Borrowers’ Nightmares from CMBS Funded Loans
Much of our lender liability practice revolves around borrowers in CMBS loans. Although down in number from their heyday in 2008, they are still in use and many borrowers seek them out. While they may look attractive at first, they often catch borrowers off guard.
CMBS is short for Commercial Mortgage Backed Securities. CMBS loans are commercial mortgage loans that are sold by the lender on the secondary market. These loans are pooled, securitized and placed in a REMIC trust.
CMBS loans are common ways to finance hotels, office parks, shopping centers and apartment buildings.
Unlike a traditional balance sheet loan, shortly after the loan is funded the lender packages and sells the loan. The loan and many others are pooled together.
The pooled loans are divided into bonds which are segregated into different classes or “tranches.” The yield and payment priority vary by tranche. Typically, the bottom most tranche gets to name the loan’s special servicer since that tranche is the most at risk in the event of a default.
The loan is serviced in accordance with a Pooling and Servicing Agreement. How the loan is serviced becomes important later when we discuss common problems encountered by CMBS borrowers. But first, let’s look at why CMBS loans appear attractive to borrowers.
Advantages of CMBS Loans
Lenders like CMBS loans because the value of the assets in the pool is typically worth more than the sum of individual loans. Risk is spread across a pool of loans. Lenders find it easier to sell bonds covering a portfolio of loans rather than selling an individual loan.
We represent borrowers, never lenders. So what is the attraction for borrowers?
Lower Interest Rates. Because the risk is spread over many loans, banks have an easier time selling bonds that cover a pool of loans. Part of that savings can be transferred to the borrower meaning banks can charge lower interest.
Increased Availability of Capital. When a bank makes a traditional balance sheet loan, banking regulations require the bank to reserve against each loan made. In a CMBS financing, the bank sells the loan into a trust. With the exception of a 5 percent interest the lender must retain, the lender is free to reuse its capital to keep originating loans. (The 5% retention rule was part of the Dodd Frank reforms but didn’t take effect until late 2016.)
Higher Loan to Value Ratios (“LTV”). Typically, a traditional balance sheet lender can’t or won’t loan more than 70% of the value of the property. That means borrowers must fund the rest. None of these rules apply with CMBS loans meaning we typically see 80% LTV loans. We also many loans that are interest only, something most traditional lenders won’t do.
No Personal Guaranties. CMBS loans are typically non-recourse. You may lose all your equity on a project if it fails but unless there are bad boy provisions in the loan agreements, the borrower is not personally liable for any deficiency.
So what’s not to love? Ask any borrower who has ever been assigned to special servicing and you will likely get an earful. And that brings us to common problems in CMBS loans for borrowers.
Disadvantages of CMBS Loans
Before we talk about the disadvantages of CMS loans, lets first define two terms, “master servicer” and “special servicer.”
Earlier we discussed a Pooling and Servicing Agreement. This document is often 1000 pages and is rarely read by borrowers or their counsel. They do so at their peril.
The master servicer services the loan and is typically paid a fixed fee. Its duties are very limited. It collects money from the borrower, pays the bondholders in accordance with their stated priority, makes sure taxes are paid, makes sure the property is insured and reviews financials required from the borrower. The master servicer has no authority to waive or modify terms. The slightest variation or a request to modify terms throws the loan into special servicing.
The master servicer doesn’t even authority to make common sense modifications. We show discuss a real example below.
Unlike the master servicer, the special servicer has tremendous powers. They only get paid, however, when the loan is special servicing.
Let’s examine what that means.
In the typical balance sheet loan, the bank holds the paper. If you have a question or problem, you have someone to talk to. A CMBS trust, however, has no office, no employees, not even a phone number. It exists on paper only.
Despite our general distrust of banks, typically most banks don’t want to see a borrower fail. A distressed borrower directly impacts their profitability and reserve requirements. They may try to gouge a bit on forbearance fees and the like but at the end of the day, they have a vested interest to see borrowers succeed.
Not so with special servicers. In fact, it’s usually the opposite. The longer a loan is in special servicing, the more the special servicer makes. And many Pooling and Servicing Agreements allow the special servicer to bid on the property. (See the many links below.)
So the first disadvantage is that the borrower has no relationship with the lender in a CMBS loan. Once the loan is sold and pooled, the original lender is out of the picture.
The lack of relationship means it is impossible to obtain future advances. Let’s say that you are a borrower and have the ability to attract a major, A rated long term tenant. That tenant, however, wants certain tenant improvements. Even though that might be advantageous for all parties. Neither the servicers nor the trust has the ability to loan money.
Another disadvantage is that special servicers have an incentive to keep you in special servicing. Although they have a duty to the bondholders, the longer you stay in special servicing, the more money they make. The typical loan agreements allow them to charge all sorts of fees and charges. Once you are in special servicing it becomes very difficult to get out.
As noted above, special servicers often have the ability to acquire the property. Banks aren’t supposed to be in the real estate owned business. But there are no such prohibitions for servicers. If they are able to acquire the property, they may have even more incentive to make your life a living Hell. Perversely, the more valuable the property, the more incentive to try and acquire the property for their own portfolio.
It’s no surprise that the big special servicers – LNR Partners, CWCapital, C-III and Rialto - coincidentally all have their own real estate portfolios. And because they have access to all your financials, they know exactly what the property is worth and what your cash flow situation is like.
The loan documents and Pooling and Servicing Agreements often give special servicers the right to reassign payments as they see fit. That means once you get put in special servicing, even if you make all your payments timely, the special servicer can arbitrarily keep you in default with high fees or by reassigning payments into reserves instead of loan payments.
Let’s look at the master servicer. They are responsible for many of the CMBS problems suffered by borrowers. Typically, these folks are getting a flat fee and don’t want to do anything above and beyond what the loan documents say they must do. [The master servicer we most often encounter in CMBS loans is Wells Fargo.]
Many loans have complex reserve requirements. A common example is a work reserve in which a certain amount is set aside each month for capital improvements. As work is done, the borrower asks the master servicer to release some of the reserves. It sounds great on paper but servicers are notorious for screwing up reserve accounts and not releasing money when they should.
Another problematic reserve might be a seasonality reserve. Let’s say you financed a ski lodge and hotel in Colorado and used a CMBS loan to acquire the property. A seasonality reserve lets you skip a payment or two in certain out of season months. During the ski season, the reserve is replenished.
Again, these arrangements sound great on paper but often don’t work. Borrowers can’t get their own money bank. Unfortunately, it’s okay if the master servicer violates the loan agreement but a different story if the borrower is just a day later or dollar short.
In fact, the master servicer has no authority or incentive to make any deviation from the loan documents. Let’s look at a real example.
Borrower operates a hotel. The hotel is forced to close for a week when a nearby river floods and blocks access to the town. The nearby community is devastated but the hotel suffers no damages.
Under the terms of the loan, there is a default if occupancy fails to meet some preordained formula. Here the hotel was closed for a week but immediately after the flood, was filled to capacity for months and at top rates as area residents took up rooms while their homes were being rebuilt.
Any lender would be happy that the hotel was filled. The borrower never missed a payment. The subsequent months financials showed best ever performance. The borrower was shocked when the master servicer transferred the loan into special servicing.
Why? Because in the month of the flood, the hotel failed to maintain its required occupancy. That meant default interest, special servicing fees and ridiculous new reserve requirements. The master servicer has no discretion and the special servicer uses these events to maximize their profits.
Yet another problem with CMBS loans is the hefty prepayment penalty typical of CMBS loans. That makes it difficult for borrowers to get out. The prepayment makes it too costly to sell and the borrower isn’t happy about the inflexibility of loan. Making it worse, its usually quite difficult to have someone assume the loan either.
Assumptions are difficult because the loan documents often let the servicers trip a cash management clause upon assumption of the loan.
Lender Liability and CMBS Loans
We are a boutique litigation firm that sues banks, lenders and loan servicers. Despite the emphasis on litigation, we believe the best way to resolve a dispute is without courts and litigation. For that reason, we always try to help our CMBS borrowers avoid problems through workouts and refinancing. See our CMBS workout cornerstone page for details. That page also contains links to our many pages on such CMBS topics as Pre Negotiation Agreements (and why borrowers should be wary), springing guaranties and bad boy provisions, horror stories on specific special servicers (LNR Partners is our “favorite”) and a link to special page for first time CMBS borrowers.
Unfortunately, if you find yourself in special servicing, time is not on your side. The longer you stay in, the more default interest and other charges accrue. In other words, the longer you are in special servicing, the harder it is to climb out. In a few short months you could see all your equity washed away. It is possible to keep your property. Despite the lack of regulation for special servicers, they still have duties of good faith and fair dealing and can't act arbitrarily. But quick action is necessary.
If a workout isn’t possible or if you are already in foreclosure, we are ready to match the aggressiveness of special servicers. When playing nice doesn’t work, we are the team to call. Unlike most lender liability law firms, we are unique in that we do not represent banks or servicers.
Most lawyers follow the money which means representing banks and servicers. Not us. If you believe you have been victimized by a loan servicer or lender, contact us. All inquiries are protected by the attorney – client privilege and kept confidential. For more information write to attorneys Chris Katers at [hidden email] or the author of this post, attorney Brian Mahany ([hidden email]) or call us 877-858-8018.
Are you a lawyer? Much of our business comes from other lawyers. We are happy to partner on CMBS special servicer fraud and foreclosure cases.
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