GRAPEVINE, TX—When I created the CMBS assumption expediting role in 2005, the primary reason CMBS assumptions didn’t end up closing was because the approval process took too long, plus the buyer and seller had no way of understanding where the file was at any given time. The assumption approval process was described by most buyers and sellers as a “big black hole” and the approval process often took as long as it would to have a baby.
Flash back to 2003
The Mortgage Bankers Association performed a survey of the industry in 2003 to rate borrower satisfaction with different lending types (bank loans, FHA loans, CMBS loans, etc.) and to no one’s surprise, CMBS loans were rated the worst. AND within the CMBS lending type, an assumption was rated as the worst experience ever. The main reason cited then was length of time for approval and the “big black hole” theory.
Fast forward to 2017
The primary reason CMBS assumptions don’t close now is not due to the length of time to obtain approvals, but rather, because of the conditions placed upon the buyer as part of the approvals. Mind you, the approval process is still lengthy and can feel like a “black hole,” but there are other, more problematic issues that cause a CMBS assumption to not close.
Here are the top 7 reasons CMBS assumptions don’t close in 2017:
1. Loan to purchase price. Some special servicers are requiring the loan to “value” (“LTV”) be equal or less at the time of assumption than what it was at origination of the loan. Let’s say a property was appraised at $30 million in 2015 and a new 10-year CMBS loan was made at 75% of the appraisal, or $22.5 million. The property is being sold in 2017 for $28 million. To retain the 75% LTV from origination of the loan, the loan balance would only be $21 million. In this instance, the buyer assuming the existing loan will be required to deposit $1.5 million (the difference between the 75% LTV loan amount at origination of $22.5 million, and the 75% LTV of current $28-million purchase price; $21 million) into a reserve account to be held by the servicer until payoff of the loan in 2025.
CMBS loans cannot be paid down, so the $1.5 million cannot be used to pay down the loan, but will simply sit in a reserve account untouched for the remainder of the term of the loan. This one condition kills many assumptions as it kills the return on investment for the buyer of the property; especially in more severe cases where the reserve is higher.
2. Increase in reserves. Most people know by now that an assumption of the loan is a time for CMBS servicers to re-assess the adequacy of the reserves, but many people do not understand the magnitude of the potential increases being required. Let’s say a 10-year CMBS loan was originated in 2015 and at that time, had sufficient reserves according to all the parties involved in the original loan. The property is being sold and assumed by a buyer in 2017. Let’s assume some of the tenants on the property have a lease expiring in 2018.
The servicers will review all roll-over between the assumption date and maturity and want to ensure that all future potential tenant improvement and leasing commissions are in reserve at the time of closing of the assumption. AND, the servicer will use a market term for a lease, so they may assume the lease will roll twice during the remaining life of the loan! These new reserve requirements often have the net effect of the buyer backing out of the transaction. The real problem then is that the seller will encounter this same issue with the next buyer and may be virtually unable to sell his property.
3. Non-recourse carve-out guarantors. If the servicer has a ‘warm body’ as the current carve-out guarantor for the CMBS loan, they will likely not look too keenly on replacing that with an entity of some kind. Servicers are pushing back on this, hard, and are almost demanding the buyer put up a warm body as the replacement carve-out guarantor. If the buyer has a structure that does not allow a warm body as the replacement guarantor, like a REIT, the “cost” of replacing a warm body with a fund will be expensive.
Most often, the servicer will demand the new entity maintain a minimum net worth, and liquidity, at all times after the assumption is closed, and the minimum net worth is typically significantly more than the loan amount being assumed. They often will also require a springing warm body in the event the fund falls below the minimum net worth test. This means the buyer is required to identify one or more warm bodies to serve as the springing carve-out guarantor(s) and the servicer must underwrite those warm bodies at the time of the underwriting of the assumption.
4. Controlling Class Representative (CCR). The CCR, the holder of the lowest rated bond position in the investment stack, is the last approval party in the long chain of approvals required on a CMBS assumption. Prior to CMBS 3.0, the CCR rarely got involved in assumption requests/consents, let alone added new conditions when the file got to it. The conditions placed by the master servicer and special servicer were deemed sufficient for its approval.
In the later vintage CMBS pools, the CCR has demonstrated a higher level of involvement in the approvals and often places its own conditions on the approval. So, practically speaking, the buyer will negotiate conditions placed by the master servicer and then again negotiate conditions placed by the special servicer thinking the conditions are final, and yet, it isn’t over yet! Until the CCR has finished its review and issued its approval, the conditions are not final! This catches most buyers off guard and the added conditions in the 11th hour often result in a dead deal.
5. Foreign buyers. Seventeen percent of all commercial real estate purchases in 2015 were from foreign investors; yet foreign investors cannot assume an existing CMBS loan—unless the foreign investor has previous US real estate experience with like property type and US-based fixed assets. Foreign investors looking to make their first purchase in the US will likely not qualify for the assumption of a CMBS loan. Many sellers do not know this and start the assumption process believing the buyer will qualify due to its/their financial strength, only to find out much later in the process that the deal will not be approved.
6. Crowdfunding. The definition of crowdfunding is “the practice of funding a project by raising many small amounts of money from a large number of people.” Regardless of what you call the buying entity, the servicers will require at least one, large, “deep pocket” investor who owns a controlling interest in the borrower. A seller may believe it is selling the property to a REIT, only to find out the REIT is structured like a crowd funded deal and the approval will not be granted. Any structure without at least one, large, “deep pocket” investor will likely not be approved.
7. Cash management. Most buyers planning to assume an existing CMBS loan believe cash management will not be required if cash management is not in place today. Nothing could be further from the truth. Cash management is often being added as a condition to the assumption approval due to any of the following reasons: (a) seller is perceived as stronger than buyer financially or experientially, (b) buyer’s credit history on its commercial real estate portfolio is less than stellar, (c) an entity will be the new carve-out guarantor and a warm body is in place with the seller, or (d) any other reason the servicer deems appropriate.
The process of getting CMBS assumptions approved is DRASTICALLY different than it has been in the past. New standards of underwriting, additional approval authorities, harsh new conditions of consent and significant negotiations can cause many proposed deals to “fall out” before reaching the closing table.
It is no longer the days of “perfunctory” reviews and approvals. While some of these “deal killers” are set in stone and are virtually impossible to overcome, some can be dealt with in an effective manner, IF you know how to approach it. Experience in the new and “improved” assumption process can be the most effective way of ensuring a successful transaction.
Whether you hire a consultant to assist you with the process, or spend time talking with someone who is a veteran of the latest trends in CMBS assumptions, don’t go into the fight “unarmed” thinking you can easily make your way to the finish line.
Ann Hambly is founder, president and CEO of 1st Service Solutions, based in Grapevine, TX. The views expressed here are the author’s own.