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Subject Property – A new suburban office building containing approximately 50,000 rentable square feet. During the construction process, the lender invoked the “no material adverse change” clause to require that the owner provide additional cash collateral of $750,000 based on deterioration in the leasing market. Immediately after completion of the project, two tenants failed and repudiated their leases. The construction loan has matured and the project does not meet the criteria for converting to a permanent loan and the cash flow from the property is not sufficient to pay the operating costs and pay the debt service. The owner has been paying the deficiency each month. 25% of the space in the building remains vacant because the lender has not approved any of the proposed leases for the space because the rents were lower than the lender’s minimum requirement and the TI costs were over the original budget.
Original Capital Stack:
Construction/Perm Loan - $8.2M, 6% per annum (interest only during both construction and permanent phases), secured by first lien deed of trust that closed in early 2008, and was to be converted to a 5 year permanent loan upon completion of construction with maturity in late 2014 (5-year term). A junior lender participant in the loan has been taken over by the FDIC.
Mezzanine Loan - $750,000 from the original equity investor to provide the additional cash collateral
Owner – SPE, with two members, the original developer and an investor who provided the 20% original equity in the project and the mezzanine loan and has been paying the operating shortfall each month (excluding the management fee to Developer).
Regulatory Constraints. Primary Lender is operating under various agreements with the state and federal regulators and the Junior Lender has been taken over and its assets sold to another bank (New Junior Lender).
Position of the Parties:
Equity Investor wants the cash collateral to be released to pay the operating shortfall each month. Equity Investor refuses to put any new cash into the project.
Developer has no cash to put into the project and wants the cash collateral to be applied to the shortfall including its management fee.
Primary Lender wants to convert the loan to permanent status and apply the cash collateral to pay the shortfall.
New Junior lender has a loss sharing agreement with the FDIC and is worried that any extension of the loan term (and conversion to permanent status) could be seen as violating the provision in the loss sharing agreement requiring it to use best efforts to recover the value of the loan. New Junior Lender will not approve a conversion to permanent status or an extension of the loan.
First Mortgage Workout/Modification:
The parties entered into a Forbearance Agreement whereby the loan is not officially extended but the lenders forbear to exercise their remedies for 24 months if the terms of the agreement are met. The Agreement allows the cash collateral to be applied to pay the operating shortfall, including the management fee.
Why Did This Work:
Neither Lender wanted to foreclose and take back this project. New Junior Lender had leverage due to the fact that the participation agreement did not allow loan modification without Junior Lender’s approval.
Both Owner and Lenders felt that the rental market would recover in the short term and they would be better off waiting to relet until the rents were higher, thereby avoiding locking in the lower rents and the resulting reduction in the value of the project.
The additional cash collateral had been posted earlier, at a time when the equity investor still had resources available.
Lenders and Equity Investor felt that Developer had valuable connections in the leasing market and was important to retaining existing tenants and attracting new tenants.
Restructured CMBS Loan Example
Subject Property – A 25-year-old urban office building containing approximately 350,000 net rentable square feet (very good location; B+ condition). Over 90% occupancy, but lease of largest tenant (“Key Tenant”) occupying approximately 150,000 square feet is expiring in late 2009; Key Tenant will remain at attractive rents only if:
Building is retrofitted to achieve a minimum of LEED gold, and
A substantial tenant improvement upgrade and building common area renovation is completed. Cost of retrofit, tenant improvement upgrade and common area renovation is approximately $12M (“New Money”). If Key Tenant vacates, replacement tenants will be at substantially lower rents, and Owner in any event would have substantial tenant improvement and leasing costs.
Without Key Tenant, value of building less than outstanding balance of First Mortgage.
Original Capital Stack:
First Mortgage - $65M, interest only at 5.6% per annum, secured by first lien fee deed of trust that closed in late 2005, and transferred to securitization trust in early 2006. Maturity date in late 2010 (5-year term).
Owner – Two member SPE, with sole members being a semi-institutional fund with $10M in cash invested in connection with acquisition of building and assumption of First Mortgage in mid-2007 and other member a local sponsor/developer.
Securitization Structural Constraints
Authority and Approval of Special Servicer and Controlling Holder under Pooling and Servicing Agreement
Position of the Parties:
Owner - Owner unwilling to fund any New Money fully subordinate to First Mortgage, because (a) after repayment of First Mortgage, unlikely to receive any return of New Money, and (b) as a policy matter not willing to fund New Money into highly leveraged “legacy assets” with short First Mortgage maturity dates. Owner willing to fund New Money only if (a) reasonably certain New Money will be recovered with appropriate return and (b) maturity date of First Mortgage extended to permit “market recovery.”
Special Servicer - Special Servicer unwilling/unable under Pooling and Servicing Agreement to fund any New Money. Special Servicer owns “B piece” of CMBS certificates and does not wish to force immediate liquidation and resulting loss on “B piece” holder but must take into account interest of senior certificateholders
New Capital Stack in First Mortgage Modification:
Term of First Mortgage extended by three years (from late 2010 to late 2013) to allow market recovery for a sale of building or refinance of First Mortgage.
Waterfall established in mortgage modification for distribution of sale proceeds or payoff of First Mortgage; purpose of waterfall was to establish an elevated priority for return of and return on New Money. If Owner sells the building to any unaffiliated third party at or prior to extended maturity date, then net proceeds (less customary closing costs) distributed as follows:
First, pay discounted payoff amount of First Mortgage which was set at $50M ($15M less than existing principal balance);
Then, pay Special Servicer Workout Fee (1% of (a) above);
Then, pay New Money and Return on New Money;
Then, any remaining proceeds split 65% to Lender and 35% to Owner until Lender receives the remainder of original First Mortgage balance; and
The balance, if any, to Owner.
If First Mortgage is refinanced and Owner retains building, then net sales proceeds for purposes of above waterfall is determined by fair market value appraisal.
Note that neither principal balance nor monthly payment of First Mortgage was reduced at time of First Mortgage modification; discounted payoff of First Mortgage can only occur in connection with sale or refinance of First Mortgage.
Why Did This Work:
Owner was perceived by Special Servicer as (a) trustworthy, (b) reasonably competent and (c) knowledgeable about local market. Owner willing to invest additional capital with certain conditions.
Special Servicer had some knowledge of local market conditions and was also controlling holder under Pooling and Servicing Agreement (Special Servicer was able to move quickly). Special Servicer as “B piece” holder wished to let/hope market would substantially recover.
Owner willing to bet market would substantially recover and it would at least recover New Money and a small portion of old money; in addition keeps property management affiliate busy. If you weren’t an optimist, you wouldn’t be in Owner’s business.