special servicer, who is a specialist in managing defaulted loans. The special servicer's ability to work out loans will be subject to certain legal requirements and the terms of the PSA, which also may address the special servicer's ability to sell the loan.
The special servicer must take special care not to risk the favorable tax status of the trust. Thus, it cannot engage in any "prohibited transaction," which would cause the trust to be taxed as a corporation. In particular, the loans in the trust must remain as a "static pool," which means no new loans can be contributed to the trust and no substitution of loans can be made after a short period of time after the trust begins. A loan in the trust that is significantly modified might be deemed a new loan and cause the trust to lose its tax-advantaged position. However, there is substantial flexibility to modify a loan after it goes into default without risking that tax status.
Although a special servicer has great flexibility in dealing with a defaulted loan, it does not have unlimited power. Typically, it can forgive principal, accrued interest or prepayment premiums, reduce monthly payments and extend the maturity date, although such extensions usually are limited to one-year increments and the number of extensions may be limited in the PSA. On the other hand, the special servicer usually cannot substitute collateral, take an equity interest or loan additional money to the borrower.
How willing a special servicer will be to work with the borrower in any specific instance will be impacted by many factors. For instance, the special servicer may have different motivations depending on what entities hold the bonds, the compensation to be paid for handling the defaulted loans, whether the borrower is taking appropriate care of the collateral and dealing honestly and openly with the servicer and, most importantly, whether the borrower is willing to pay additional money in exchange for concessions. In some instances, subordinate bondholders will have a voice in the handling of defaulted loans. The rating agencies may even be involved depending on the impact of any loan modifications to the pool of loans that had been rated. The identity of the special servicer can even change if the PSA enables bondholders to vote it out.
There are only a handful of special servicers throughout the country that deal with CMBS loans. They have been gearing up for the onslaught of defaulted commercial real estate loans they expect to come their way. How they handle them will play a substantial role in who turns out winners and losers in this fast-evolving cycle of the hotel industry.
David M. Neff, co-chair, Hotel & Leisure Group, Perkins Coie, Chicago, Illinois. David can be reached at (312) 324-8689 or dneff@perkinscoie.com.