By Shawn Hill and Charlie Marshall
It’s little wonder why CMBS loans—those made with the express purpose of being packaged and sold in commercial mortgage-backed securities transactions—are a popular choice today among sophisticated self-storage borrowers. After all, the ability to lock in to historically low fixed rates for 10 years is a savvy move. Furthermore, CMBS lenders are willing to offer extended amortization periods of 30 years, often with an interest-only period during the initial term of the loan. This can translate to significant additional cash flow for the investor. Finally, the nonrecourse nature of these loans insulates the borrower from personal liability, which helps keep contingent liabilities on the balance sheet to a minimum.
CMBS lenders also structure transactions with which many bank and other recourse lenders may struggle, a creativity that often makes these lenders the “go to” on transactions with special needs. For example, CMBS lenders generally have no issue financing transactions with a significant “cash out” of equity to the borrower (a deal point that creates concerns for many traditional balance-sheet lenders) and structuring deals that may have had a “troubled” past. Additionally, some borrowers may be asset-rich and cash-poor. A lack of liquidity can be a high hurdle for many traditional lenders but isn’t overly problematic for CMBS lenders.
One aspect of CMBS lending many borrowers find onerous is the extensive legal aspects and associated costs of these transactions. They struggle to make sense of the CMBS lender’s legal bills and have a hard time understanding why the legal requirements are so complex.
This article is the first in a series intended to better educate self-storage investors on CMBS legal requirements and terminology. It focuses on the single-purpose entity, commonly known as an SPE.
Requirements
To take advantage of the favorable economic terms provided by CMBS loans, the borrowing entity and collateral must satisfy several basic elements that may be more rigorous or structured than other loan sources. While some flexibility exists for smaller-balance loans, particularly if good sponsorship or lower leverage, think of the requirements as the loan-closing formula.
Any lender, whether a community bank, life company or CMBS originator, prefers that its borrower only own the financed property. CMBS lenders impose more formality and mandate a “bankruptcy-remote” borrower: An entity structure that minimizes the risk that a borrower will be subject to a voluntary or involuntary bankruptcy proceeding or adversely affected by the negative credit of an affiliate. Based on decades of real estate bankruptcy experience, the SPE requirements must be reflected in both the loan and entity organizational documents.
The SPE requirements impose several limitations on the borrower, including:
- The legal purpose of the borrower must be limited to owning, leasing and operating the property, which is security for the first-lien mortgage financing.
- The borrower is prohibited from 1) guaranteeing any obligation of any affiliate; 2) incurring any additional debt other than limited unsecured trade payables in the ordinary course of business; and 3) filing any bankruptcy or insolvency proceeding without the unanimous written approval of all of its owners.
- The borrower must be operated separately from all affiliates, which means it must 1) maintain separate books and records and bank accounts; 2) prepare and file its own tax returns separate from any affiliate to the extent required by applicable law; 3) conduct business in its own name (with separate stationery, invoices and checks); 4) not commingle its assets or funds with those of any other person; or 5) not pledge its assets to secure the obligations of any other person.
- The borrower must pay its liabilities and expenses out of its own funds and maintain adequate capital in light of its business purpose. Although lenders now generally recognize these covenants don’t require any equity owner to make additional capital contributions to the borrower, or prohibit capital contributions and distributions under the borrower’s organizational documents.
These legal covenants impact the typical closely-held borrower. The requirements apply since the borrower’s formation, not just at the date of the CMBS loan. There can be no additional debt from any other lender, including inter-company loans to the borrower. The borrower must not have previously owned other property or interests in other entities.
Use of an entity that hasn’t been a true SPE during its existence may require either conveyance to a new SPE (and incurrence of transfer tax), or additional diligence, increased pricing and structure. This might include, for example, acceptable inter-creditor agreement, clean environmental report on prior properties and recourse liability.
All borrowers must be structured as either a corporation, limited-liability company or limited partnership. Entity structures such as a general partnership don’t qualify. Depending on loan size (typically more than $5 million), the general partner or managing member of the borrower must also be required to satisfy the SPE requirements. A single-member Delaware Limited Liability Co. as borrower, due to statutory protections not generally available in other states, is a typical exception to the dual-level SPE requirement. Loans above $20 million may also require an independent director/manager to affirmatively consent to major actions, such as filing bankruptcy and a separate bankruptcy non-consolidation opinion.
Compliance with SPE requirements may seem technical and frustrating to borrowers and counsel not frequently exposed to capital-market requirements. However, such requirements should be understandable considering the purpose and risks of single-asset real estate lending and easy to anticipate in planning an investment entity. SPE is, after all, the first element in the closing formula.
In future articles, we’ll discuss additional aspects of CMBS legal documents, including what can actually be negotiated to gain the most favorable terms and flexibility possible on the borrower’s side.
Shawn Hill is a principal at Chicago-based The BSC Group, where he advises clients on debt and equity financing and loan-workout services for all commercial property types nationwide, with an emphasis on the self-storage asset class. For more information, call 312.207.8237; e-mail [email protected]; visit www.thebscgroup.com.
Charlie Marshall is a partner with Alston & Bird in Dallas. He represents commercial real estate lenders, with an emphasis on CMBS loan transactions. He can be reached at 214.922.3503 or [email protected]. Visit www.alston.com.
