The Top 4 Misconceptions of CMBS This Year

In my role as a borrower advocate, I get the opportunity to work directly with commercial real estate owners who have CMBS debt. These are the 4 most common misconceptions those borrowers have today (in 2018):

I don’t need to worry about cash management springing on my loan if my property is performing and my DSCR is well above the threshold in the loan agreement

The general premise of springing cash management is to allow the lender to capture all cash flow in the event of declining property performance. I think everyone agrees with that general statement and understands when they sign up for springing cash management that is the intent. As they say though; “the devil is in the details!”

Typical current CMBS loan agreements include many definitions within definitions which the servicer uses to calculate DSCR and the servicer’s calculation is “final absent a manifest error”. Those words are actually in most loan agreements. The definitions are very important as they state what should be included in the income component of the DSCR calculation as well as the expense component. For interest only loans, the debt service used in the DSCR calculation often assumes the loan is a 30-year amortizing loan; making the payments much higher than the actual interest only payment.

An example of some of the income that is excluded in the income definition in the typical CMBS loan agreement are:

• Fully paying tenants which are dark
• Rental income after a tenant gives notice of non-renewal
• Short term leases, such as seasonal leases

The bottom line is that there are many well performing properties today with ACTUAL DSCR of 1.5 and above are being put into cash management. That is because the servicer is performing its own calculation based on the specific details in the loan agreement and are excluding certain income line items, adding other expense items and using an amortizing payment (even for interest only loans). The servicer’s DSCR is often much lower than the actual and again ~ is final, absent a manifest error!

So, just because YOUR calculation of DSCR is above the threshold for springing cash management in the loan documents, doesn’t mean the servicer’s calculation won’t be below the threshold and cash management will be sprung!

I don’t need to worry about cash management because my property is out-performing the market with higher occupancy and/or higher rental rates.

Included in the details of the servicer’s DSCR calculations, there is a term called “Underwritten Operating Income”. This definition allows the servicer to adjust rental rates, occupancy rates, and other items to the lower of (a) actual, (b) market, or (c) underwritten rates. So, in the instance where you have negotiated better than market rental rates and/or have better than market occupancy, you will not get the credit for that when calculating your DSCR as it relates to cash management.

Where this really stings is when the underwritten occupancy at origination of the loan was 80% and current occupancy is now at 90%. With this definition of; “the lower of (a) actual, (b) market, or (c) underwritten rates”, in your loan agreement, your income will always be calculated assuming 80% occupancy, that is; unless the market occupancy is below that, regardless of your actual occupancy of 90%.

So, again, just because YOUR calculation of DSCR is above the threshold for springing cash management in the loan documents, doesn’t mean the servicer’s calculation of DSCR won’t be below the threshold and your cash management will be sprung! Your income will be adjusted downward to the lowest possible allowable number in the loan documents.

When a buyer assumes an existing CMBS loan, the terms of the loan will not change

Most buyers entering into an assumption of an existing loan, believe they will be assuming the terms of the loan as written in the loan documents. That is sort of the case, but not entirely. This one issue causes many lawsuits between buyers and sellers when the conditions for approval contain what the buyer believes are deal “changes”.

There are deal terms that cannot change, like interest rate and maturity date (without a modification anyway).

What is wide open to change, however, is:

Reserves. Servicers can add reserve requirements that aren’t in the loan documents today 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. Sometimes the additional collateral is in the form of a reserve, sometimes it is a letter of credit and sometimes it is in the form of a guarantee. The point is, the servicer can ask for additional collateral for any number of reasons (or no perceived reason at all).

Cash management. If the loan has springing cash management, you can bet that it will be sprung at the time of assumption, regardless of the property performance. Now, don’t be fooled into thinking the buyer can request changes to the loan documents at the time of assumption. The servicer will not entertain changes requested by the borrower. So, when buying a property with existing CMBS debt, be prepared for higher reserves, cash management and other conditions. And don’t expect to be able to change the loan documents.

If I am assuming an existing CMBS loan, the purchase price of the property doesn’t really matter since the loan is already in place

That used to be the case! In many presentations I did in the industry in 2009 – 2014, I often said that “LTV” at the time of assumption didn’t matter. Well, times have changed! Some special servicers are requiring a buyer to establish a reserve at the time of assumption equal to the amount required to make the LTV equal to what it was at origination of the loan. This is best understood by giving an example:

Say the property was appraised at origination for $25MM and the borrower got a 65% LTV loan at that time. The loan would equal $16.25MM. Fast forward a few years and the property is being bought for $22MM, and let’s assume the loan is interest only, so the total due was still $16.25MM. A 65% LTV loan on a property value of $22MM would equal $14.3MM. Since the current loan is $16.25MM, the difference between $16.25MM and $14.3MM ($1.95MM) would be required in the form of a collateral reserve at closing of the assumption. The $1.95MM cannot be used to actually pay the loan down because CMBS loans have prohibitions and/or penalties for paydowns (if they are allowed at all). So, the $1.95MM sits in a collateral reserve and cannot be used by the buyer for the life of the loan. This one item impacts buyers IRR so severely that many buyers back out of deals when they learn of this requirement.

What does all this mean?

1. Don’t sign new CMBS loan documents without a thorough understanding of the business side of the specific terms, definitions, and servicer process
2. Don’t believe your cash management will not be sprung based on your own DSCR calculations! The servicers’ calculation is final absent a manifest error
3. Be prepared for additional cash requirements when assuming an existing CMBS loan, including the possibility of an LTV reserve
4. Most of all, know what is in your loan documents!

1st Service Solutions is the official full service CMBS advisory firm with a singular focus on owners/borrowers. Founded in 2005 by industry leader, Ann Hambly, the firm is also the 1st borrower advocate firm ranked by Morningstar Credit Ratings.