Transactions. Terry Buquicchio and Jenny Story

Transcription

1 Transactions Terry Buquicchio and Jenny Story Buquicchio Loans originated for securitization often include provisions that restrict a borrower from incurring debt in addition to the first mortgage. However, Fitch Ratings periodically rates commercial mortgage-backed securities (CMBS) secured by first mortgages that allow or have allowed a borrower to obtain additional debt. The additional financing can be structured in the form of preferred equity, partnership or mezzanine debt, a second mortgage, or as an NB or NB/C note, in which the first mortgage is bifurcated into senior and junior components. Story: A preferred equity interest is generally an equity interest in the borrowing entity that receives a preferred return prior to the common equity but is not a debt instrument. Mezzanine debt does not directly encumber the property; however, it is secured by a pledge of limited partner (LP) or membership interests in the first mortgage borrower. In contrast to preferred equity and mezzanine debt, Band C notes and second mortgages are both forms of additional debt that are secured by a lien on the property. Whether rating a single-borrower or multi borrower first mortgage transaction, Fitch Ratings assumes that added leverage in any form puts greater suess on the cash flow of a property and increases losses in the event of default. Therefore, Fitch Ratings adjusts credit enhancement levels accordingly. To determine the degree to which credit enhancement levels should be increased, Fitch Ratings evaluates how the additional debt is suuctured and assesses any control rights held by the additional debt lender or preferred equity investor. This report outlines Fitch Ratings' methodology for evaluating different types of additional debt and the related risks borne by the first mortgage loans. Additionally, recent transactions have been proposed that would securitize the additional leverage as pan of a larger CMBS transaction, which mayor may not include the related senior mortgage. The methodology used by Fitch Ratings to rate uansactions that include secondary debt or mezzanine financing differs somewhat from thc proccss used to rate first mortgages. This report also outlines Fitch Ratings' rating process for CMBS transactions that include various forms of additional debt as collateral. TyPES OF ADDITIONAL DEBT The different types of additional debt are discussed in detail in the following sections in the general order of increasing risk to the first mortgage. PERMITTED INDEBTEDNESS In most CMBS transactions, loan documents generally prohibit botrowers from incurring any additional debt that may hinder the borrower's ability to support and maintain the asset in the future. However, limited amounts of trade payables are allowed. Typically, trade payable debt is unsecured, limited to 5% or less of the outstanding principal balance of the rated first mortgage debt, and is payable within 60 days. These limitations are in place because certain types of trade payables can create liens that become senior to the first mortgage (such as mechanics or materialmens liens). Also, unsecured debt in general can increase the likelihood of involuntary bankruptcy. In either case, the repayment of the first mortgage may be impaired. 28 CMBS WORLDh

2 Evaluating Additional Debt in Commercial Mongage Transactions (cont.) Therefore, Fitch Ratings may require increased credit enhancement to the first mortgage if limitations on the unsecured debt are not in place. PREFERRED EQuITY One alternative financing option for mortgagors is preferred equity. In a preferred equity arrangement, the investor makes a capital contribution to the first mortgage borrowing entity. In exchange, the preferred equityholder receives an equity interest in the borrowing entity. This interest generally carries a preferred return and payment priority over the common equity. Because preferred equity is not a debt instrument, it has no maturity date. In addition, the preferred equity investor does not have any control rights that could hinder repayment of the first mortgage. The only right the preferred equity investor has is the ability to terminate property management, subject to rating agency confirmation, and to sell the property (see Chart 2). The preferred equity documents should provide for and the preferred equiryholders should acknowledge that a failure to make preferred equity payments will not create a debt obligation on the partnership. Distributions to the preferred equity investor should be subordinate to all debt and property expenses. The initial preferred equiryholder should be disclosed to Fitch Ratings, and any transfers of preferred equity should be subject to rating agency affirmation. PARTNERSHIP OR MEZZANINE FINANCING Another common form of additional leverage is partnership or mezzanine debt. Security The only security for a mezzanine loan should be a pledge of the direct or indirect equity interests in the first mortgage borrowing entity. The mezzanine loan should not be secured by a lien on the property, an assignment of leases and rents, a guarantee from the first mortgage borrowing entity, or any other structure that would impede the first mortgage borrower's ability to pay its debt service or violate any special purpose entity (SPE) covenants. Since SPE covenants restrict a borrowing entity from incurring additional financing, the first mortgage borrower may not be the named obligor for mezzanine debt. Mezzanine Borrowing Entity Typically, the first mortgage borrower is either a limited partnership consisting of at least one LP and a SPE general partner (GP) or a limited liability company (LLC) consisting of at least one non-managing member (NMM), as well as a SPE managing member. In either of these structures, the mezzanine debt will generally be secured by either the LPs or NMMs (whichever is applicable) ownership interest in the first mortgage borrower, and the LP or the NMM will be the mezzanine borrower. If the first mortgage borrower is a limited partnership, the GP should not be an obligor or guarantor for mezzanine financing, nor should it pledge its ownership interests in the first mortgage borrower as security. Any of these arrangements introduce consolidation risk and additional creditors to the first mortgage collateral. However, the owner of the Gp, such as a stockholder, can pledge its ownership interest (or shares) in the GP as security for the mezzanine dcbt. ldcally, the sccuriry should consist of a plcdge of SPRING

3 Evaluating Additional Debt in Commercial Mortgage Transactions (cont.) equity in both the GP (by its parent) and the LP interests in the first mortgage borrowing entity (see Chart 3), such that upon a default of the partnership debt, the mezzanine lender can foreclose on its security and become the owner of both the LP interests in the borrowing entity and the owner of the GP. A securitized first mortgage with mezzanine debt placed outside of the trust should have certain structural features in place that ensure the security of the first mortgage and prevent consolidation risk. First, a nonconsolidation opinion between the mezzanine borrower and the first mortgage borrowing entity should be in place regardless of whether or not the mezzanine borrower is a SPE. This reduces the risk of a bankruptcy of the mezzanine borrower affecting the assets of the first mortgage borrower. Additionally, the GP of the first mortgage borrower (or at least one of the GPs if there are several) should be structured as a SPE. and a nonconsolidation opinion between the GP and its parent is necessary to reduce risk. If the first mongage borrower is a LLC, the individual members may pledge their NMM interests in the first mortgage borrower as security for the mezzanine loan. It is preferable to have all the NMMs pledge their interests as security. Additionally, the parent of the managing member may pledge its ownership interest in the managing member as security. Under this structure a nonconsolidation opinion between the mezzanine borrower and the first mortgage borrower (even if the mezzanine borrower is a SPE) should be in place, as well as a nonconsolidation opinion between the managing member and its parent (see Chart 3). Mezzanine lender Fitch Ratings conducts a thorough evaluation of the initial mezzanine lender since it has the ability to foreclose on the equity interests of the mezzanine borrower and assume complete control of the first mortgage borrowing entity. The evaluation includes a review of senior management, ownership structure, financial condition, lending, workout, and overall real estate expertise. If the mezzanine debt is held by more than one lender, the likelihood of competing interests in a workout scenario is increased. This could lead to delays in achieving a resolution, which could cause a further decline in an asset's value and result in higher loan losses. The participation should be structured so that only one lender retains control during a workout. In addition, a predetermined time limitation for negotiations between participants should be established. Without these structural features, credit enhancement will reflect the increased risk associated with a mezzanine loan that is structured as a participation. Transfer Restrictions When rating a first mortgage that has mezzanine debt associated with it, the mezzanine lender should be restricted from freely transferring the loan without rating agency confirmation. Since the transferee could ultimately control the first mortgage borrower, Fitch Ratings reviews the proposed transferee in the same manner in which it would review the initial mezzanine lender. The mezzanine loan documents should clearly state that any transfer of the mezzanine loan requires rating agency affirmation with respect to the existing ratings on the CMBS transaction in which the related first mortgage is included. These transfer restrictions reduce the risk of a non-creditworthy or inexperienced entity assuming control of the first mortgage bortower. Frequently, mezzanine loan documents may provide for a "permitted transferee" to whom the mezzanine debt may be transferred. A permitted transferee is generally defined as a major money center bank, life insurance company, or investment-grade real estate investment trust with predetermined levels of capital and extensive real estate experience with the respective property type. Fitch Ratings will review the definicion of a permitted transferee. Servicing Conflicts If the master or special servicer (or any controlling parry) for a CMBS transaction is a mezzanine lender on any loans in the trust, a conflict of interest could arise. For example, during a workout scenario, the special servicer, which is obligated to protect the interests of all of the certificateholders, may be required by the trust documents 30 CMBS WORLD~

4 Evaluating Additional Debt in Commercial Mortgage Transactions (cont.) to implement a recovery plan that could result in a loss to the mezzanine lender. Therefore, certain servicing and advancing requirements should be stipulated in the trust documents to ensure that the certiticateholders' interests are protected. Appointing an independent party to service the affected loans is one way the risk of conflict can be mitigated. Overall Leverage When rating single-borrower first mortgage transactions, Fitch Ratings reviews the total leverage associated with a transaction, including the first mortgage and any additional debt a borrowing entity has or may incur. To test the solvency of the transaction, Fitch Ratings calculates an aggregate debt service coverage ratio (DSCR) using the Fitch Ratings adjusted cash flow, the Fitch Ratings stressed refinance constant on the first mortgage and the higher of the actual constant, the Fitch Ratings stressed refinance constant or the accrual rate (if applicable) on the mezzanine debt. When tranching a first mortgage transaction that has mezzanine debt, the DSCR sizing parameters for each rating category is increased. If the combined DSCR for the first mortgage plus the mezzanine debt is less than 1.0 times, then the DSCR sizing parameters will be further increased at each rating category. Payment Priority When rating first mortgages that allow or have mezzanine debt, specific cash management procedures should be in place. Ideally, a hard lock box should be in place at the beginning of the first mortgage term and remain in place until the first mortgage is fully repaid. The payment priority of the property's cash flow should be clearly defined so that the mezzanine debt lender is paid from excess cash flow after the following items are paid: taxes, insurance, ground rent (if applicable), first mortgage debt service, operating expenses, all capital reserves, and any necessar")' or discretionary capital items approved by the servicer. If the first mortgage has an anticipated repayment date (ARD) or other events that trigger a cash trap, any payments on the mezzanine loan after the ARD date or cash trap trigger must accrue, as all excess cash flow from the property should be used to pay down the first mortgage. Maturity The mezzanine debt can mature up to two years prior to the maturity of the first mortgage but only after the lockout period on the first mortgage has expired. However, if the mezzanine debt is structured as a balloon loan and it is co-terminus with the first mortgage, a minimum of two one-year extension options should be available at the mezzanine borrower's option. The ability of the first mortgage holder to release its lien cannot be contingent upon the satisfaction of the mezzanine debt. FinalIy, the mezzanine debt should have no lock-out periods or penalties for prcpayment, either in whole or in pan. Control Rigftts of the Mezzanine Lender Generally, a mezzanine lender wants additional control rights over a borrower and property operations to further protect its interests. Examples may include crossdefaulting the mezzanine loan with the first mortgage loan; retaining the right to terminate property management; and having the right to approve the first mortgage refinancing, the property budget, the sale of the asset, new leases, amendments to the senior loan documents, or amendments to the borrower's organizational documents. Control rights held by the mezzanine lender that impede the repayment or refinancing of the first mortgage or are not subordinate to the senior lender will be reflected in increased credit enhancement levels. [vents of Default The mezzanine debt should be structured to limit the events of default solely to monetary defaults resulting from a missed current payment or balloon payment on the mezzanine debt. With the exception of fraud, no covenants in the mezzanine loan documents that can trigger a nonmonetary default should be allowed. Furthermore, the mezzanine debt should not be crossdefaulted with the first mortgage. It is acceptable that an event of default on the rated debt trigger an event of default on the mezzanine debt. Remedies The only remedy available to the mezzanine debtholder should be its right to foreclosure upon its ownership interests in the first mortgage borrower. The mezzanine lender generally accomplishes this through a Uniform Commercial Code (UCC) foreclosure. After the foreclosure. the former mezzanine lender becomes the owner of the first mortgage SPE borrowing entity and, therefore. the first mortgage borrower. In addition to its right to foreclose upon its UCC interest. the mezzanine lender generally has limited rights to terminate the management company. subject to rating agency confirmation. AIB AND AlBIC NOTES Another method of providing additional financing is through an NB or NB/C note structure. Generally, in this structure, the entire debt is secured by a first mortgage that is bifurcated into component notes: an A note, a B note, and a C note component. Although considered to be in a senior position, the A note typically receives its proportionate share of interest and principal pari passu with the Band C notes as long as the whole loan is performing. However, upon an event of default, the A note component becomes senior to the Band C note components and receives all cash flow until it is fully repaid. The holder of the C note component (or B note if only two components exist), has the right to buy the A note out of the CMBS transaction at par but otherwise SPRING

5 Evaluaring AddirionaI Debt in Commercial Mortgage Transactions (cont.) must "stand still" during an event of default. In addition, the holder of the C note (or B note if only two components exist) is allowed a limited role in advising the special servicer with respect to a workout strategy, which is subject to the servicing standard. Although the A note component is often rated investment-grade and placed in a CMBS pooled transaction, Fitch Ratings' rating of the A note component depends on the specifics of the whole loan structure. The loan is structured so that the entire debt amount (the A, B, and C note components combined) is secured by a first mortgage, and any nonpayment to any noteholder results in a default of the entire loan. The same process that is used to rate stand-alone single asset deals is used when rating single asset transactions involving an NB or NBIC structure. Credit enhancement levels are based on the Fitch Ratings stressed DSCR which Second Mortga,. -.ecured by prvperty is derived by applying the Fitch Ratings net cash flow to the Fitch Ratings debt service for the whole loan and loan to value ratio (LTV). If an NB or NB/C loan is rated non-investment-grade, credit enhancement levels at each tranche will reflect the additional leverage associated with the NB or NB/C structure. Fitch Ratings also considers the rights afforded to B or C note buyers through the intercreditor agreements.' SECOND MORTGAGE DEBT A second mortgage is a loan that is subordinate to the first mortgage debt but secured by a lien on the property (see Chart 5). This additional debt could place stress on the property, particularly during an economic downturn when the property's cash flows may not support a junior debt service payment. In this case, the mortgagor could default on the secondary debt and declare bankruptcy, which would negatively affect the performance of the first mortgage. In addition, the presence of other secured creditors can increase the likelihood of default on the first mortgage since a default on the junior debt may cause the creditors to pursue legal proceedings, such as foreclosure, to prevent or recover losses and complicate the workout process, potentially drawing out the foreclosure and increasing the likelihood of higher losses. If the second mortgage is structured as a "soft second," which minimizes the added risk to the first mortgage, the additional credit enhancement required will be reduced. A soft second is a second mortgage that contains a subordination and intercreditor agreement between the first mortgagee and second mortgagee and restricts the actions the second mortgagee can take in the event of default. For a loan to qualify as a soft second, the subordination and intercreditor agreement should contain a standstill clause that prohibits the subordinate lender from exercising any remedies, including the commencement of foreclosure proceedings while the first mortgage is outstanding. The subordinate mongagee may foreclose only if it first purchases the senior mortgage at a price of par plus any accrued interest and trust expenses. In addition, the second mortgage should only be paid out of excess cash flow. Furthermore, the second mortgagee should agree to subjugate its voting rights to the senior lender in the event of bankruptcy. Finally, the junior lienholder should be willing to subordinate to a refinanced senior mortgage. If any of the aforementioned restrictions are not in place, credit enhancement levels will reflect the additional risk associated with the lack of structural features. RATING ADDITIONAL DEBT AS CMBS COLLATERAL Fitch Ratings' methodology for rating CMBS pools that include additional debt as collateral follows the process used for rating CMBS pools of first mortgage debt. Similarities include the ways in which pool level issues, such as geographic, borrower, and loan conccntrations, arc evaluated. Additionally, Fitch Ratings uses a similar methodology to derive its stressed DSCR and LTV for individual loans. This process includes re-underwriting property cash flows to derive a stabilized Fitch Ratings net cash flow and then applying a Fitch Ratings stressed refinance constant to the debt. As with single-borrower transactions, the total leverage that encumbers the associated property must be evaluated. Therefore, Fitch Ratings combines the stressed debt service on the first mortgage and the higher of the actual or stressed debt service on the additional leverage to determine the total debt service that the property must support. This combined debt service is then applied to the re-underwritten cash flow to arrive at an aggregate Fitch Ratings stressed DSCR. In instances where accrual and pay rates on the debt exist, Fitch Ratings will apply the higher of the Fitch Ratings stressed refinance interest or accrual rate. Fitch Ratings stressed DSCR is the primary determinant of probability of default for mortgage loans (followed by (continued on p. 89) CMBS WORLD~

6 Mezzanine Debt: Suggested Standard Form of lnterrreditor Agreement (conlinued from p. 26) mezzanine financing, will require a much more stringent intercreditor agreement.) Significant issues that have been addressed in the form intercreditor agreement include permitted transferees of the mezzanine loan, conditions to taking title to the pledged equity interests, limitations on modification to the first mortgage loan and the mezzanine loan, rights of the mezzanine lender to cure defaults on the first mortgage loan, rights of the mezzanine lender to purchase the first mortgage loan, certain control rights and financing of the mezzanine loan. These issues have been sticking points in many mezzanine loan intercreditor agreement negotiations and the source of the most inconsistencies. The form attempts to reach a middle ground on these issues and reflects where market participants have often ended up in recent transactions after extensive negotiations. Standard & Poor's and Fitch Ratings have indicated that this form will generally be acceptable for most securitized mortgage loan transactions with mezzanine debt. In some cases, certain language may be modified due to the specifics of the transaction. The form intercreditor agreement is available in electronic format on the CMSAc website, and at Widespread use of the form by market participants should ultimately benefit all CMBS participants by creating a higher level of consistency in intercreditor agreements and reducing the time, expense and uncertainty associated with negotiating mezzanine loan intercreditor agreements. 0 Dovid ~ Forti and Timothy A. Stafford are members of the Finance and Real Estate Group of Dechert. The authors would like to thank the over 30 market panicipanrs thot contributed to the creation of the form intercreditor agreement. Evaluating Additional Debt in Commerr:ial Mortgage Transactions (continued from p. 32) adjustments for collateral and pool level issues, as those mentioned above}. The lower the Fitch Ratings stressed DSCR, the greater the probability of default. Since it is calculated on an aggregate basis, the Fitch Ratings DSCR for additional debt is lower than that for the related first mortgage. Therefore, additional debt included in a CMBS transaction receives a higher probability of default assumption than the respective first mortgage CMBS collateral. Another difference between rating additional debt and first mortgage debt is the loss severity assumption thac is applied to each loan. As che LTV increases on a Fitch Ratings stressed basis, additional losses are attributed to a loan. Therefore, when rating additional debt, Fitch Ratings calculates its stressed LTV by combining the first mortgage debt and the additional debt, which results in higher loss severities. Fitch Ratings will generally assume a loss severity of 100%. CMBS transactions that include additional debt may have limitations on how high they can be tranched given the junior position of the additional debt. Fitch Ratings would be unlikely to give significant tranching benefit to additional debt that is junior to an already highly leveraged first mortgage loan. Furthermore, a pool consisting of additional debt may not meet the higher level of loan divers icy needed to tranche up. First mortgage loan transactions with additional debt placed outside of a CMBS trust are subject to increased credit enhancement, depending on how the additional debt is structured. However, the structural features of additional debt utilized to reduce the risk posed to the rated first mortgage debt may increase the credit enhancement required for additional debt when it serves as collateral for a CMBS transaction. 0 Terry Buquicchio is Senior Director; and Jenny Story is Managing Director; at FitchRatings. IFor more details, see Fitch Ratings Research on "ABCs of AlBIC Notes-EvalUl1ting AlBIC Note StroctZIres in Commercial Mortgage Transactions," dated December 10, 2001, available at the Fitch Ratings website: wwwfitchratings.com. SPRING