Understanding Commercial Mortgage Backed Securities (CMBS) can be a daunting task for the novice investor. As lender liability lawyers, we grapple with complex loan arrangements daily. We understand the jargon, the many different players in a CMBS transaction and how all the pieces fit together. Institutional investors and servicers share that knowledge but typically individual investors do not.
Our practice is unique in that we don’t represent banks or servicers. We represent borrowers. Many of those borrowers are individual investors who suddenly find themselves facing looming maturity dates and seemingly no way to refinance. Perhaps their real estate investment lost a major tenant and now they are facing a non-payment default (technical default).
This post is written for the novice investor. Novice investor does not mean unsophisticated, however. Many of our clients are retired executives, physicians and lawyers. They are smart and successful; that is how they came to have money to invest. These folks may be highly sophisticated but they are not institutional investors and don’t invest in commercial real estate on a daily basis.
If you are an individual investor with a CMBS loan, chances are good that you pooled your money with others and invested in 2007 or thereabouts. Money then was cheap, property values were increasing and projects all had great cash flow.
Back then, we relied on the representations of the promoter and the underlying value of the real estate. What could go wrong? With property values increasing and cash flows great, it was a pretty sure bet that you could either ride out a small downturn or simply cash out.
If you are reading this post, chances are good that things didn’t work out as planned. Even projects that have great cash flow are having difficulty getting refinancing. And refinancing means everything today as most notes CMBS notes are 10 year, interest only and are coming due. Unfortunately, even on projects with positive cash flow and where there was never a missed payment, lenders simply don’t want to refinance.
Where can you go for help?
Commercial Mortgage Backed Securities CMBS Trusts
The promoter who “sold” you on the deal may not even be in business anymore. If they are, they are long out of the picture. They can't help. Any involvement they had probably ended when the note was sold.
The lender that originally made the loan? They are called the “originator” and were only in the picture for a very short period. Many of the loans written for investment properties were securitized. They were packed and sold into a pool of loans. These loan pools are known as Commercial Mortgage Backed Securities. The owner or holder of the loan is now a CMBS trust, not a bank.
Your loan is one of many held by the trust. As part of your investment package, you received several hundred pages of documents. You aren’t alone if you didn’t read them. One of those documents is a “Pooling and Servicing Agreement.” That agreement details how your loan was packaged with others and placed into a trust.
And who is the trust? Who owns the trust?
Chances are good that the owners of the trust are many and that they are not banks. Most CMBS trusts are held by multiple anonymous bondholders.
The trust doesn’t have an office and there is no staff. You can’t walk in off the street and ask the trust to refinance the loan or grant an extension.
The face of the commercial mortgage backed securities trust is the “servicer.” These are companies like Berkadia Commercial Mortgage and Wells Fargo. Servicers are hired to collect payments and insure that taxes are paid and insurance maintained. Any leftover money goes to fund certain reserves and then to the trust’s bondholders.
When things are going well, you probably rarely hear from the servicer. Typically, the only contact is the occasional request for financials or a call six months before the loan comes due. (Warning! Waiting until the maturity date of the loan is a recipe for disaster.)
Hidden Traps in CMBS Loan Agreements
The loan documents obviously require taxes and insurance be paid but also have provisions that sometimes trip up novice investors. Losing a big tenant or having the loan to value ratio fall below a certain point can trigger a technical default.
We all know that on our home mortgages, as long as the lender is paid, we aren’t hassled. Not so in the investment property world. Even if the property is cash flowing just fine, loss of a tenant or a decrease in valuation can trigger a default. In some loans, the trust can declare a default if it merely feels insecure. Such measures would never fly in a residential mortgage.
Simply having the loan come due without new financing in place can trigger a default. In this case, a "maturity default".
When a loan is in default the servicer hands over control to a “special servicer.” These are companies like LNR Partners or CWCapital. Special servicers can be brutally efficient in their work… usually to the detriment of the borrowers. Make no mistake, special servicers work for their own interests or that of the trust. Never the borrower.
Once a loan is in special servicing, most rules go out the window. Pooling and servicing agreements and the loan documents typically allow the special servicer to reallocate payments, pull money from reserves and take actions that they believe are in the best interest of the trust. Usually their interests and your interests are very different.
Special servicers generally owe no fiduciary duty to investors / borrowers. Under most state laws, however, they do have a duty of “good faith and fair dealing.”
Negotiating for Extensions / Refinancing
As noted above, most real estate investment loans are for a fixed 10-year term and are interest only. At the end of the term the loan must be refinanced or the principal paid in full. Unlike a traditional bank loan, however, investors cannot simply go to the trust and ask for refinancing.
Commercial mortgage backed securities trusts are not banks. They are investors like you, however they are usually institutional investors. The trust is a one-time investment. They don’t write loans and typically don’t refinance loans.
The trust itself is governed by a “controlling class member.” Commercial mortgage backed securities trusts usually have layers called “tranches.” The layer or tranche dictates how much of a rate of return one receives and the order of payment. The top tranches generally have a lower rate of return but are the first to get paid. The lower tranches have more risk but also carry the possibility of a higher rate of return.
The holder of the bottom tranche is the controlling class member. Why? Because the bottom tranche is the first to suffer a loss in the event there isn’t enough money to pay all the bondholders.
Knowing the controlling class rep and the special servicer is key to knowing whether an extension or other relief can be negotiated. It is also important to understand the dynamics faced by the special servicer. They have a fiduciary duty to the trust and therefore all the bondholders but also are hired by the controlling class rep.
In our experience, some controlling class reps simply do not want to renegotiate terms with borrowers. They would rather see outside money come in and a new borrower. Sometimes in projects with good cash flow, the special servicer decides it wants the property. Often the pooling and servicing agreement will allow them to bid on the property. That’s when things can very tricky and borrowers often find themselves in very hostile territory.
Investors should begin developing a refinancing plan or exit strategy long before they hear from the servicer about an impending maturity. If you don’t have a plan when you get the maturity letter, expect to find your loan in special servicing. If the property isn’t profitable, the controlling class representative of the commercial mortgage backed securities trust has more incentive to work with you.
If the property is valuable and has good cash flow, however, you may lose significant equity while the property is in special servicing. You may also find that others involved in the process have interests different from yours. They may want to take your property.
We have seen cases where special servicers have bled the equity out of a property only to sell it to themselves. The bondholders, controlling class rep and special servicer all make money. You, the investor, are left with nothing.
Knowing how to swim in shark infested waters is critical for novice investors. If you don’t have significant experience with commercial mortgage backed securities trusts, find an advisor who does.
The lender liability lawyers at MahanyLaw and Judge, Lang & Katers have represented dozens of individual investors and borrowers. We are two law firms that join together to represent borrowers across the United States. (We are unique in our ability to represent groups of investors too.)
If you are facing an impending maturity default or find yourself in special servicing with no easy way out, call us. For more information, contact attorney Chris Katers at 414-777-0778. The author of this post, attorney Brian Mahany, can be reached at [hidden email].
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