First of all, there are three main types of cash management arrangements:

1. Soft lockbox |
   • Tenants pay into account controlled by lender
   • All cash is immediately moved (swept) to a cash management account until there is enough for debt service
   • Debt service is paid
   • All remaining funds are sent to borrower

1. Hard lockbox |
   • Tenants pay into account controlled by lender
   • All cash is immediately moved (swept) to a cash management account until there is enough for debt service
   • Debt service is paid
   • Based on a pre-approved budget, monthly operating expenses are paid
   • Any remaining funds are typically put into reserve account

2. Springing Lockbox |
   • No lender controlled account is set up but framework is established
   • Trigger
   • Tenants pay borrower directly until/unless trigger event (defined in loan documents)
   • Once trigger event occurs, it will function like a Hard Lockbox

If you have a soft or a hard lockbox, you are likely aware of how it works after you close the loan and nothing will change during the life of the loan.

Springing Cash Management Triggers

If you have a springing lockbox, you probably know generally how it works and you agreed to the triggers in your loan agreement. What you may not be aware of until it is too late is how the triggers are calculated. The two main types of triggers are (a) loss of a specific or major tenant, and most commonly, (b) debt service coverage ratio (“DSCR”). Fair enough, right? As they say though, the devil is in the details. Let's take a look at some of the common language in the loan documents for how the DSCR is calculated.

Under the definition of DSCR, you will likely find the words “as determined by Lender” and the calculation is then based on another definition called “Underwritten Net Cash Flow”. Under the Underwritten Net Cash Flow definition, you will see some or all of the following points:

• Income is based on in-place base rents based on “bona-fide” leases open for business and paying full rent. This means that you will not get credit for leases which are (a) dark but paying, (b) tenants paying with temporary concessions, and (c) those that are not “bona-fide” (which is not defined and left up to servicer discretion).
• Operating expenses are adjusted to market If your property is performing above the market, you will be adjusted down to the market. You will not get credit for performing above the market.
• There are even instances where the vacancy is adjusted to the lower of: (a) market, (b) underwritten, or (c) actual. So, for a property that was say 80% occupied at underwriting but is now 90% occupied, the DSCR test will always include occupancy at 80%.
• Operating expenses can be further adjusted at the servicer's discretion based on other variables.

Keep in mind also that the master servicer who will be doing these calculation throughout the life of your loan, is tasked with ensuring the loan is compliant at all times with the terms of the loan documents. The master servicer will NOT be able to use “common sense” or “intent” to make the calculation. They must adhere to the specific calculations described in the loan documents.

Many CMBS borrowers are finding this out the hard way and it is very painful.

Waterfall

Once a loan is cash managed, the “waterfall” becomes vitally important as this will dictate the order in which funds received are applied. The most common order of payments for a waterfall are: (a) taxes and insurance, (b) debt service payment, (c) lender held reserve payments, (d) any other amounts due to lender (late fees, default interest, etc.), (e) operating expenses (per an approved budget), (e) extraordinary expenses approved by lender, and finally (f) to borrower; or in instances where cash is swept and held by lender, the excess funds will be maintained in a reserve account per the loan documents.

In situations where the DSCR is low, there is often not enough money to pay the entire waterfall and often the shortage happens at the operating expenses. There may be enough to pay the tax and insurance reserve and the debt service payment but no more. In that instance, the servicer will look to the sponsor to come out of pocket to fund the shortfall.

This is where it gets very painful! Especially in instances where the property IS performing but the servicer calculation of the DSCR is what caused the loan to go into cash management.

Let me explain a few case studies of actual deals. Names have been left out to protect the innocent.

Case Study

A large commercial property owner got a new CMBS loan to pay off his construction loan after construction. At the closing of the loan, the property was 70% physically occupied with 2 more tenants taking occupancy shortly after closing. After these additional tenants took occupancy, the property had a DSCR greater than 1.7. The borrower had a springing lockbox, which took effect if/when the property DSCR dropped below 1.2.

The borrower submitted his first quarterly financial reports and was shocked to hear from his servicer that their calculation of his DSCR was 1.15 and that he would now need to be cash managed. The definition of Underwritten Net Cash Flow in this borrower's loan agreement contained a vacancy adjustment based on the lower of: (a) market, (b) underwritten, or (c) actual. See the problem?

The worst part about this is that there would never be a way for this borrower to get out of cash management, as the underwritten occupancy was 70%, which meant the DSCR would be below 1.2 in almost all cases.

In another instance, the property was performing well, but the servicer calculation of DSCR included an adjustment for market vacancy (even though the property was almost fully occupied), and rent from a tenant was not included in the income because the tenant had received a small rental concession. So, even though the property had an actual DSCR of 1.35, the servicer calculation triggered cash management.

The even bigger issue becomes how to get out of cash management.

How do you get out of the trap?

For springing cash management, the loan documents will contain provisions to cure. Typically, the cure is one or two quarters of a DSCR greater than the amount that caused the trigger to begin with. The problem though is the calculation for this cure is based on the servicer's calculation. So, when the DSCR was triggered because of servicer adjustments for market vacancy or underwritten vacancy, it is easy to see that getting out of cash management is not nearly as easy as getting in! It feels like a lobster trap!

So, what do you do if you are a CMBS borrower and you have springing cash management in your loan documents?

There is unfortunately not much you can do other than to read the documents very clearly and understand that the calculation will be performed literally according to the words. Your mouse trap is already set, so just be careful not to step on it!

Cautionary tale

The main message here is for borrowers getting a new CMBS loan. Be sure to read the DSCR definition and also the Underwritten Net Cash Flow definition very carefully and know that the words will be applied very literally throughout the life of your loan. The intent of the loan documents and your originator's commitment will likely not help you later when the master servicer performs the calculation.

This I know for sure (to quote Oprah Winfrey)!

Ann Hambly is founder, president and CEO of 1st Service Solutions, based in Grapevine, TX. The views expressed here are the author's own.