First Resolution: Exercise More (Good Judgment): CMBS “Do’s and “Don’ts” on the Lender Side

CRE Finance World, Winter 2014

First Resolution: Exercise More (Good Judgment): CMBS “Do’s” and “Don’ts” on the Lender Side ith thawing credit markets, issuance of commercial mortgage-backed securities (CMBS) has increased.1 CMBS loan delinquency rates are declining, and seeming resilience of CMBS lending may produce increased transactional activity. Increasing CMBS lending requires real estate finance attorneys to navigate the complexities of CMBS—from origination through securitization (including servicing of the loan).2 In the spirit of the new year, this article presents a refresher of DOs and DON’Ts to lenders’ counsel guiding a CMBS loan from “cradle to grave.” Loan Origination Origination generally begins with submission of a loan application and concludes upon “legal closing” and disbursement of funds. A typical CMBS “conduit loan” is structured as a 10-year fixed rate, non-recourse loan with a 30-year amortization and a LTV somewhere around 75%.3 Throughout negotiations during origination, lender and counsel must remain mindful of securitization and not permit concessions hindering or halting the process. DO consider a CMBS loan’s short duration with the originating lender and address the following issues in order to properly prepare a loan for securitization: Real Estate Structure Counsel must resolve borrower and property level structure issues so the structure satisfies both the originating lender and securitization requirements. (i) Structuring the Borrower. For securitization, rating agencies generally require CMBS borrowers meet single purpose entity (SPE) requirements. SPEs may be structured in different ways depending on the transaction’s size and complexity. Generally, SPEs are structured to isolate financial risk through limiting the borrower from owning other property or acquiring other indebtedness.4 Ideally, the SPEs should preclude substantive consolidation of equity owners, should such owners seek protection under the bankruptcy code. DO review the borrower’s corporate structure and recognize noncompliance with these requirements. DON’T forget there is always a risk that the borrower may be subject to consolidation in a bankruptcy proceeding, as seen in the General Growth Properties, Inc. (GGP) case of 2009.5 In GGP, the SPE and parent entities did not keep separate operating accounts. Instead, they violated all SPE covenants and comingled accounts. As a result, the court deemed that the SPE entities were not bankruptcy-remote and could be consolidated in a larger CRE Finance World Winter 2014 80 bankruptcy proceeding. Lenders now require controlling individuals or entities of a borrower to sign a guaranty whereby violations of SPE covenants result in recourse liability for such guarantors. (ii) Structuring the Property. Properties must generate sufficient income to satisfy debt service; hotel receipts or rents are examples of property generated cash flow. DO evaluate the property’s structure and evaluate (i) the asset’s current and future value, (ii) future property operating cash flow and (iii) the borrower’s potential to bring in additional capital.6 Underwriters should consider, inter alia, property location, operating history, competitive market analysis, financial history and net cash flow. DON’T forget to advise clients to avoid the inclusion of non-real-estate cash flow in their analysis, as this may present issues for the securitization’s structure and REMIC status. For example, a large resort may have a national franchise restaurant on premises. The borrower may wish to include the cash flow from that tenant; however, only lease income from the collateral should be included in the total revenue computation.7 Real Estate Finance The next stage in the life of a CMBS loan involves understanding real estate lending transactions and related documents. When drafting loan documents, counsel face many issues, including, inter alia, ground leases, cash management, future advances, extensions and two-tiered SPEs. Special mitigants must be added to address transactional nuances, whether full-recourse carve-outs for dissolution of tenancy-in-common transactions or specific REA estoppels to address any potential for liens. DO remember mortgage law is highly state-specific; DON’T rely on a local opinion as an absolute. Due Diligence and Basic Dirt Law While loan documents are being drafted, the borrower and sponsors should begin providing various due diligence for lender’s counsel’s review. Property due diligence helps ensure compliance with securitization requirements, as well as the lender’s familiarity with the collateral securing the loan. The following areas are important: (i) Zoning Laws: Sellers in securitization make representations and warranties as to the property’s compliance with zoning and municipal codes. DO review zoning reports, and if a report shows “legal, nonconforming,” counsel will need to determine if, in the event of a casualty, the collateral can be properly restored and continue to maintain an equal or greater cash flow. For example, deficiencies created by failure of the property to meet parking requirements W Rachel Pignatiello Associate Alston & Bird LLP Geoff Maibohm Counsel Alston & Bird LLP Robert Sullivan Partner Alston & Bird LLP


CRE Finance World, Winter 2014
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