CRE Debt

Wally Boudry, Spring 2014

Admin I’m going to post a bunch of readings up on

Blackboard for this topic They cover a lot of the issues we will go over

in this topic (A/B notes, mezz debt etc.) They aren’t necessarily easy reading, but they

got a student a job at Blackstone last year so they aren’t exactly pointless either…

Warning I’m going to use a lot of industry jargon in

this lecture This is the language of commercial real estate

debt, so you really need to learn it Many terms can have multiple meanings

depending on the context If you get confused, ask me to clarify what I mean

What is it all about? Assumption: You all know basic mortgage

math If you don’t, see Brueggeman and Fisher

We are going to cover 3 topics 1. The who and what of CRE Debt

This is just who lends and what kind of loans do they give

2. Distress, structuring, modifications etc. How capital stacks are put together How they come apart Where the economics come from

3. Calculations Defeasance, yield maintenance, incremental

borrowing costs, day count conventions

Q1 2012 & Q1 2011

Commercial v MF: Q3 2011

Commercial RE Multifamily

Banks $1,144.3 B Life Companies

$260.6 B CMBS $512.4 B Fed Agencies $66.3

B Other $265.4 B Total: $2249 B

Banks $189.8 B Life Companies $49

B CMBS $94.1 B Agency CMBS $81.1

B GSEs $256.4 B Other $170.5 B Total $840.9 B

There is $3.1 T of secured commercial real estate debt out there…

Source: Flow of Funds Q3 2011 http://www.federalreserve.gov/releases/z1/Current/z1r-4.pdf

Commercial v MF: Q3 2013

Commercial RE Multifamily

Banks $1,222 B Life Companies

$280.9 B CMBS $487.4 B Fed Agencies $71.6

B Other $170.7 B Total: $2232.6 B

Banks $272.3 B Life Companies

$52.3 B CMBS $75.2 B Agency CMBS

$138.8 B GSEs $251.8 B Other $117.7 B Total $908.1 B

There is $3.1 T of secured commercial real estate debt out there…

Source: Flow of Funds Q3 2013 http://www.federalreserve.gov/releases/z1/Current/z1r-4.pdf

We talk a lot about CMBS maturities, but the banks have more in the short term…the main question we face is who will fill this funding void?

Rates

So rates are mid 4-5

1998 1999 1999 1999 2000 2000 2001 2001 2001 2002 2002 2003 2003 2004 2004 2004 2005 2005 2006 2006 2006 2007 200750

100

150

200

250

300

350 SATO (Spread-at-Origination) by Property Type

CTL Health Care Hotel Industrial Manufactured Housing Multifamily Office Other

Retail Self Storage

CTL = credit tenant lease

Hotel is always the most expensive…

Banks Banks tend to do

Shorter term (max out towards 5 years although this is getting longer)

Floating rate debt (You can get a fixed rate loan, but it is usually a floater swapped to fixed)

At moderate LTVs (smaller banks tend to be much more aggressive than larger banks)

Recourse and non-recourse Most locations, subject to market fundamentals

Nationals tend to be more primary market based, while regionals/locals are secondary/tertiary

Banks Loan size is determined by bank size

Large banks could take ~100m loan or syndicate an even larger loan (typical loan is in the 15-35m range – this gets rid of the “crazy small guys”)

Smaller/regional banks max out around 10-15m due to diversification issues.

Small banks are loaded up on CRE loans relative to large banks

CMBS (Conduit loans) CMBS loans tend to be

Fixed rate (although there is a large loan stabilized floaters market)

Longer term (10 years is the norm; very little < 5 years)

Non-recourse Max leverage (usually the highest LTV you can

get is in the CMBS market) Most locations, subject to CRA underwriting

(CRA= credit ratings agency) Loan sizes vary greatly

Ability to take down huge (>$1b) loans using pari passu structures or stand alone deals

Most loans are much smaller

Life Companies Life company loans

ARE VERY CONSERVATIVE They are the top of the lending pyramid

Best assets, in the best markets, conservatively underwritten (60-65% LTV max; typically lower.)

If you meet their filter they will pretty much give you the best prices available.

They typically look to lend to stand alone “A-rated” or above loans The average CMBS loan is junk rated

Agency The GSEs have multifamily lending

businesses Just as they support the resi-market they

subsidize the MF market This is why MF has the lowest borrowing rates

They have their own unique underwriting criteria, which is why you will see agency underwriting specialists

As Fannie and Freddie are wound down, MF lending rates should rise Although the Fannie and Freddie MF portfolios

have been rock solid through the crisis, so they could be easily spun off into a private entity

“Specialty” Lenders There are a set of lenders who will lend

across the stack, but typically they look to fill a high yield hole in the stack Think of them lending in places that a bank might

not want to go due to leverage or coverage issues e.g. Mesa West, Ladder Capital Leverage: usually higher LTV than the banks

want Coverage: usually a transitional asset (think

lease up story) Usually this will be short term floating rate

money. They don’t really have many restriction about

what they will lend on apart from being able to get comfortable with the loan.

Mortgage Basics In real estate the term “mortgage” is used very broadly

even though it has a very specific meaning in law The standard set up of a “mortgage” is as follows:

Promissory Note: this is the note that promises that you will pay the lender back and sets the terms for the payments. This is where you get your liability.

Mortgage Document: this specifies the collateral (in this case real estate) that secures the promissory note.

There are also Deeds of Trust in some states Promissory note: as above Deed of Trust: the title for the property is transferred to a

trustee. If the promissory note is breached the trustee then has “power of sale” rights and can sell the property to pay the lender (who is the beneficiary of the trust). This is a lot faster than a judicial foreclosure.

In the end we use the term “mortgage” to mean all of the above

Notice that a Deed of Trust is easier/faster to foreclose on because you don’t have to do a judicial sale…

Some terminology I’m going to assume you know mortgage

math You can crank out an amortization schedule or at

least a basic amortization schedule There may be some mortgage terms you

haven’t seen Lock boxes ARD loans Recourse and bad boy carveouts

Some terminology you may not have seen… “Hard” and “Springing” Lock Boxes are a

typical feature of CRE loans In a hard lock box, the revenue from the asset

goes into the lock box and once all property “expenses” have been paid, the equity gets the residual cash flow Debt can be paid before operating expenses

In a springing lock box, the lock box goes into effect only when a trigger occurs (like a drop below a threshold DSCR or when coming close to maturity)

Notice that the “expenses” can include capital reserves for TIs/LCs, capital improvements etc. So equity might not be getting cash flow unless

all the reserve accounts are full – this is very lender friendly.

Some terminology you may not have seen… ARD – anticipated repayment date

When amortization term > loan term, the loan will have a balloon payment

Some loans have a maturity date – the date this balloon payment is required to be made

Some loans have an anticipated repayment date – the date this balloon payment is anticipated to be made

For a loan with a maturity, missing the balloon payment makes you in default You can start foreclosure proceeding etc.

For an ARD loan, missing the balloon payment does not mean you are in default A full cash flow sweep will be put on the property and

any excess cash flow used to pay down principal The interest rate will reset to an above market level (to

give the borrower an incentive to refinance.)

Recourse CRE loans (typically apart from construction

loans) are non-recourse Most residential loans are recourse with some state

exemptions Most CRE loans are going to be non-recourse and

set up in special purpose entities (SPEs) The goal is to have the property be a stand alone legal

entity “Jingle mail” is always an option (I heard a story of a

borrower quite literally mailing the keys in an envelope to the lender)

More conservative lenders may want recourse to a “warm body” A warm body is an actual human; a cold body is a

guarantee given by a corporate entity which may or may not be a shell.

Recourse is a touchy area A lot of borrowers have a “no recourse” policy

Recourse and Incentives Notice that recourse has seriously large

effects on incentives If I know I’m personally liable for losses, my

incentives look different from if all that is at stake is my equity (especially if that equity is small)

Notice you don’t need full recourse, just an amount that is economically significant to the borrower

CRE loans are typically non-recourse, simply because we want the down state of the world to be as simple as possible A borrower is much less likely to fight a lender if

their personal assets aren’t up for grabs However, lenders don’t want borrowers

messing around simply because recourse is off the table This led to what are known as “bad boy”

carveouts

Non-recourse carveout guaranty: Bad Boy Carveouts As the name suggests, these are triggered by

“bad” acts Voluntary bankruptcy, collusive involuntary

bankruptcy, fraud, violations of SPE covenants, illegal transfers

What defines a “bad” act?? They trigger two kinds of penalties

“Above the line” – you can sue for damages “Below the line” – the loan becomes full recourse

(you can get back a deficiency) or a fixed penalty is payable This is a BIG hammer because typically you can get a

summary judgment (you don’t need to prove anything the judge just says “pay the money”)

The below the line stuff tends to be big things like involuntary bankruptcy, fraud etc.

Be very careful what you sign… Courts have been very strict in interpreting

carveouts Princeton Park Corporate Center v SB Rental

Typical non-recourse SPE loan The borrower signed a carveout agreeing not to place

any subordinate debt on the property In 2004 the borrower took out a second mortgage and

repaid it in 7 months In 2006 the loan went into default and the lender sued

for full recourse on the carveout Although the breach of the carveout had been remedied

and the lender suffered no loss due to the breach, the court still ruled in favor of the lender and they were able to recover the $5m deficiency on the loan

Courts appear to take the view that if the borrower freely and knowingly signs away the recourse protection that they have negotiated, then it isn’t the court’s role to limit the damages and penalties they may face because of that bad decision.

Lightstone – Bad Boy David Lichtenstein owner of the Lightstone

Group was ordered to pay a $100m penalty for breaching a bad boy carve out related to the Extended Stay bankruptcy

Lightstone (the owner of Extended Stay) filed for bankruptcy protection after a junior lenders tried to foreclose and this breached the bankruptcy carveout in the loan docs The court didn’t care about Lighstone’s

motivation. As far as the below the line carveout was concerned it didn’t matter.

Bad Boy Takeaway Both borrowers and lenders should make

sure the carveout states exactly what they mean As the courts are viewing them, they can at times

act like a weapon against borrowers If both parties want something less than the

standard sledge hammer carveout, it is imperative that it is clearly outlined in the loan docs

Capital Stacks

The stack can be sliced horizontally (senior/subordinate) and it can also be sliced vertically (pari passu) There will be loan documents for each loan (this document governs the rights and responsibilities of the lender and the borrower)

There will be intercreditor agreements both within slices and between slices of the stack (these agreements outline the rights and responsibilities between the different layers of the capital stack)

B Notes v Junior Participations I’m going to use the term “junior” notes quite

liberally Technically a “note” has its own promissory note

(that is, it is secured against something) In an A/B note structure there are two promissory notes

When capital stacks are sliced, a lot of times a senior note will be split into a senior participation and junior participation Both participations are secured by the same note A participation agreement is what is used to subordinate

the cash flow of the junior participation to the senior participation (the borrower just makes one payment and the participation agreement states who gets what portion of it)

The reason I’m going to be loose with terminology is that economically it doesn’t really matter The participation agreement ties the junior

participants hands to essentially buying the senior participant at par plus accrued interest

Why did these complicated capital stacks develop? Sliced and diced capital stacks are all about

achieving more leverage and better pricing You want to put together the cheapest set of

financing for a given amount of leverage High leverage senior loans were not popular

CMBS investors/CRAs didn’t like high leverage senior loans, so they would penalize subordination levels and make the transaction less profitable for the sponsor

Portfolio lenders didn’t want that kind of leverage in the loans on their books

The end result being that it would be prohibitively expensive to get a high leverage senior loan

Why did these complicated capital stacks develop? Since the borrower still wants more leverage

than the 60-75% provided by the senior lender, we need to fill the funding gap

We did this using complicated capital stacks A/B notes Mezz debt Preferred equity

Notice that I haven’t said that we used these structures to get “optimal” leverage. We used them to get maximum leverage. They may be the same thing, but it is unlikely…

Documents Commercial loan documents are not boiler

plate The CMBS market has led to standardization typically

based on CRA considerations

The actual terms in the loan documents are the outcome of a negotiation between the borrower and lender and are subject to the bargaining position of each party at the time the loan was negotiated They will invariably not cover every contingency and may

also be incomplete

Intercreditor agreements are even less boiler plate Once again the CMBS market has “standard”

intercreditor agreements, but these are a starting point These agreements become very complicated when you

are trying to negotiate your way through the capital stack

Standards The universal rule of underwriting is that

standards fluctuate together I can underwrite a loan conservatively or

aggressively depending on what terms I put in the loan docs and intercreditor agreements Part of being aggressive or conservative is

financial (LTVs, DSCRs etc.) and part of it is non-financial (recourse, lock boxes etc.)

When we get aggressive financially we typically also get very loose in terms of covenants and we tend to do it in all markets at the same time (single family and commercial)

What time in the cycle do we do this?

Where you are in the capital stack matters Think of the capital stack as ranking all the

liabilities of the borrowing entity in order of priority of payment Mechanic’s liens and property taxes comes first, but we

will assume they are paid, so we will worry about the financial liabilities in the capital stack

Senior lenders get paid first, then junior lenders, then equity This is either simply a matter of economics (pay the

senior lender first because they can do the most “damage” to the rest of the capital stack) or enforced by loan documents and intercreditor agreements (lock box pays the senior note first…)

This means that when you see defaults, they will start at the bottom of the capital stack and move up as cash flow drops Equity doesn’t get paid, then junior lenders don’t get

paid etc. Notice that two tranches might stop being paid at the

same time

Why does this matter? You typically can’t force another part of the

capital stack into a foreclosure proceeding if they aren’t also in default

If a senior lender is foreclosing on a mortgage, they will join all the junior lenders to the suit (because they are also in default due to a one way cross-default clause – the opposite scenario is more complicated) This is essentially their legal way of letting everyone who

has a claim on the property know what they are doing and gives those parties the responsibility to act

Those parties joined in the suit will have their claims extinguished at the end of the foreclosure proceedings.

At the foreclosure auction everyone can bid up to the face value of what their claim is worth without adding new cash

An example may help

Example Assume all notes are in

default A Note = 80 B Note = 20 C Note = 10 Equity = 10 Total = 120 What happens if the

property’s value falls to 90?

A Note (80)

B Note (20)

C Note (10)

Equity(10)

What happens at 90? A can bid 80 and not put any

money into the deal Will they win? No! The property is

worth 90 B can bid 20, so if they talk to A

and agree to keep the loan in place, they can bid a total of 100 with no money down (or they could borrow 80 and pay A off) Will they win? Yes! Even if B doesn’t have the money

they could sell the note to someone who does

What does C do? Nothing! There is no economics in

the deal for them.

A Note (80)

B Note (20)

C Note (10)

Equity(10)

Fulcrum Tranche The above example shows that B has the

economic incentive to control the deal This is what is commonly referred to as the

Fulcrum Tranche in the capital stack They are the last tranche “in the money” and have the

incentive to roll up the capital stack The general rule is you have the right to buy out the

more senior tranches to you at par plus accrued interest. So in most cases you can roll up the capital stack.

In many cases if the mortgage senior to you is defaulted you have to show you have the intention to do this when you foreclose Mezz loans may be unable to foreclose once the senior note

accelerates (this is what the Stuy Town ruling was all about)

All tranches below them have no incentive to do so.

What happens if only the junior note is in default? In the above example the senior note was in

default and the senior lender was foreclosing What happens if only the junior note, say C, is

in default? There are theoretically 3 options

1. Do nothing (this is sometimes part of an intercreditor agreement)

2. Foreclose and join all creditors 3. Foreclose and join only creditors junior to you.

Option 1. This is not good. It is also sometimes something that was

negotiated in an intercreditor agreement This was very typical in CMBS loans where the A-

note is in a CMBS pool and the B-note is out of the pool

In this case you can’t do anything and you just have to hope you charged a high enough interest rate to make up for your position being wiped out Typically your option is you have to buy out the

stack ahead of you first. You could then go ahead and turn around the

asset

Option 2 Typically if a senior loan isn’t in default you

can’t make it a party to the foreclosure i.e. they are getting paid, so they don’t want to be

part of the action Even if you could, they are senior to you in

the capital stack so you would have to buy them out to win the foreclosure auction This essentially leaves you in the same position as

Option 1 (do nothing or pay off the stack in front of you to get control)

Option 3 If you don’t join the senior lender to the suit

then you can foreclose and their claim remains on the property while all the creditors junior to you get wiped out

So effectively you get title, with that mortgage already in place (so you get an encumbered titled) This is usually a lot better than having to pay

them off When new debt capital is scarce (say in a

recession when everyone is foreclosing) the existing debt is also likely the cheapest high LTV loan you will be able to get

Mezz Debt Mezzanine debt or mezz debt is debt on

equity Senior debt is secured by the property (that is,

the mortgage provides that the security for the note is the title to the property) Senior in this context means senior to the equity, so it

could include both senior and subordinate “senior” debt

Mezz debt is secured against the equity (the partnership interest in the LLP) that owns the property

If you default on mezz debt, the mezz owner forecloses through onto the equity This is called a UCC (Uniform Commercial Code)

foreclosure (this is the piece of legislation it is done under.)

After a mezz foreclosure, all the senior debt is still in place All that has happened is a new entity is now the

“equity” in the deal

Mezz Foreclosure Auction

Mezz lender: TRT – Comerica Mezz LLCBorrower: 1717 Dallas Partners, LLCProperty: Comerica Bank Tower

The winner of the auction will own 1717 Dallas Partners, LLC. And hence control Comerica Bank Tower in Dallas.

TRT can bid to the face value of their mezz debt, so anyone who wants to win the auction has to at least buy out TRT at par plus accrued interest.

“Qualified Transferee” relates to who can become the new equity. The senior debt is in a CMBS pool, so you either have to meet certain guidelines to be rubber stamped or get CRA opinion that it won’t change the rating on the loan and hence the pool.

UCC There are two types of UCC foreclosures

Public sale process Strict foreclosure

Public sale is what you just saw A public auction is held in a “commercially reasonable”

manner This usually takes 60-90 days and involves costs (brokers,

advertising etc.) Strict foreclosure

The mezz lender takes ownership of the collateral in full or partial satisfaction of the mezz loan

This is quick: 20 days Problem: the borrowers can send an objection notice

which stops a strict foreclosure (a bad boy carveout related to objections can be included in the mezz loan docs to prevent this)

Mezz Debt Although the mezz debt is junior to the senior

debt, the senior lender is still very interested in who the mezz lenders are

Ideally the mezz lender is a deep pocketed RE specialist The idea being the senior lenders wants to be at

least indifferent between the current owner being the equity or the mezz lender being the equity

Exactly who can be the mezz lender is often times part of the loan documents and intercreditor agreements This is especially true for securitized mortgages

because a change in ownership could materially affect the risk of the loan and thus the risk of the CMBS pool

Mezz Foreclosures Where most “foreclosure” processes get ugly

is in the mezz Each tranche of mezz will front run the

tranche senior to them to try and foreclose The way things appear to be working out is that

you should act as soon as you are defaulted on because this protects your rights

So the most junior tranche moves first Once the most junior mezz tranche becomes the

new equity, the more senior mezz tranches will try and foreclose on them once they are defaulted on…

The new equity will typically try and stall this by filing for bankruptcy protection. What is the problem here?

Bankruptcy Carveout & Mezz The original bankruptcy carveout guarantee

was signed by the original equity That entity promised not to file for bankruptcy

and the guarantee attaches to the original principals of the equity

The mezz that became the new equity owner may or may not have signed such an agreement The mezz lender will often times be required to

sign a guarantee as part of the intercreditor agreement (basically saying if it ends up as the new equity it will takeover the guarantee)

If no guarantee exists the mezz, as the new equity, can file for bankruptcy protection It is unclear if this would trigger the recourse

carveout on the original equity (this is still up for litigation)…but has now been contracted away in the CMBS market

Incentives Put yourself in the shoes of the mezz lender You are reading through the senior loan docs

and you see very restrictive bad boy carveouts. You also see in the intercreditor agreement that you have to agree to those same provisions if you ever do a UCC foreclosure

What are the positives? What are the negatives?

4 Different Foreclosures No foreclosure is like another because:

Loan documents/intercreditor agreements differ Parties to the deal differ The economics of the property differs

We will examine 4 different “foreclosures” Stuytown/Peter Cooper Village (senior & mezz) 100 Church Street (mezz) W Hotel @ Union Square (multiple mezz

tranches) Omni International Mall in Miami (mezz loan with

senior loan buy out.) Note: these are all complicated foreclosures

involving more than a single tranche of debt

Stuytown The Stuytown deal is easily the most high

profile transaction and subsequent default of the bubble and bust What did the deal look like in general terms? Where were the gremlins?

This deal is a great example of how not to underwrite a transaction

The Math 3b @ 6.434% = 193MM 1.4b in mezz @ ~10% = 140MM In place NOI is 112MM!! There was a 400MM interest reserve at

origination to pay senior and mezz (although the mezz has the ability to accrue)

Stabilized DS (193+140) 333MM which is pretty much what 2011 NOI was projected to be… The cash flow change was because in place deregulated

and rent stabilized rents were ~2000 a month below “market” or 270MM in revenue

So even if everything went according to plan, this was still a really risky loan…

2012 NOI was actually 127MM

Stuytown (the foreclosure) CW Capital is the special servicer for the senior

note So think of them as the senior lender

Pershing Square and Winthrop (PSW) bought a chunk of the mezz debt for about $45m (well below face value)

PSW wanted to foreclose on the mezz loan and become the equity owner I believe the plan was to then file for bankruptcy and run

a cramdown on the senior loan (I may be wrong but that seems like the most likely option)

CW argued that under the loan documents and intercreditor agreements PSW could not foreclose through on the equity while it was foreclosing on the property unless it was to pay off the senior loan in full They would go from 45m into the deal to $3.4b into

the deal

Stuytown In the end, CW bought the mezz loans from

PSW to get them out of the capital stack I believe they paid them 45m, so PSW came out

whole This should allow CW to reorganize the

property without foreclosing which should save a huge amount in transfer taxes (these are in the $100m+ range) If Stuytown was in a low tax state then PSW

would have had much less leverage Moral of the story – worry if Pershing

Square/Bill Ackman takes an interest in you… Last appraisal on the property had it around

$3b, so the senior lender will take a loss due to fees and advances, but it shouldn’t be enormous

100 Church Street This was a midterm a few years back 1m sqft Class A office building in lower

Manhattan Kind of a basket case building with historically poor

management SL Green foreclosed on the equity at 100 Church

Street Wells Fargo has the senior loan (140m) and it isn’t in

default SL Green and Gramercy had pari passu $40m mezz loans

on the property Sapir stopped paying the mezz loans and SL Green

foreclosed (Gramercy didn’t participate, but appears to have some subordinate equity interest in the property)

SLG went from being a mezz debt holder in the property, to being the equity owner of the property They paid down the senior loan by 2m, but mainly funded

60m in new reserves for the lease up The idea is to re-tenant the building which was about

50% occupied at foreclosure

100 Church Street SLG refinance the 140m senior loan for 230m in

2012, so even if they are fully through the reserve they have about a 10m basis in the asset including their sunk 40m mezz loan!

This deal made sense because the property “as is” could service its senior debt and SLG is always hugely bullish on its ability to lease up NYC office

This is a perfect example of what a senior lender looks for in a mezz lender Deep pockets and the ability to turn around the asset

W Hotel @ Union Square This is one of the ugliest wild west

foreclosures you will ever see 2006: 285m acquisition by Istithmar

115 in senior debt into CSCMT 2006-C5 117 in mezz debt (60 to DekaBank; 37 to

Sandelman; 20 to LEM) Istithmar has 53 in equity ~ 80% total LTV

2008: Property value drops to around 175m and cash flow falls to a level just covering the senior loan

At this point The senior loan is not in default, but the mezz

loans are This means you can’t touch the senior note

Now the fun begins…

Foreclosure, bankruptcy, law suits… 1. LEM does a UCC foreclosure to get control

of the property 2. Istithmar is wiped out in the foreclosure,

but goes and buys Sandelman’s 37m mezz loan for 3.6m and then starts its own UCC foreclosure to wipe out LEM

3. DekaBank starts its own UCC foreclosure to wipe out both Istithmar and LEM, but at the same time tries to line up Host as a final purchaser of the property

4. LEM files for bankruptcy protection to halt the Istithmar and DekaBank foreclosures and sues Istithmar for violating the intercreditor agreement by buying the Sandelman loan At this point we are in litigation gridlock and it is

time to negotiate

End Result Host puts in 80m of capital for 90%

ownership 60 went to Deka 10 to LEM; plus an additional 10m in the future;

and agrees to drop law suit against Istithmar Istithmar agreed to wipe out its 37m position and

contribute some capital in return for a 10% equity stake

Deka gets out whole LEM gets out whole Sandelman takes a 90% write down even

though they were senior to LEM!

Omni International Mall in Miami 160m senior note 45m mezz note Jorge Perez buys the senior note for 100m Genting buys the mezz Genting forecloses the mezz and buys out the

senior note for 160m and gets control of the site so they can develop

Perez makes 60m in about 6 months, but is annoyed he didn’t get to develop…

Moral: control matters If you want control you need to own the fulcrum

tranche Last I heard, the development plan didn’t go

through…

Workout Options Let’s ignore any subordinated claims for now

and think about a senior lender’s options Modification Foreclosure Bankruptcy

The chosen option is usually a function of: The lender The property The “borrower” The RE market in general State law / Taxes / Environmental issues

The Lender There are a few considerations

Lenders have historically not wanted to become property owners (suggesting they would rather restructure than foreclose)

This has changed somewhat with the “loan to own” lenders in the current down turn (but they are typically mezz lenders)

Has the lender already set up loss reserves for the loan? What events would trigger the loan becoming “non-performing” for the lender for reporting purposes?

What does the lender think of the borrower?

The Lender Does transfer of ownership through foreclosure

trigger any capital events? Hotel management contracts often have Change of

Control (CoC) PIP clauses that require large capital improvements when ownership transfers

Can the lender manage the property? Single tenant NNN probably yes, but something more

complicated? Then again, why would single tenant NNN default??

Can the lender legally operate real estate? Many institutions have restrictions on operating REO

portfolios Is the loan large enough to make it worth the

lender’s time and effort to modify it Many small loans are sold at auction because it isn’t

worth the paper work of working them out (especially true for SS)

There is very much a fixed cost to loan workouts, so for small loans these become a large fraction of the outstanding balance quite quickly

Special Servicer as the Lender If the loan was a CMBS loan then in default it

gets kicked over to the SS The SS is mandated to “maximize the NPV of

the loan” The Pooling and Servicing Agreement (PSA)

typically tells the SS to foreclose unless modification has a higher NPV In this sense they dual track loans (foreclosure

and modification)

The Property Considerations

Why did the loan fail? Good property, back luck Bad property, bad luck?

How complicated is the property to operate? How easy is it likely to be to sell the property? How much is the property worth and where do

you think value is going?

The Borrower Considerations

How far is the loan underwater? What are the incentives for a deep underwater

borrower? Reputation (this is becoming less and less of an

issue) Does the borrower want to keep the property? Does the borrower have deep pockets?

The property isn’t funding itself, so could the borrower fund capital reserves? Would they want to?

Recourse/non-recourse, guarantees…what leverage does the lender have to bring the borrower to the table?

The Market Considerations

Is the market underpricing assets due to illiquidity? Secondary/Tertiary assets are hard to deal with due to

a lack of demand for those assets Is the market likely to turn around and “the rising

tide raise all ships” As a general rule, the rising tide thing hasn’t

really played out – longer times in foreclosure lead to larger losses on average

State Law / Taxes / Environmental Certain states (e.g. New York and California) have certain

non-property based considerations California has very strict and non-lender friendly loan

enforcement rules (“one form of action” rules mean you get one remedy. So you could take simple actions like off setting cash accounts that prevent you from foreclosing)

New York has very heavy transfer taxes in foreclosures (these can be gotten around in bankruptcy because that falls under Federal law and Federal courts can set aside transfer taxes – this was one of the issues in the Stuytown deal)

States like NY, FL, OH are horribly slow and expensive to foreclose in using judicial foreclosures It might be worth your while to modify/sell especially for small

loans. 60c today is better than 80c 2 years from now plus incurring 20c in costs

Versus TX where “you get to shoot delinquent borrowers on the second Tuesday of each month.”

You also may not want to go on the title due to environmental exposure (the Superfund has exemptions for lenders, but people are typically wary) or regulatory issues relating to holding property

Modification The golden rule of modification “you must be

in a better position as a lender than you were before the modification.”

If the overall impression the lender gets is the borrower: Is competent and was just unlucky Has capital and would be willing to use it Has acted in good faith

Then the lender will usually be more likely to modify the loan especially if it has incentives to not become the owner

The end goal of modification is to have a reasonable amount of debt on the property and have the property be able to services this debt Lender could write down the loan Borrower could pony up more equity and pay

down the loan

Hope Notes The lender may be willing to write down the

loan, but wants to avoid the possibility that the borrower gets a windfall if the market improves If the loan is currently underwater and the lender

writes it down to parity and then prices rise, the lender loses out

A hope note or A/B note is a strategy to get around that The lender takes the mortgage and splits it into

two parts: the senior loan and the hope note The hope note does not receive interest payments

and only gets repaid if certain thresholds are met when the property is sold (this may be subordinate to new equity in the deal)

This means the borrower now has some potential of having equity in the property and the property also has a serviceable amount of debt

A/B Notes Typically you will size the A Note to at least

100% of the current value of the building The reason for this is that you should only use

this structure if you fundamentally believe property values are going to increase because of the new capital put into the asset If you don’t believe this, don’t use an A/B Note

structure!

Hope Note Example Oak Hills Mall

Small mall in Salem, OR 9.5MM loan @ 5.99%

97% occupancy U/W at 1.6x DSCR; 80% LTV U/W NOI 920,000

2011/2012 Lost major tenant (~30% NRA) Borrower had some success leasing up space, but

there are still occupancy issues NOI ~550,000 Appraised value ~7.5MM

A/B Notes A Note: 8MM (>100% LTV at present)

Pays 4% until 2014; then contract 5.99% ~ 320 in DS on 550 in NOI (can stay current)

B Note: 2.029MM This was 1.5MM in principal plus all the accrued

payments from default Note is just accruing interest

Structure Hard lock box (so no cash control issues) Borrower funds 150,000 lease up plus reimburses all

delinquent tax payments 100% excess CF sweep over A note DS and Op Exp until

leasing reserve hits 500,000; after that, 60% to lender (used to pay accrued interest on B note), 40% to borrower.

Capital event: pay A note, then 60% to lender, 40% to borrower.

A/B Notes There really are no hard and fast rules on A/B

note modifications Some times the A note is sized big >100% LTV Some times the rate on the A note is dropped,

some times it is increased Some times the B note rate is increased, some

times it is the same

Cost of Borrowing Often times when you are structuring the

debt on a property you will have various options

For example, on a 500,000 property you may have the options of 80% LTV @ 6% 90% LTV @ 7.5%

Since the LTV is higher on the second mortgage we expect to pay a higher rate because the default risk is higher

What we want to know is, how much is that additional 10% of LTV costing us?

Incremental Borrowing Cost The way to analyze this problem is to think

about it incrementally We are trading higher payments (the

difference between the debt service of the two loans) for a specified amount of cash today (LTV2*price – LTV1*price)

So the 10% increase in LTV is actually costing us the rate of return that makes the present value of the payment differential equal to the higher funds we receive today

Calculation

Option 1 Option 2 DifferencePrice 500,000 500000LTV 0.8 0.9Loan Amt 400000 450000 50000Rate 0.06 0.075Monthly Rate 0.005 0.00625Periods 360 360PMT $2,398.20 $3,146.47 $748.26Borrowing Cost 0.0148922 $0.00Annualized 0.178706

Explanation The payment differential is 748.26 The increased funds we receive today is 450,000-

400,000 = 50,000 We want to solve

50,000=PV(x%,360,748.26) X=0.014892 or 17.87% annually

That incremental 10% LTV is actually costing us 17.87%!

So if we could get a second mortgage for a lower rate, then we would be better off taking the smaller LTV first mortgage and a $50,000 second mortgage

This incremental cost of borrowing is why second mortgages or B notes can carry high interest rates and still be viable

Prepayment Penalties Fixed rate commercial mortgages virtually

always have “prepayment penalties” The common forms are:

1) Prepayment Penalty 2) Defeasance 3) Yield Maintenance

So the decisions to “pay off a loan and refinance” or to “sell the asset and repay the loan” are not always simple

You can also have a combination of these Locked out 60 months, then yield maintenance 55

months, then open for 5 months etc.Why do we have prepayment penalties?

Prepayment Penalty A true prepayment penalty is quite rare in

CRE. This is a function of them not being liked by

the CMBS market These penalties will typically take the form of

a fixed percentage of the outstanding balance e.g. 3% of the outstanding balance Often times the percentage will be on a declining

scale based on how many years are left on the loan

Notice that they are also very crude from an economic perspective The penalty isn’t linked to the lender’s loss

Defeasance Defeasance is the darling of the CMBS

market which is why it is very common The idea is that CMBS investors don’t like

additional variation in their projected cash flows, they want exactly the cash flows promised

To defease a mortgage, all you have to do is exactly replicate the payments from the mortgage using treasury securities In some cases agency securities are allowed Because treasury rates are nearly always going to

be lower than your borrowing rate, the defeasance portfolio will cost you more than the outstanding loan balance

A Real Defeasance Example First Pay Date: 1/1/1998 Term: 10 Years Amortization: 25 years Amount: 4,450,000 Rate: 7.03% Defeasance Date: 8/18/2006

Defeasance Example

These are the remaining payments

Treasury Portfolio

Each row is a different treasury security. Par is the bullet you get back Coupon = rate/2*par You have to pay “price + accrued interest” to buy the bond Notice that you could use any treasury portfolio (say a strips

portfolio of zeros) – you just want the cheapest one (that is where the work comes into to.) Thankfully Wachovia did the portfolio for me! As a general rule, the optimal portfolio will be a mix of bills and bonds.

BondPrincipal

Coupon Mortgage Payment

Remainder

Economics It cost 3,775,997.10 to buy the securities plus

the 727.33 in cash for a total of 3,776,724.43 The outstanding mortgage balance was

3,669,972.44 Defeasance premium = 106,751.99 or 2.9% of

the outstanding balance Plus of course the fee from the bank and the costs

associated with setting up the defeasance portfolio

Notice that defeasance can get very expensive when treasury rates are very low At 0%, the cost of defeasance is $4,006,718 (the

sum of the future dollars required) or a 9.2% defeasance premium

I have a friend who looked at defeasing a loan in 2010 and the premium was around 25%!

Yield Maintenance The idea behind a prepayment penalty is that typically

borrowers prepay when it hurts lenders (i.e. when rates fall)

The lender then has to reinvest (i.e. loan out) the principal at the new lower rate

Yield maintenance makes up for the yield the lender would lose out on by re-lending the principal out today at the lower rate This is the same logic as a make whole call provision in corporate

bonds

A typical yield maintenance calculation is: (Rate-Benchmark)*Outstanding Balance*PVAF(Benchmark

Rate, Remaining Term) “(Rate-Benchmark)*Outstanding Balance” is the $ value we

are losing each period due to reinvestment (this is a constant)

“PVAF(Benchmark Rate, Remaining Term)” simply calculates the PV of the annuity of the $ we are losing each period due to reinvestment

Yield Maintenance Our loan from before

Rate 7.03% Term 16 months left Treasury 4.919 (2 year)

Spread Difference: 7.03 - 4.919 = 2.111 This is what we are losing out in %

Outstanding Balance = 3,669,972.44 So we are losing (2.11*3,669,972.44) $77,473.12 each

year in interest PVAF(0.04919,16/12,$1)=1.26

This is a value of an annuity for the time we are losing the spread

Yield Maintenance = 77,473.12*1.26 = $97,616.13 or 2.65% of the outstanding balance

Day Count Conventions The amortization schedule you were taught in

Principles is technically a 30/360 amortization schedule It is probably the most common, but not the only

one out there In the 30/360 model, the year has 360 days

and each month has 30 days When you calculate the interest due in any

given month we typically make a simplification “rate/12*BegBal” This is actually “(rate/days in year)*days in

month*BegBal” In the 30/360 model this is,

“(rate/360)*30*BegBal” or “rate/12*BegBal”

Act/360 The other day count convention you might run into is the

Actual/360 model The number of days is the actual number of days in the

month and there are 360 days in a year What is the problem here?

To calculate the interest in a given month requires knowing how many days there are in the month “(Rate/360)*Days in month*BegBal” is the interest in any month

The total fixed payment you make under either method is the same, all that changes is how interest accrues (and hence how much of total debt service is principal and how much is interest)

30/360 v Act/360 The effect will be that for the same contract rate

The Act/360 will pay more interest (because there are 365+ days in a year)

The mortgage will amortize slower under Act/360 – it will have a larger balloon payment

For IO loans, the Act/360 method will have slightly different monthly payments because of the different number of days each month.