Since 2003, roughly $110 billion of lodging mortgage debt has been originated and securitized into Real Estate Mortgage Investment Conduits (REMICs) in the United States, collateralized by slightly over 18,000 lodging properties. To put this number into greater context, there are by several estimates roughly 51,000 hotels in the entire U.S. hotel market. So, the notion of financing hotels with a “conduit or REMIC mortgage” was by most measures successful, given the apparently large number of hotels financed with this method. This type of financing offered a ready source of senior mortgage debt, often at attractive pricing and terms. And the cycle continued until late 2007/early 2008 when the music stopped rather abruptly because of the rapid deterioration of the credit markets. Then, with the failure of Bear Stearns and more dramatically Lehman Brothers, the game was really at an end. However, even when the securitization era was in full swing (circa 2005 to 2007), borrowers would often complain about what appeared to be overkill in documentation at closing, including the necessity of placing the hotel asset in a Special Purpose Entity and other seemingly arcane and annoying requirements such as the need for a separate director, who was not supposed to be affiliated with the real ownership entity. And the biggest complaint often was that there was apparently no real lender to talk to in the event that a question or difficulty arose in connection with the loan.
It is obvious that this financing market has clearly become sour, if not alarmingly depressed. At present, there are estimated to be roughly $66 billion to $70 billion of hotel mortgage debt still held in the universe of REMIC trusts. This difference in dollar amounts is based on how the measurement is calculated, i.e., whether foreclosed/REO hotels are included in the calculation. The staggering news is that of the roughly $66 billion in currently outstanding hotel mortgage debt, over $17 billion (roughly 26%) is now in Special Servicing, and of that amount, nearly $13 billion (almost 20% of the $66 billion!) is listed as +60 days delinquent in debt service payments. These numbers far exceed the most dire predictions made as recently as this time last year. To further put these numbers into context, in “normal” times, the rate of default as measured by the level of hotel mortgage loans in Special Servicing varies from ½% to 1%. If a borrower’s property is in Special Servicing, or soon to enter into Special Servicing, or if there is a likelihood that debt service payments will soon be missed (which makes imminent transfer to Special Servicing almost a sure thing), what’s a borrower to do? Well, it’s a little tedious; but for starters, the borrower should become rapidly familiar with the variety of parties that now somewhat collectively constitute the makeup of the “lender,” and how to interact with them. The following is a very brief overview of the various parties.
Loan Originator – This was the institution with which the borrower had initial contact when the loan was first granted. It was usually a large, well-known investment bank. Officials within the institution did the initial loan underwriting, submitted a loan term sheet, and ultimately closed the loan. However, in most cases, very soon after the loan was closed, the loan was “securitized” by the Loan Originator (at which point the Loan Originator essentially exited the deal), placing the loan into a REMIC pool, and pass-through certificates – generally referred to in the market as “bonds” – were sold to a variety of investors. Although these “bonds” were structured to perform, in most cases, as fixed-income securities, generally, they technically are a fractional ownership of the CMBS trust and accordingly are in the underlying assets. At the time of securitization, certain key documents were generated. Notable are the Pooling and Servicing Agreement (PSA) and the Intercreditor Agreement/Participation Agreement. These documents are, collectively, the governing documents in the administration of the loans and are designed to govern the lenders’ actions in case of a loan workout; however, the borrowers are not a party to these agreements, and most borrowers never see a copy of them.
Trustee – This entity doesn’t play an obvious role in sub-performing/non-performing debt issues. Essentially, the Trustee is the nominal owner of all the assets in a CMBS trust, whose primary responsibility is to hold the assets in trust for CMBS investors. Borrowers won’t generally hear from the Trustee; via power of attorney, the Trustee delegates the day-to-day administration of the loans to the Master Servicer or the Special Servicer, although in the event of a foreclosure, such action is taken in the name of the Trustee, and after title passes, it is held in the name of the Trustee.
Servicers – As was described above, although individual mortgage loans in CMBS pools are routinely tranched into varying classes of interests, which in turn are held by multiple investors, they still represent interests in single loans secured by individual properties (or in some cases, pools of properties). It then follows that various investors do not have their own Special Servicers for their portion of a mortgage loan. Common sense would have it that there can only be a single Master Servicer and a Special Servicer for any single mortgage loan. Mayhem would result if there were multiple servicers with potentially conflicting servicing strategies on a single loan (or collateral package). It is important to note that during negotiations, servicers are required to adhere to a “servicing standard,” which requires that they service each mortgage loan in a manner that benefits all investors/lenders (in the REMIC) in a fashion that benefits all classes, collectively, with a view toward maximization of proceeds on a net present value basis (more on this in a later article).
- Master Servicer – This is the entity with which most borrowers have contact. A Master Servicer is responsible for servicing performing mortgage loans, i.e., collecting payments, handling routine (minor) borrower requests, and performing a general review of borrower compliance with the terms of the loan. This entity also prepares periodic reports concerning the property for use by the Trustee. Any request by a borrower for a significant modification of the loan while it is still being serviced by the Master Servicer generally will be pointless. Only when a loan has been transferred to the Special Servicer will the borrower be able to meaningfully negotiate for some relief in the form of a modification or restructuring.
In addition, the Master Servicer is required to fund (from its own cash), any delinquent payments on the underlying loans so that the CMBS holders do not experience shortfalls as a result of borrower delinquencies. The Master Servicer also funds such items as may be necessary to protect the collateral position, such as delinquent taxes or overdue insurance premiums, as well as any other costs associated with servicing or enforcing the loans. This is true even for loans that have been transferred to Special Servicing. In return, the Master Servicer receives a “super-superior” right to be reimbursed for these advances. Advances are repaid as a priority from the first funds realized on a defaulted loan and if, for any reason, the advance is not recoverable from the proceeds of the loan on which the advance was made, the Master Servicer may reimburse itself from the proceeds of other loans in the CMBS pool. These advances are not intended as a form of credit support; Master Servicer advances are intended as liquidity for the CMBS.
- Special Servicer – Upon certain uncured monetary defaults (such as +60-day delinquency in debt service) or other circumstances, including failure in certain non-monetary default covenants that could affect the CMBS, the Master Servicer can refer the loan file to the Special Servicer, known as a “servicing transfer event.” Special Servicers have significantly greater powers to consider restructuring of the debt. Prior to late 2009, Special Servicers generally did not permit loan modifications unless there was an actual default on the loan (some borrowers actually defaulted on their loans in order to initiate a dialogue with the servicers – generally a bad move). However, certain changes made to the rules governing REMICs in September 2009 now allow for some loan modifications when default is either imminent or anticipated sometime in the future. Specifically, the 2009 changes referred to two items: the “Principally Secured Test” and the “Imminent Default Test.
In the Principally Secured Test (TD 9463), the REMIC rules were modified to permit changes to collateral and credit enhancement relating to a mortgage loan (even a performing mortgage loan) so long as the mortgage loan remains “principally secured” by real property after the modification. Principally secured means either (1) that the mortgage loan has a loan-to-value ratio (taking into account only the real property collateral) of 125% or less or (2) for mortgage loans with loan-to value ratios above 125%, that there is no reduction in the fair market value of the real property after the modification. The Principally Secured Test applies to all releases, including those contemplated by the parties when a loan was closed, and releases on loans in default or for which default is reasonably foreseeable. This latter requirement may present difficulty to servicers who are often obligated under mortgage loans originated prior to these REMIC rule changes to release property if the borrower meets certain specified conditions under the mortgage loan without regard to whether the Principally Secured Test is satisfied. The securitization industry has requested the IRS to modify these rules to prevent difficulties for servicers and potential liability for securitization trusts.
In the Imminent Default Test, (Rev Proc 2009-45) has been interpreted: the “IRS will not challenge the tax status of a REMIC due to the REMIC’s modification of a commercial mortgage loan that is currently a performing mortgage loan but where, in the view of the commercial mortgage loan servicer, a significant risk of default exists, even if the default is expected to occur only at some distant future date.”
Finally, any brief overview of CMBS and their workouts would not be complete without mentioning the Controlling Class. The most subordinate tranche of CMBS holders within a REMIC constitute the controlling class of CMBS holders. This tranche is “controlling” because it is in a first-loss position and will suffer the most immediate loss if the value of a loan deteriorates. In other words, most CMBS structures will designate one investor as the “controlling holder” of a mortgage loan, with rights to influence the servicing of the loan, as further described below. The controlling holder is generally the holder of the most junior tranche of the mortgage debt that is still “in the money,” as determined with reference to an appraisal. The concept of giving servicing control to the most junior investor is distinctive to CMBS. In virtually all other forms of commercial lending, the most senior lender has control in a default situation, and subordinated debt is left to fend for itself. However, in CMBS, the so-called “B-piece” investor is sometimes affiliated with the Special Servicer, and having the first-loss risk at stake in the event of default is therefore thought to make this class the most motivated; moreover, because of the provisions in the PSA, this class has the most tools at its disposal and is best positioned to achieve a favorable result in a default scenario.
However, a controlling class may lose its controlling status if the value of the pool of securitized loans declines below a minimum value. If this occurs, the next most subordinate tranche of CMBS holders will become the controlling class. Servicing control can shift from the most junior investor upward in the capital stack as a result of an appraisal. A “control appraisal event” will occur if, following application of “appraisal reductions” from the bottom tranche of the mortgage loan upward through the capital stack, the current controlling holder is not deemed secured in an amount at least equal to 25% of its portion of the loan balance. Appraisal reductions are calculated, generically, by comparing 90% of the appraised value of the property, on the one hand, to all amounts owed on the related loan and all expenses to be reimbursed from the loan or the collateral, on the other. If 90% of the value is insufficient to pay all such amounts, then the negative difference is called an “appraisal reduction amount.”
As mentioned above, one right of the controlling class is the ability to terminate and replace the Special Servicer with a new Special Servicer. Another right is the power to approve or disapprove certain actions taken by the Special Servicer. For example, unless it has obtained the consent of the controlling class, the Special Servicer may not commence a foreclosure, accept a discounted loan payoff, or modify the monetary terms of a loan. However, there is an exemption to the requirement that the Special Servicer obtain the consent of the controlling class to these actions. The Special Servicer can take any action, without the advice and consent of the controlling class, if taking such action is required to comply with the “servicing standard.” We will outline the servicing standard more fully in a later article, but it requires the Special Servicer to act in the best interests of all CMBS holders, not just in the best interests of the controlling class. The Special Servicer may employ the servicing standard as a shield to disregard any direction from the controlling class that the Special Servicer believes to be solely in the best interests of the controlling class and thus in violation of the servicing standard. The terms of the servicing standard are set forth in the PSA, which as mentioned above, acts as the governing document for the rights, duties, and limitations of the trustee, servicers, and CMBS holders. The servicing standard requires the Master Servicer and Special Servicer to act in the best interests of all CMBS holders.
In a later article, we will examine the specific steps in a typical CMBS workout (presuming there are any “typical” workouts!). For now, suffice it to say that on that day several years ago, when the hotel owner signed loan documents for a new hotel mortgage with a CMBS lender, it is unlikely that the borrower had any real idea of the complex, sometimes arcane, world of lending that would ultimately envelop that loan. However, with some understanding of who the parties are on the lenders’ side of the table, what challenges they face, and the rules governing their actions, plus a lot of patience, usually a satisfactory resolution to a hotel workout can be achieved.