Why Owners Should Care About CMBS Loan Servicing
The servicing entity for a CMBS loan can have real bottom-line impact on the financial success of a retail development.
Marty O’Connor

Shopping centers have become one of the top forms of collateral for CMBS loans — thanks largely to the fact that CMBS loans typically offer the best financing terms for the permanent finance of properties with stabilized cash flow. Because CMBS loans require a static collateral pool — you can’t swap properties in and out of the loan — it is easy to believe that the servicing entity is merely an administrative function. But this is a dangerous misconception: the servicing entity not only has limited authority to modify terms, but also can offer financial tools and strategies that may offer you the ability to make your properties more profitable.

As CMBS loan volume has grown over the past decade, CMBS servicing organizations have become more sophisticated in managing the flood of loan originations. Today’s servicers not only collect payments and remit distributions to investors, but also facilitate interactions among borrowers, lenders, investors and rating agencies, as well as providing cash advances to facilitate CMBS bond structuring.

For shopping centers with a large number of small shops, other value-adds can make a big difference. For example, CMBS servicing organizations affiliated with major commercial banks are also able to offer value-added treasury management capabilities. By adding lock-box and cash management services, for example, to a servicing assignment, a servicing organization can augment the business goals of CMBS investors, capital providers and property owners.

Servicing Behind The Scenes

CMBS servicing includes a range of functions, including collection of payments, escrow management and cash distribution throughout the life of the loan. It’s a significant, long-lasting responsibility, given that the average CMBS loan backed by retail sector properties has a term of 10 years or more, and one that requires the backing of a strong financial organization. As the major servicers continue to consolidate, servicing increasingly is the domain of large institutions that can efficiently manage large volumes of loans of varying complexities, and that can afford to invest in current technologies that reduce costs while improving accuracy. This means that whether it is a large regional mall or a series of strip centers, the efficiencies a servicing entity can bring to the table can positively impact both short-term cash flow and long-term performance.

Servicers also manage interaction with outside agencies such as rating agencies, bond investors, including controlling certificate holders, and they must interact effectively with the other servicers related to the servicing assignment, including designated sub-servicers. Since servicers fund advances and are responsible for large sums of cash, those with strong credit ratings are preferred.

Servicers also must provide timely and accurate investor reporting, particularly since many CMBS investors are institutional bondholders with sophisticated internal reporting requirements. Leading CMBS servicers have adopted state-of-the-art technology to expedite record keeping and reporting. This is an important bridge between the Wall Street investor and the local shopping center owner or investor.

Most CMBS loans are supported by three servicers, each with a specific role. The master servicer is responsible for all current (non-defaulted) shopping center mortgages owned by the trust created to hold the CMBS loans with respect to which bonds/certificates are issued to investors (i.e., the securitization of the conduit loans). That entity is generally required to initiate and run the processing of all borrower requests related to consents, waivers, and modifications related to performing loans. The primary servicer acts on behalf of the trust as the main point of contact with the borrower and sometimes takes the form of a sub-servicer reporting to the master servicer. A special servicer is identified upon issuance of the CMBS to service loans in the event of their default.

Shopping Center Developer Misperceptions

While many borrowers are familiar with CMBS loans, the role of the CMBS servicer in the overall retail real estate development process is sometimes misunderstood. For example, while borrowers sometimes perceive servicers as being inflexible, the reality is that even master servicers have some limited authority to modify the terms of a CMBS transaction after it has closed. The good news is that borrowers can build flexibility into their CMBS loan up front if they are able to identify future contingencies, and the resulting CMBS bonds can be rated and priced accordingly. For example, a retail developer who knows they may want to sell a given property in a few years’ time may be able to build in appropriate exit strategies to allow for a sale before the term of the loan has matured.

While negotiating the origination of the shopping center loan, it is important for potential CMBS borrowers to think through the needs of the property over the life of the loan and to identify the features that should be specifically spelled out in the loan documents before the loan is finalized. For example, a shopping center developer should anticipate a potential need for partial releases of the collateral properties and attendant partial loan paydowns. CMBS loans these days are no longer one-size-fits-all, and a variety of loan structures are available depending on the needs of the borrower and the market positioning of the shopping center. However, special terms, such as an interest-only period or the right to future mezzanine funding, must be negotiated into the loan in advance in order for the rating agencies to provide reliable ratings information for prospective bondholders.

Critical to understanding your servicing entity’s role in the process is understanding its primary fiduciary duty. Despite the fact that the loan is originated to provide capital to borrowers, the primary obligation of the servicer is to protect the interests of the CMBS bond investors. In CMBS securitizations, loans of varying sizes, property types and locations are pooled together and transferred into an IRS-qualified trust sometimes referred to as REMIC (Real Estate Mortgage Investment Conduit) trusts. The master servicer’s ability to waive, consent to or modify the terms of any mortgage loan is governed by a “Pooling and Servicing Agreement” (PSA) created along with the trust when the CMBS loans are securitized.

Whether primary, master or special servicer, the servicing entity is required to act in accordance with the applicable PSA. The PSA governs the allocation and distribution of loan proceeds and losses to the bondholders, describes how the loans are to be serviced and includes guidance to ensure that the trust continues to comply with the U.S. federal tax code to maintain its favorable tax treatment.

Borrowers, mainly concerned with obtaining capital at the best terms available and (rightly so!) focused on their own returns, are not always aware that conduits operate under U.S. federal tax laws that help keep CMBS loans affordably priced. The CMBS transaction is priced accordingly, and on the premise that its tax treatment will not be altered.

Naturally, servicers are not likely to accept loan modifications that would jeopardize the tax standing of the trust and/or undermine the economics of the securitization. One such REMIC tax restriction is that the loan pool remains static. There is no substitution of collateral and no material modifications in terms permitted unless specifically provided for in the loan documents or unless a loan default is underway or is imminent, at which point the special servicer is usually the decision-maker on the proposal. Should a shopping center fall into default, the special servicer becomes a very important decision-maker in the workout of the loan — and thus, the future of the shopping center in its economic lifecycle.

Servicers also are restricted or prohibited from allowing changes to loan terms that might affect the credit risk rating of the rated CMBS bonds. The bond ratings, assigned at the time the securitization closes, assume that the credit quality of the loan pool (i.e., the retail center mortgages) will not change significantly over time. Since investors purchase fixed-income bonds according to their appetite for credit risk, yield and duration, any change in a bond’s rating changes the nature of the investment.

With those caveats in mind, borrowers should know that experienced servicers are very good at anticipating whether a borrower’s request for a modification will be problematic or on the other hand somehow can be accomplished. A good servicer may be able to propose alternative solutions that address the borrower’s needs while protecting the interests of the bond investors.

Beyond The Loan

A servicer associated with a major bank can gain a competitive edge by being able to offer full commercial banking services that enhance shopping center property ownership and investment. Such value-added capabilities can include depository services, collection products, including lock-box clearing accounts for implementing cash management agreements between borrowers and lenders (including the CMBS trusts succeeding to ownership of the loans), electronic remote check capture, disbursement solutions, liquidity management, e-commerce solutions and international cash management for global companies.

These capabilities can help an owner or investor in multiple properties nationwide or globally manage their cash more effectively without needing to visit a physical bank branch to conduct business. Treasury management services are especially relevant to owners and investors in multi-tenant retail properties, in which a high quantity of rent checks, property taxes and vendor payments must be processed in a timely fashion.

As the CMBS marketplace continues to evolve, loan originators and servicers, by the effective offering and implementing of their services, will continue to educate retail sector borrowers about the role of the servicer. In gaining an understanding of the rules governing CMBS transactions, a borrower will view their servicer — as they do their capital provider — as a trusted resource, vital to the health and longevity of the CMBS industry.

Marty O’Connor is executive vice president, loan servicing and asset management, for KeyBank Real Estate Capital.

How Flexible Can A CMBS Servicer Be? When a borrower requests a change to a CMBS loan, the servicer’s response is largely governed by the loan’s pooling and servicing agreement (PSA), as well as consideration of the bond rating agency’s perspective. Lenders and shopping center borrowers alike should consider these restrictions when considering a CMBS loan, keeping long-term investment goals in mind. Prohibited in REMIC trusts: • Defeasing a loan within 2 years of the securitization’s closing date • Changing interest rates and amortization payments or otherwise affecting the amount or timing of the loan payments • Making any decision that materially and adversely affects the collateral • Allowing any modification of a loan, i.e., a “significant modification” that would affect the trust’s REMIC tax status Permitted if addressed before securitization: • Releasing a portion of the collateral • Substituting collateral • Undoing cross-collateralized loans • Changing escrow payments • Releasing lease termination payments to the borrower • Allowing casualty and condemnation proceeds for restoration on certain conditions Likely prohibited in loan or servicing documents, and thus prohibited from deviation by the servicer in the REMIC trust: • Prepaying the loan during a lockout period • Waiving or reducing a prepayment premium • Allowing for secondary financing • Releasing a guarantor of non-recourse carve-outs (except for future acts following a loan assumption that brings in new guarantor(s) • Making transfers of property or direct and indirect interests in the borrowing entities without lender consent and proper loan assumption procedures • Entering into or modifying material leases at the property without lender review and consent

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