“Since extending the current loan is likely the solution in so many situations, it is important that brokers understand how lenders and servicers are handling these cases.”

The current freeze in commercial mortgage activity has been ongoing for much of 2023 and sales transactions have dropped precipitously. According to a recent forecast from the Mortgage Bankers Association, commercial and multifamily mortgage lending is expected to fall to a total of $504 billion this year, down 38% from the total of $816 billion in 2022. In many cases, property owners who can afford to wait are choosing to do just that in hopes that interest rates will fall in the future.

Looming problem

A major problem may be looming in the future, however, as more than $1 trillion in commercial real estate loans will be maturing in the next few years. Mortgage brokers with clients who have maturing loans secured by office buildings or apartment complexes don’t have the luxury to sit and wait. Property owners are going to be forced to refinance at rates that are twice as high (or even higher) than their current loan, depending on the lender and the location.

Even the largest players are feeling the market effects. S&P Global Ratings announced this past October that it was putting Brookfield Property Partners on a negative watchlist, meaning that the Canadian real estate giant might be downgraded to junk status. Bisnow reported that the reason for the move is Brookfield’s large amount of maturing debt amid high interest rates and downward pressure on property values.

Brookfield isn’t alone. All borrowers are facing limited options. Refinancing is going to be difficult as lending for office buildings this year has slowed and nearly halted. And the sales options (assuming the value of an office property is more than the loan amount) are also limited as borrowers will be required to put a lot more cash into the deal. So, their only other option is to get the lender to extend the loan.

The property owners who have maturing loans secured by multifamily housing also don’t have the choice to sit and wait. Just like office owners, their options are limited. While there is an abundance of debt available in the multifamily sector, the interest rate on a new loan will, once again, be much higher than that of the current loan.

The loan-to-value (LTV) ratio will also be much lower for a new loan. Some lenders are now offering loans with maximum LTVs of 50%, which means that the borrower will likely need to use a significant amount of cash to pay off the existing loan. Luckily, there’s a durable market for multifamily transactions, so these properties can often be sold. The final option is to get the lender to extend the loan.

Extension issues

Since an extension is the likely solution in many situations, it’s important for commercial mortgage brokers to understand how lenders and servicers are handling these cases. First, brokers need to explain to borrowers that lenders have an advantage when they know that owners are desperate for an extension and have few other options. Lenders smell blood in the water. After all, what else is a borrower going to do but accept the term a lender is willing to give them?

Unfortunately, even when borrowers have good relationships with lenders, they’ll find this to be the case. Everyone working with commercial real estate is ultimately in the business of making money. When they see good opportunities to turn a profit, they go for it, so there is no faulting a lender or servicer for doing the same thing even when it may not feel fair to the borrower.

This appears to be what’s happening these days. It’s no secret that an owner’s options are limited, so they’ll usually have to accept the lender’s terms. Many borrowers wind up with two options: accept an expensive offer to extend or find a private lender, often known as a hard money lender, to refinance. In essence, the current lender is the lender of last resort.

Other borrowers, however, may qualify for other creative methods, such as a high-rate bridge loan, or they could sell the property. Although some of these options may be more expensive than the offer from their existing lender, they are still worth considering. The broker needs to emphasize to the client that the best thing they can do is keep all options open and approach the lender in plenty of time to pivot to the best solution.

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The lucky owners in 2023 may be those who didn’t have their mortgage mature. The owners in trouble today — and for a few years to come — are those who will see their loans come due. Unlike COVID-19, there are no vaccines for maturing loans. The best advice that commercial mortgage brokers can offer clients who face loan maturity issues is to plan ahead.

Brokers need to advise clients on debt issues or work with them to find the right advisers at least six months prior to the loan maturity date. Borrowers need to figure out what their options are and how their lenders are handling extensions. This information will allow them to be prepared for the process they’re about to begin. ●

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Mortgage brokers should be aware of these pitfalls and explain them to their clients, who are most likely going into their loan negotiations with a lack of understanding.

The concept of the DSCR trigger is for the lender to trap all excess cash flow after debt service, which may happen if and when cash flow has trouble.

The cash sweep

Hidden pitfalls

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Banks, for the most part, gave borrowers verbal assurances that they would be willing to defer or forbear repayments. But holders of commercial mortgage-backed securities (CMBS) debt were left with few options. CMBS loans, particularly those underpinned by hotels and struggling retail assets, were an immediate casualty of the COVID-19 crisis.

According to Fitch Ratings, the delinquency rates for CMBS hotel and retail loans stood at 17.5% and 11.3%, respectively, as of October 2020. Within the retail sector, regional malls had a delinquency rate of 21%. Some 1,252 CMBS loans totaling $30.1 billion in debt were in special servicing at this time. And, unlike the banks that generally worked with their clients to avoid foreclosure during the early months of the health crisis, some CMBS debt holders had no choice but to walk away from their properties at a steep loss.

Market bellwether

CMBS is often viewed as a bellwether for the larger commercial mortgage market as friction and stress are often experienced there first, and the current crisis is no exception. Some analysts believe a similar reckoning will eventually occur for banks. It is important to know, however, that bank loans and CMBS loans have significant differences.

By now, many CMBS borrowers have had a crash course on the inner workings of CMBS and are keenly aware of the differences with traditional loans. But these nuances often are not widely reported and escape the public eye. It is well worth the time of commercial mortgage brokers to gain a sense of what is happening behind the scenes right now in the CMBS world.

The struggles of CMBS borrowers may have a lasting impact on the demand for these loans. According to the Mortgage Bankers Association (MBA), CMBS debt comprised about 14% of the $3.82 trillion in outstanding commercial and multifamily mortgage debt in third-quarter 2020.

As with all loan types, CMBS originations plummeted with the coming of the pandemic. MBA reported a 58% year-over-year decrease for CMBS origination volume in the third quarter of last year, which was second only to the drop in bank portfolio originations. Unlike other investor types, however, it is not as clear that CMBS loan volumes will bounce back as quickly once the pandemic ends. Borrowers have long memories. The CMBS market share fell significantly after the Great Recession and has never recovered. With that said, let’s review some of the key nuances of CMBS that have made relief extremely problematic for borrowers.

Because this relief is short term in nature, must be paid back in its entirety, requires a guarantee and comes with a fairly large price tag, many borrowers are simply concluding that the benefit of taking the relief is not worth the cost.

Multiple obstacles

First, unlike with banks, it is more difficult for CMBS borrowers to negotiate assistance. The decisionmaker for granting relief is not the master servicer or the special servicer but the controlling class representative (CCR) for the CMBS pool that a loan is in. Typically, this is the investor in the most-subordinate bond classes. Borrowers typically cannot speak directly to the CCR, even if they figure out who they are, but they are the party that is essentially pulling the strings.

Another issue with CMBS workouts is that it takes a long time to obtain relief. The approval process lasts three to six months or longer. CMBS servicers are overwhelmed with requests and also are dealing with the inefficiencies created by the health crisis. This is the source of much frustration for borrowers.

Third, all relief is in the form of a deferral. All funds have to be paid back eventually. Nothing is forgiven, and borrowers whose requests are approved will have to pay back the deferred amount typically over a 12-month period starting in 2021 or 2022. For some property types (hotels as a clear example), the asset will likely not generate enough income to make a full debt payment by the end of the relief period. These property owners will be saddled with a regular debt payment and will be required to pay back the deferred amount. This is likely to push many more properties into foreclosure.

In addition to this, special servicers typically require deferred payments to be personally guaranteed, leaving the borrower on the hook for the entire amount. And CMBS relief can be expensive. Special servicers will charge a fee for all loans transferred to them, regardless of whether any relief is actually granted. There are other fees the special servicer will charge upon granting relief and these are typically negotiable.

Furthermore, a condition for many of these relief agreements is for the loan to be placed in cash management. This essentially sweeps up all collected rents and revenues, and places them in an account to service the debt, which is exactly what borrowers are seeking to avoid at all cost.

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Because this relief is short term in nature, must be paid back in its entirety, requires a guarantee and comes with a fairly large price tag, many borrowers are simply concluding that the benefit of taking the relief is not worth the cost. The moral of the story is that CMBS is a highly structured financial instrument and does not work like a traditional loan. When all is going according to plan, CMBS loans are a great lending option. But when things begin to go wrong, CMBS can be a cruel teacher. ●

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The borrower has only a few options. One way is to defease the loan, which is a complicated process that sets up a portfolio of investments to service the debt. Defeasance can be costly, an expense that depends on interest rates. Another option is to pay a hefty prepayment penalty that is specifically intended to discourage borrowers from paying off their CMBS loan early.

Often, these routes are simply not financially viable. The only option left is for the buyer to assume the seller’s CMBS loan. At times, however, a loan assumption is almost impossible to do and will cause the deal to fall apart. It is possible, however, for commercial mortgage brokers to anticipate the common problems. In most cases, with proper planning and knowledge of the common deal killers, the buyer and seller can come together to close on an assumption.

Deal killers

The No. 1 reason that caused loan assumptions to fail last year involved the relationship between the loan balance and the asset’s value. In order for a new borrower to assume a CMBS loan during a property sale, a servicer may require the loan-to-value (LTV) ratio to remain the same as it was at the origination of the loan, even if the value of the property being purchased has changed.

If the value of the property has dropped from origination, for example, the borrower may have to place a sizable amount of money in a reserve account that artificially lowers the LTV for the duration of the loan. This often destroys the buyer’s internal rate of return — the measure of the investment’s profitability relative to other investment options — and often causes the potential buyer to walk away.

For example, a buyer may be trying to assume a $10 million CMBS loan on a property that was originally appraised at $15.4 million, or 65% LTV. The buyer agrees to pay $14.5 million and assume the $10 million loan. The servicer requires the buyer to put $575,000 in a reserve account that can never be used until the loan is paid off, so that the LTV will remain close to the same percentage.

The No. 2 most common deal killer last year involved control over cash. The buyer may have discovered that the servicer planned to trigger a clause in the CMBS agreement that would give the servicer control of the property’s net cash flow. Roughly 70% of CMBS loans have what are known as springing cash-management agreements. Basically, a servicer can take control of the cash flow if the debt-service-coverage ratio falls below an acceptable level based on their calculation, or if a major tenant ends a lease.

The problem is that when the loan is assumed by a new buyer, the servicers often spring the cash-management clause as a condition of closing on the assumption, even when the property is performing well and has not otherwise triggered cash management. Many times, the servicer will put all of the property’s net cash flow into a special cash-collateral reserve that the servicer holds, and no funds go back to the owners.

Another issue involves skin in the game. Most CMBS loans have nonrecourse provisions, meaning the borrower isn’t held personally liable after a default, but CMBS loans sometimes have exceptions that require a guarantor to assume liability for certain bad acts of the borrower. Many servicers are now requiring that this guarantor — typically an entity with significant assets unrelated to the property — have at least a 10% ownership stake in the borrowing entity. When this requirement is known upfront in the structuring phase of a deal, it can be worked around. When a buyer finds this out during the assumption approval process after raising all the funds to buy the property, however, it can turn out to be deadly.

Different priorities

Loan assumptions also can fall apart for several other reasons. Individuals and companies, for example, often require anonymity, but the servicer sometimes will not process the assumption without full disclosure of each investor that owns 10% of the borrowing entity.

Another common problem can arise regarding the size of the reserves. Many buyers begin the process assuming — and often demanding — that the existing reserve requirements remain the same, but usually the reserves are increased as a condition of an assumption, even if the loan is assumed within one year of the original agreement. You might wonder why the original reserve amount isn’t sufficient, when nothing has changed about the property. There’s an easy answer.

When originating a loan, the mortgage broker is focused on getting a deal closed and is typically interested in repeat business from that client. The lender typically wants to get the deal done and is trying to get the client the best terms. At the time of the loan assumption, however, the servicer’s role is to ensure that the loan won’t default in the future and, should it default, that the bondholders are ultimately protected. The servicer is not focused on repeat business and is not advocating for the buyer, but is looking out for the investors in the CMBS pool.

CMBS assumptions once had trouble getting done simply due to the lengthy amount of time it took to receive approvals. Those days are not gone, but there are bigger issues that cause the CMBS assumption process to be painful for buyers and sellers. The bottom line is that CMBS loan assumptions can fall apart for many reasons but, armed with the right information and an advocate, most problems can be resolved. The worst thing a mortgage broker and their buyer client can do is to start the assumption approval process unarmed and with a belief they will be dealing with a servicer that is watching out for them and their future business. Servicers in these transactions are looking out for one thing and that is the certificate holders in the CMBS pool — not the existing borrower and certainly not the new buyer. 

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About 70 percent of all CMBS loans originat-ed today have some sort of cash-management system, or lockbox, that allows a lender to capture a property’s cash flow. Understanding “springing” lockboxes, which are especially common, can help borrowers avoid deals that start well but wind up going bad. 

here are three types of cash-management systems for CMBS loans. They include hard lockboxes, which do not allow the borrower to have control over the property’s cash flow; soft lockboxes, which allow some control of cash flow; and springing lockboxes, which are triggered when certain situations occur.

The general premise of springing cash management is that it gives lenders the power to capture cash flow in the event of declining property performance. Mortgage brokers and borrowers may agree with this premise and understand its intent when they sign a deal with springing cash-management provisions, but it’s important to remember the devil is in the details.

Following are four common misconceptions about CMBS cash-management plans.

Income restrictions

Some borrowers think they won’t need to worry about cash management springing on their loan if the property is performing well and the debt-service coverage ratio (DSCR) is above the threshold spelled out in the loan agreement.

Typical CMBS loan agreements, however, include many definitions within definitions that give the servicer the right to calculate DSCR, and the servicer’s calculation is “final absent a manifest error.” These words actually appear in many loan agreements and the definitions are very important as they state what should be included in both the income and expense components of the DSCR calculation. With interest-only loans, the debt service used in the DSCR calculation often assumes the loan is of the 30-year amortizing variety, making the monthly payments in the formula much higher than interest-only payments.

Mortgage brokers and their clients should know about income that may be excluded from the DSCR calculation in the typical CMBS loan agreement. These examples include fully paying tenants that “go dark,” meaning they shut down their operations but continue paying rent; rental income from a tenant that has chosen not to renew its lease; and short-term leases, such as those for seasonal businesses.

The general premise of springing cash management is that it gives lenders the power to capture cash flow in the event of declining property performance.  

The bottom line is there are many well-performing properties today with DSCRs of 1.5 and higher that are being placed into cash-management plans. This is because the servicer has performed its own calculation based on the specific details of the loan agreement and is excluding certain income line items, adding other expenses and using an amortizing payment plan (even for interest-only loans). The servicer’s DSCR is often much lower than the actual ratio. Again, however, the servicer’s numbers are final, absent an obvious error. Just because the actual DSCR is above the documented threshold for springing cash management, it doesn’t mean the servicer’s calculation won’t be below the threshold.

Occupancy and rental rates

A second misconception is that a borrower won’t need to worry about cash management when his or her property is outperforming market expectations because of higher occupancy rates or higher rental rates.

“Underwritten operating income” is a term often included in the details of the servicer’s DSCR calculations. This stipulation allows the servicer to adjust rental rates, occupancy rates and other factors to the lower of (a) actual, (b) market, or (c) underwritten rates. So, in cases where the borrower has negotiated higher-than-market rental rates or has an occupancy rate above the market average, they will not get credit for that when the servicer calculates their DSCR as it relates to cash management.

This can really sting a borrower, for example, if the loan was originated with an underwritten occupancy rate of 80 percent, but the current occupancy is 90 percent. If the loan agreement defines the occupancy rate as the lower of actual, market or underwritten rates, then the income will always be calculated assuming 80 percent occupancy — or lower, if market-rate occupancy is below that — regardless of the actual occupancy rate of 90 percent. 

Once again, just because the actual DSCR is above the documented threshold for springing cash management, it doesn’t mean the servicer’s DSCR calculation won’t be below the threshold and cause the lockbox to be sprung. Income will be adjusted downward to the lowest allowable number in the loan documents.

Loan assumptions

Many buyers entering into an assumption of an existing loan believe they will receive the same terms as the previous borrower. This is partially true — but not entirely — and this one issue causes many lawsuits between buyers and sellers when the conditions for approval contain what the buyer believes are deal changes.

Without a modification, there are loan-assumption terms that cannot change, such as the interest rate and maturity date. There are other requirements that are wide open to change, however.

Reserves. Servicers can add reserve requirements that aren’t in the current loan documents, and they can increase the amount of reserves as much as they feel warranted. Often, any caps in place on the reserves are removed at the time of assumption.

Additional collateral. This can be in the form of a cash reserve, a letter of credit or a personal guarantee. The point is that the servicer can request additional collateral from the assuming borrower for any number of reasons — or no perceived reason at all.

Cash management. If the loan includes springing cash management, you can bet that it will be sprung at the time of assumption, regardless of the property’s performance. In today’s marketplace, this is a common condition for loan-assumption approvals.

Don’t be fooled into thinking a buyer can request changes to the loan documents at the time of assumption. A servicer is unlikely to entertain changes requested by the borrower. When buying a property with existing CMBS debt, mortgage brokers and their clients should be prepared for higher reserve amounts, cash management and other conditions. Don’t expect to be able to change the loan documents.

Purchase-price adjustments

When a buyer assumes an existing CMBS loan, they may believe the purchase price of the property doesn’t matter since the loan is already in place. This used to be the case. From 2009 to 2014, loan-to-value (LTV) ratios at the time of assumption didn’t matter.

But times have changed. Some special servicers now require a buyer to establish a reserve at the time of assumption in order to make the LTV equal to the original loan-to-purchase (LTP) ratio. This is best understood with an example.

Let’s say a CMBS loan was originated on a property with an appraised value of $25 million and the borrower got a 65 percent LTV loan — $16.25 million — at that time. Fast forward a few years and the property is being sold to a new buyer for $22 million. The original loan is interest-only, so the total balance is still $16.25 million.

On a property valued at $22 million, a 65 percent LTV loan would equal $14.3 million. Since the current loan is for $16.25 million, however, the difference between $16.25 million and $14.3 million ($1.95 million) would be required in the form of a collateral reserve at the closing of the loan assumption. 

To make matters worse from a borrower’s perspective, the $1.95 million cannot be used to pay down the loan because CMBS loans have prepayment prohibitions or penalties. So, the $1.95 million sits in a reserve account and cannot be used by the buyer for the life of the loan. This one item can impact a buyer’s internal rate of return so severely that many back out of deals when they learn of this requirement.

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What does all this mean for commercial mortgage brokers and their clients? Don’t enter into new CMBS loan documents without a thorough understanding of the specific terms, definitions and servicer processes. Don’t assume cash management will not be sprung based on actual DSCR calculations. This decision is based on the servicer’s DSCR calculation, which is binding unless there is an obvious error.

Be prepared for additional cash requirements when a buyer is assuming an existing CMBS loan, including the possibility of an LTV reserve. And, most of all, know that every word in the loan documents matters in regard to springing cash-management and DSCR calculations.

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