By: Josh Siegel
The sub-prime mortgage crisis and recession of 2008 triggered a comprehensive restructure of the commercial mortgage-backed securities (CMBS) market. Between 2005 and 2007, while underwriting standards were at their weakest, more than $300 Billion in maturing commercial real estate mortgages were originated. These underperforming securities will need to be refinanced between 2015 and 2017, which according to Trepp – the leading global provider of CMBS analytics – is more than 2.5 times the volume that matured between 2012 and 2014.
Prior to the credit crisis and corresponding downturn in the real estate finance market, cash management arrangements in CMBS loans that originated during or before 2008 gave borrowers significant control over cash flows from the property due to increasingly high levels of lender competition.
This increased competition was another significant reason lenders lost specific remedies designed to intervene in a situation where a borrower or security was underperforming. The market competition was extremely borrower-friendly, and routinely borrowers would choose lenders based on the borrower’s ability to retain cash flow control.
Cash flow management is a critical feature in commercial real estate loans, especially those intended on being securitized in the CMBS market. The primary focus of cash management structures in the securitized loan market appear in loan documents and will describe when, and to what degree, lenders will be able to control free cash flow from a property. Often, the cash management structure of a CMBS loan is highly negotiated and can be critical in determining the most effective strategy for closing, operating, restructuring, or exiting a commercial real estate asset.
Post-recession, with an influx of new regulations, including Dodd-Frank and Basal III, new capital requirements for banks in commercial real estate finance generally require stricter, more lender-friendly cash management protocols. Lenders attempt to ensure that monthly debt service on the loan, expenses, and certain reserves accounts are all paid in full before funds are returned to the borrower.
The most utilized mechanisms that lenders now have in the post-recession CMBS toolbox are Lockbox Accounts, which utilize Cash Flow Sweeps to further shield the loan from underperformance or default:
Lockbox Accounts: There are primarily three types of lockbox accounts: Hard, Soft, and Springing lockboxes. A Hard Lockbox account, in most circumstances, will require all rents and cash flows generated by a property to be directly deposited into the lockbox account controlled by the lender. This decreases the risk of the borrower misappropriating funds and provides the lender with immediate control over property revenues.
Much like hard lockboxes, Soft Lockboxes require the borrower to deposit revenues into the lockbox account, but they give the borrower a specified amount of time to make these deposits. Although the soft lockbox increases the risk of fund misappropriation, lenders can mitigate this risk with additional recourse liability to the loan guarantor.
The Springing Lockbox is an arrangement where the lockbox account is not established at the time the loan closes. Rather, the lockbox is only established once a triggering event has occurred. For example, the lockbox could “spring” into effect if a major tenant does not renew a lease, or in the case of default under the loan, or if the loan falls below its minimum Debt Service Coverage Ratio.
The Cash Flow Sweep is the process by which the lender appropriates net cash flow (beyond the borrower’s operating costs and debt service) into the appropriate account once the triggering event has occurred and a financial test, accompanied by a lockbox account, pursuant to language in the loan documents, has not been met.
The effects of 2008 are evident in the CMBS market today. Changes in underwriting quality could expose investors to more risk, especially as the volume of CMBS deals grow in 2015 and into the future. Whether or not the loosening of underwriting standards creates another significant wave of distress remains to be seen, but lenders now have more tools in their toolboxes to shield their risk and avoid default.
Metropolitan Capital Advisor’s Senior Directors have extensive experience in advising our clients on negotiating the terms of CMBS transactions and assisting them in crafting financing strategies specifically tailored to their unique situations.