Our CMBS due diligence practice has been red hot since Valentine’s Day. What makes me excited is that we have seen a brisk business from ten shops. There have already been three successful CMBS bond issuances this month totaling over $2.5 billion and another 4 issuances have just been announced that total over $4 billion.
$55 billion dollars in CMBS debt is due to role in 2012 and that does not count some of the paper that was scheduled to role in 2010 and 2011 and has not yet refinanced or sold. The bottom line is that everyone knows this should be a good year, but if you are willing to look at due diligence books as a leading indicator, I am here to say that it is happening.
I don’t know if we are calling this CMBS 2.0 or CMBS 3.0, but as with software upgrades we try to do things a little better with each iteration. This blog is an opportunity to discuss how due diligence is different.
My partner, Charlie Tallinger recently blogged about the importance of the recent Commercial Real Estate Finance Council (CREFC) guidance documents for the underwriting of commercial real estate loans that are originated with the intention of being packaged and sold as CMBS.
- CREFC – Principles-Based Underwriting Framework (December 2010); and
- CREFC – Model Representations and Warranties (March 2011).
The Underwriting Framework document serves to encapsulate CREFC’s views and suggestions on conformance with Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Specifically, the Dodd-Frank Act directs federal banking agency regulators to craft underwriting standards “that specify the terms, conditions and characteristics of a loan within the asset class that indicate a low credit risk with respect to that loan.”
The Model Reps and Warranties document generally serves to provide an industry standard that will conform with Section 943 of the Dodd-Frank Act and the new SEC Exchange Act Rule 17g-7 which require that credit rating agencies (CRAs) include in any ratings report descriptions of the representations, warranties, and enforcement mechanisms available to investors in the offering as well as a comparison to the representations, warranties, and enforcement mechanisms in “similar issuances.”
Guidance for CMBS on Seismic Risk Management
The CREF Model Representations and Warranties are shaking up the industry as they require an architectural or engineering consultant has performed an analysis of each of the Mortgaged Properties located in seismic zones 3 or 4 in order to evaluate the structural and seismic condition of such property, for the sole purpose of assessing the probable maximum loss (“PML”) for the Mortgaged Property in the event of an earthquake. In such instance, the PML was based on a 475�]year return period, an exposure period of 50 years and a 10% probability of exceedance. If the resulting report concluded that the PML would exceed 20% of the amount of the replacement costs of the improvements, earthquake insurance on such Mortgaged Property was obtained by an insurer rated at least “A:VIII” by A.M. Best Company or “A3” (or the equivalent) from Moody’s Investors Service, Inc. or “A�]” by Standard & Poor’s Ratings Service in an amount not less than 150% of the PML.
Guidance for CMBS on Environmental Concerns
The specific sections of these documents that outline how environmental issues are to be handled are abstracted below.
CREFC – Principles-Based Underwriting Framework – Environmental Related Expenses
An underwriter must engage a qualified environmental engineer to prepare a Phase 1 environmental assessment as defined by the American Society of Testing Materials (ASTM) E1527 – 05. If issues of environmental concern are identified by the Phase 1 consultant, an underwriter may:
- Require additional investigation in the form of a Phase 2 Assessment as defined by ASTM E1903-11;
- Require that the issues identified be remediated prior to or subsequent to loan closing (the underwriter generally requires the establishment at closing of an environmental escrow to cover the costs of any post-closing remediation);
- Require that the borrower implement an operations and maintenance (O&M) program (in the case of properties with manageable asbestos or lead-based paint);
- Implement an environmental insurance policy; or
- Withdraw or reduce the amount of the proposed financing.
The offering documentation should detail the amount of any upfront or ongoing reserves required for environmental remediation.
CREFC – Model Representations and Warranties – Environmental Conditions
If a material noncompliance with environmental laws or the existence of a recognized environmental condition is indicated in the Phase 1, then in order for the loan to comply with the Model Reps and Warranties document one of the following statements must be true:
- 125% of the funds reasonably estimated by a reputable environmental consultant to be sufficient to cover the estimated cost to cure any material noncompliance with applicable environmental laws or the environmental condition has been escrowed by the related mortgagor and is held by the related lender;
- If the only environmental condition relates to the presence of asbestos-containing materials and the Phase 1 only recommends the implementation of an O&M Plan then such a plan has been implemented by the mortgagor;
- The environmental condition identified in the Phase 1 has been remediated or abated and a no further action or closure letter has been obtained from the applicable governmental regulatory authority;
- An environmental policy or a lender’s pollution legal liability insurance policy that covers the liability for the identified circumstance or condition was obtained from an issuer rated now less than A- (or equivalent) by Moody’s, S&P and/or Fitch [there is an entire paragraph that outlines the specific requirements that the insurance policy must meet];
- A party not related to the mortgagor was identified as the responsible party for such condition or circumstance and the loan seller has reasonably estimated that the responsible party has financial resources adequate to address the situation; or
- A party related to the mortgagor having financial resources reasonably estimated to be adequate to address the situation is required to take action.