News for the Hospitality Executive
The Alarming Tidal Wave of Hotel Mortgage Loan
By Michael T. Sullivan
The “Extend and Pretend” era is rapidly giving way to “Get Real to Heal,” and this article explores the complexities surrounding workouts of securitized hotel mortgages.
Since 2003, roughly $110 billion of lodging mortgage debt has
been originated and securitized into Real Estate Mortgage Investment
Conduits (REMICs) in the United States, collateralized by slightly over
18,000 lodging properties. To put this number into greater context,
there are by several estimates roughly 51,000 hotels in the entire U.S.
hotel market. So, the notion of financing hotels with a “conduit or
REMIC mortgage” was by most measures successful, given the apparently
large number of hotels financed with this method. This type of
financing offered a ready source of senior mortgage debt, often at
attractive pricing and terms. And the cycle continued until late
2007/early 2008 when the music stopped rather abruptly because of the
rapid deterioration of the credit markets. Then, with the failure of
Bear Stearns and more dramatically Lehman Brothers, the game was really
at an end. However, even when the securitization era was in full swing
(circa 2005 to 2007), borrowers would often complain about what
appeared to be overkill in documentation at closing, including the
necessity of placing the hotel asset in a Special Purpose Entity and
other seemingly arcane and annoying requirements such as the need for a
separate director, who was not supposed to be affiliated with the real
ownership entity. And the biggest complaint often was that there was
apparently no real lender to talk to in the event that a question or
difficulty arose in connection with the loan.
In the Principally Secured Test (TD 9463), the REMIC rules were modified to permit changes to collateral and credit enhancement relating to a mortgage loan (even a performing mortgage loan) so long as the mortgage loan remains “principally secured” by real property after the modification. Principally secured means either (1) that the mortgage loan has a loan-to-value ratio (taking into account only the real property collateral) of 125% or less or (2) for mortgage loans with loan-to value ratios above 125%, that there is no reduction in the fair market value of the real property after the modification. The Principally Secured Test applies to all releases, including those contemplated by the parties when a loan was closed, and releases on loans in default or for which default is reasonably foreseeable. This latter requirement may present difficulty to servicers who are often obligated under mortgage loans originated prior to these REMIC rule changes to release property if the borrower meets certain specified conditions under the mortgage loan without regard to whether the Principally Secured Test is satisfied. The securitization industry has requested the IRS to modify these rules to prevent difficulties for servicers and potential liability for securitization trusts.
In the Imminent Default Test, (Rev Proc 2009-45) has been interpreted: the “IRS will not challenge the tax status of a REMIC due to the REMIC’s modification of a commercial mortgage loan that is currently a performing mortgage loan but where, in the view of the commercial mortgage loan servicer, a significant risk of default exists, even if the default is expected to occur only at some distant future date.”Finally, any brief overview of CMBS and their workouts would not be complete without mentioning the Controlling Class. The most subordinate tranche of CMBS holders within a REMIC constitute the controlling class of CMBS holders. This tranche is “controlling” because it is in a first-loss position and will suffer the most immediate loss if the value of a loan deteriorates. In other words, most CMBS structures will designate one investor as the “controlling holder” of a mortgage loan, with rights to influence the servicing of the loan, as further described below. The controlling holder is generally the holder of the most junior tranche of the mortgage debt that is still “in the money,” as determined with reference to an appraisal. The concept of giving servicing control to the most junior investor is distinctive to CMBS. In virtually all other forms of commercial lending, the most senior lender has control in a default situation, and subordinated debt is left to fend for itself. However, in CMBS, the so-called “B-piece” investor is sometimes affiliated with the Special Servicer, and having the first-loss risk at stake in the event of default is therefore thought to make this class the most motivated; moreover, because of the provisions in the PSA, this class has the most tools at its disposal and is best positioned to achieve a favorable result in a default scenario.
However, a controlling class may lose its controlling status if the value of the pool of securitized loans declines below a minimum value. If this occurs, the next most subordinate tranche of CMBS holders will become the controlling class. Servicing control can shift from the most junior investor upward in the capital stack as a result of an appraisal. A “control appraisal event” will occur if, following application of “appraisal reductions” from the bottom tranche of the mortgage loan upward through the capital stack, the current controlling holder is not deemed secured in an amount at least equal to 25% of its portion of the loan balance. Appraisal reductions are calculated, generically, by comparing 90% of the appraised value of the property, on the one hand, to all amounts owed on the related loan and all expenses to be reimbursed from the loan or the collateral, on the other. If 90% of the value is insufficient to pay all such amounts, then the negative difference is called an “appraisal reduction amount.”
As mentioned above, one right of the controlling class is the ability to terminate and replace the Special Servicer with a new Special Servicer. Another right is the power to approve or disapprove certain actions taken by the Special Servicer. For example, unless it has obtained the consent of the controlling class, the Special Servicer may not commence a foreclosure, accept a discounted loan payoff, or modify the monetary terms of a loan. However, there is an exemption to the requirement that the Special Servicer obtain the consent of the controlling class to these actions. The Special Servicer can take any action, without the advice and consent of the controlling class, if taking such action is required to comply with the “servicing standard.” We will outline the servicing standard more fully in a later article, but it requires the Special Servicer to act in the best interests of all CMBS holders, not just in the best interests of the controlling class. The Special Servicer may employ the servicing standard as a shield to disregard any direction from the controlling class that the Special Servicer believes to be solely in the best interests of the controlling class and thus in violation of the servicing standard. The terms of the servicing standard are set forth in the PSA, which as mentioned above, acts as the governing document for the rights, duties, and limitations of the trustee, servicers, and CMBS holders. The servicing standard requires the Master Servicer and Special Servicer to act in the best interests of all CMBS holders.
In a later article, we will examine the specific steps in a typical CMBS workout (presuming there are any “typical” workouts!). For now, suffice it to say that on that day several years ago, when the hotel owner signed loan documents for a new hotel mortgage with a CMBS lender, it is unlikely that the borrower had any real idea of the complex, sometimes arcane, world of lending that would ultimately envelop that loan. However, with some understanding of who the parties are on the lenders’ side of the table, what challenges they face, and the rules governing their actions, plus a lot of patience, usually a satisfactory resolution to a hotel workout can be achieved.
Michael T. Sullivan is Managing Director of HVS Capital Corp., joining HVS in June 2001. Previously, he served as Managing Director of Sonnenblick-Goldman, which he joined in 1974. During his career, he has been responsible for the financing and sale of more than 650 hospitality properties (hotels, resorts, golf courses, and shared ownership) and for completing, on average, roughly $1.0 billion per year in debt and equity transactions in hotels/resorts nationwide. In his current position, he oversees a staff of hospitality banking professionals, all of whom are involved in the origination and placement of debt and equity realty assignments, with a primary focus on the Lodging and Leisure Industry. Mr. Sullivan attended the University of Arizona, where he received a degree in accounting and marketing. He is a Certified Instructor for the National Apartment Association and a frequent speaker for the Colorado Apartment Association, BOMA, and other trade real estate groups.
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