By Rushi Shah
With the Fed’s recent and expected rate hikes, hotel owners in search of long-term interest rate savings may wade into the world of commercial mortgage backed securities (CMBS) instead of refinancing through their local bank. The lure of 10-year money without the risk of personal guaranties is strong, but borrowers often hesitate before jumping in because they are intimidated by the unfamiliar CMBS process, are concerned it will be expensive or worry the terms of the loan will be rigid.
Looking under the hood at the mechanics will help dispel common CMBS myths and misconceptions. This will give you a clearer understanding of how the lenders’ and investors’ requirements benefit you, the borrower, and ensure you don’t miss out on what could be the most viable financing option for your hotel’s long-term success.
Fueling the flow of capital
The CMBS ecosystem relies on a symbiotic relationship involving the borrower, the conduit lender and the investors who buy the lender’s pooled mortgages on the secondary market as bonds. Bond investors demand a predictable rate of return and reward lenders who offer pools likely to meet this demand with their dollars. Lenders answer by imposing borrower pre-payment penalties, reserve requirements and cash management to minimize risk, subsequently filling their pipelines with capital to lend. In exchange, borrowers gain access to more attractive financing, including higher leverage, longer terms, no recourse and the ability to take unrestricted cash out.
Concern #1: Pre-paying a CMBS loan is too costly
CMBS loan docs bake in one of two types of pre-payment structures that release the borrower from the mortgage lien prior maturity, while still delivering the same expected yield to investors for the term of the bond. With yield maintenance, borrowers pay to make up for the lost yield for the investors. With defeasance, the property is substituted with similar bond collateral. In a rising rate environment, both structures can be borrower-favorable. Because mortgage rates would always be higher than U.S. Treasury rates, with yield maintenance you could prepay for “free” (subject to any minimum fees) when interest rates rise enough to make up the spread between the current U.S. Treasury/reinvestment rate and the original loan rate. For a defeasing borrower, when interest rates are higher than the loan rate, the substituted collateral will have a higher rate of return than the original loan, making it less expensive to do the swap.
An experienced intermediary can often push a lender to allow yield maintenance instead of the more borrower-cumbersome defeasance. Furthermore, unlike a bank loan, for a 1 percent fee (which your intermediary can usually negotiate lower), the purchaser can take over or “assume” paying down the existing CMBS loan. As rates increase, the in-place loan’s lower rate may attract more buyers.
Concern #2: Reserve requirements are burdensome
To protect investors’ rate of return, CMBS conduit lenders push and pull levers to minimize risk that would otherwise bar borrowers from the closing table. For example, if a hotel PIP is coming due, or historically the property has seasonal dips in cash flow, the lender may require a borrower to set aside ready capital as reserves. These disciplinary savings belong to you and are accessible when you need them, but also assure the lender that your property will weather these costs without cannibalizing your ability to make loan payments. A knowledgeable intermediary may be able to negotiate a lower amount, roll the reserves into the loan so they are financed at the lower long-term interest rate or even devise a more creative loan structure that eliminates reserves altogether.
Concern #3: The cash-management process is too restrictive
CMBS conduit lenders require borrowers to set up a disciplined cash management process to ensure timely payments to meet investor expectations. As long as the property performs, all hotel income will merely pass through a mandated lender-controlled account to the borrower’s operating account. If performance deteriorates below set thresholds for two consecutive quarters, the income is held in the account and any surplus is passed to the borrower after all the expenses to run the hotel are paid, reserves are funded and monthly P&I payments are made. The original flow resumes once performance returns to acceptable levels for an appropriate length of time.
Hotels with good management and consistent income won’t need to worry about triggering this check and balance. If it does become a possibility, your accountant can work with you to ensure expenses are categorized properly. Capital expenditures don’t count towards ongoing expenses.
Concern #4: CMBS fees are too expensive
CMBS financing serves up an appetizing mixture of term, leverage, risk management and cash out. Banks may combine one or two benefits together, but rarely offer all without recourse. As a trade-off, the CMBS due diligence process requires more thorough (and subsequently expensive) reports for appraisals and environmental assessments. Further, because CMBS conduit lenders aren’t protected by borrower personal guaranties, their legal needs are more extensive and the subsequent fees passed onto the borrower are higher.
Don’t let initial sticker shock cloud your long-term judgement, however. These one-time costs are amortized over the 10 years of interest rate savings your CMBS financing will enable, and the benefits of the cash you take out. While the costs of a bank loan may be lower now, you’ll end up paying them all over again when you refinance in five years.
Concern #5: The CMBS transaction is too exhaustive
Using an experienced and knowledgeable intermediary with deep lender relationships is especially critical for a CMBS loan; significantly improving both the execution and quality of your financing. Most CMBS conduit lenders won’t work directly with borrowers, preferring to refer to an intermediary with whom they have closed a loan in the past. Your intermediary should maintain control of the process, aggressively negotiate on your behalf and mitigate any issues that arise.
For borrowers who are organized and responsive to lender documentation needs, a CMBS transaction can actually take less time than a bank loan. Using an attorney with CMBS experience will also streamline your transaction and keep your costs down. Successfully closing a CMBS loan transaction puts you in a different league with other sophisticated borrowers who have recently completed a deal. ■
Rushi Shah is CEO at Conlon Capital, a commercial mortgage banking firm formed by a merger with Aries Capital, which specializes in CMBS and other non-recourse lending solutions. Over the past 26 years, the Conlon and Aries teams have collectively funded over $8B for hotel, multifamily and other commercial properties. Shah held previous positions at Northern Trust and is a member of AAHOA’s Founding & Allied Member Committee. Shah holds an MBA from The University of Chicago’s Booth School of Business.