Many hotel borrowers turn to commercial mortgage-backed securities (CMBS), a type of mortgage-backed security backed by commercial and multifamily mortgages rather than residential real estate, to help finance their projects. Why? This type of financing offers capital at times at more favorable rates compared to traditional balance-sheet loans. Despite some recent challenges (e.g., the Great Recession, COVID-19 and the increase of borrowing rates after a prolonged period of low interest rates), CMBS rebounded and remains a popular option for hotel owners, developers and other borrowers due to its lower cost of capital (i.e., the interest rate and spread). This is particularly helpful in the current interest rate environment, with the Secured Overnight Financing Rate (SOFR) currently at or near historic highs.
Nonetheless, CMBS transactions can have significant limitations, particularly if the underlying loan experiences performance issues. Accordingly, it is essential that borrowers, guarantors and their counsel understand the CMBS market and the impact on the loan terms required of CMBS loan borrowers. This article explores some of the complexities and challenges of CMBS, emphasizing the necessity of thorough loan document negotiations and adequate considerations of borrower’s future plans to ensure operational flexibility, minimize risk and protect interests.
CMBS loans are often “sliced and diced” in connection with a securitization. Slicing refers to dividing the loan into separate tranches (or slices), each representing different levels of risk and return, with the senior tranches having the highest credit quality (and lower yield) and junior or mezzanine tranches bearing more risk (and higher yield). Adding another wrinkle, and depending on the loan size and whether it originated in a lender syndicate with participant banks, there can be multiple component notes within each tranche (i.e., an A/B-Note structure). Dicing refers to pooling together a large number of loans into a single securitization to provide greater diversification for investors, both geographically and by property type.
Post closing, CMBS loans are sold to investors though a securitization trust, making the closing table the last place the borrower parties will interact with the originating lender. Unlike the master servicer, which handles the day-to-day servicing responsibilities for performing CMBS loans (i.e., collecting loan payments, managing escrow accounts and processing bondholder payments), the special servicer (the “servicer”) is typically appointed by the junior, B-piece buyer and manages the loan if the loan experiences performance issues or in connection with a borrower’s default. The servicer is generally bound by the “four corners” of the transaction documents, making the initial loan document negotiations critically important.
Uniquely Hotels
Hotels operate in a dynamic environment where the only constant is change. Unlike other asset classes (e.g., multifamily), occupant turnover at hotels is a daily occurrence. As such, borrowers should insist on loan terms granting them broad operational discretion without necessitating excessive lender or servicer approval. By negotiating comprehensive provisions covering anticipated future actions, a borrower can ensure its requests are handled fairly and promptly (or, perhaps, even pre-approved), reducing the risk of encountering disputes, delays or the servicer’s rigid or unfavorable decisions. This becomes even more critical when timing is particularly of the essence, as is often the case when the servicer arrives.
Moreover, because the future is inherently unknown—Donald Rumsfeld’s “known unknown”—borrowers should seek clauses in the loan documents providing maximum flexibility (e.g., open prepayment periods, loan assumptions, permitted transfers, property releases, etc.) and thus strategic advantages, enabling borrowers to adapt to changing market conditions or business needs. For instance, if the borrower plans to change or amend its franchise agreement, replace the hotel manager, hire a separate manager for the F&B operations or undertake a corporate restructure, these actions must be expressly addressed as permitted occurrences within the loan documents. Otherwise, it will be difficult (if not impossible) to get the servicer’s approval, or the approval process with the servicer can take a significant amount of time to complete.
As important as preserving its own discretion, it is prudent for borrowers to require objective parameters for servicer’s decision-making and negotiate clear, detailed terms in the loan documents. As one example, there is constant tension between loan parties regarding lender’s budget approval rights (i.e., are all budgets subject to servicer’s approval, or only during a cash trap). Loan documents frequently require approval over all budgets, causing unnecessary delays and potentially adverse impacts to the hotel if the servicer is not responsive to borrower’s request for approval of a budget.
Defaults, and the related notice and cure periods, also require attention. Borrowers should confirm triggers are clear and there are reasonable cure periods. Similarly, for purposes of the non-recourse carveouts, the borrower parties should seek to have any recourse events requiring payment of monies (e.g., the prevention of waste) conditioned on the property producing sufficient cash flow. If all else fails, and excluding typical “full recourse” carveouts (e.g., bankruptcy, SPE violations, prohibited transfers, etc.), the borrower should seek to have the lender’s recourse be limited to the collateral. Careful attention must be provided to any provision in the recourse carveout guaranty that could require the guarantor to advance equity in the event property cash flow or available insurance proceeds are insufficient.
Negotiating recourse carveouts (i.e., “full recourse” versus “loss recourse”), especially at the term sheet stage, is imperative since these will be the exceptions to CMBS’s typical non-recourse structure. For example, should termination of the franchise agreement or borrower’s failure to complete a PIP be full recourse or limited to losses? Similarly, if a franchisor provides key money, should borrower’s repayment obligation be a carveout in favor of the lender? If so, should this be above or below the line (i.e., loss or full recourse)? These are consequential considerations for hospitality borrowers.
Other Considerations
Additionally, CMBS loans frequently require compliance with stringent performance metrics and financial covenants, such as debt service coverage ratios, debt yield and loan-to-value ratios. In addition to ensuring these covenants are realistic, achievable and accurately reflect the hotel’s operational realities, the borrower must confirm they provide a buffer to accommodate the inevitable market fluctuations. Relatedly, understanding the implications of definitions is necessary since hotel loans often arbitrarily adjust definitions (e.g., Net Operating Income and Gross Operating Profit) used for testing covenant compliance. For example, if actual reserves or fees for a hotel are less, can the hotel cover an assumed 4% FF&E Reserve or 3% hotel manager fee as a factor in the determination of Net Operating Income to meet any of the financial covenants?
Financial covenants are particularly relevant in the context of cash management. Cash management, which causes considerable consternation for hoteliers, is a critical consideration for hotel loans since lenders insist on it and hotel managers, particularly brand managers, are loath to accept it (albeit the latter more successfully than the former). In addition to negotiating the type of cash management (i.e., springing, soft or hard) and the triggers for implementing cash management, it is prudent for borrowers to pay attention to the waterfall setting forth payment priority. Taxes and insurance and debt service are typically the first buckets, but borrowers should push for operating expenses (e.g., franchise fees, hotel manager fees and payroll taxes) to be paid early in the waterfall to ensure the hotel can continue operating in the normal course.
Relatedly, it is imperative that the borrower considers idiosyncrasies particular to the asset. For example, for hotels in geographic locations where most revenues are earned within a limited calendar period it might make sense for a loan to include a seasonality reserve. This can address a situation where cash flow is “lumpy” (e.g., for hotels located on the Jersey Shore, where the summer, with occupancy approaching 100%, is when the lion’s share of revenues is earned, but the cold, wet and windy Atlantic winters hamper tourism). Although this could result in the borrower receiving less cash flow in the summer, it avoids triggering cash management in the winter where revenues drop precipitously and the borrower would otherwise be unable to make mortgage payments.
Though CMBS loans offer attractive financing options, navigating the complexities requires adequate forethought. There is no such thing as a free lunch, and the lower cost of CMBS financing comes with its own set of challenges. However, with a proactive, thoughtful approach to loan document negotiations, borrowers can successfully leverage the CMBS market to their advantage, ensuring that their financing arrangements support, rather than hinder, their business operations and strategic goals, thereby significantly reducing the borrower parties’ liability exposure and stress.
Michael D. Maloff is a partner in the Louisville office of Dentons, where he is a member of the law firm’s corporate and real estate practices. Opinions expressed are his own.
