Probate & Property Magazine
An Introduction to Commercial Real Estate CDOs (Part 2)
By John C. Kelly
John C. Kelly is chief legal officer of Prudential Mortgage Capital Company in Newark, New Jersey.
Part 1 of this article, which appeared in the November/December 2007 issue, introduced the concept of the commercial real estate collateralized debt obligation (CRE CDO). After discussing the brief history of CRE CDOs in the U.S. capital markets, Part 1 provided a side-by-side summary comparison of CRE CDOs with the more familiar commercial mortgage-backed securities (CMBS) transaction. Part 1 continued with an exploration of the basic legal structure and documentation of a CRE CDO, including available tax regimes. This Part 2 completes the introductory discussion of CRE CDOs, focusing on the post-closing role of the collateral manager, including the importance of the collateral manager’s “fully ramping” the deal, the manager’s ongoing reinvestment of proceeds, and the sale and servicing of CRE CDO collateral. Part 2 will continue to employ comparisons between CMBS and CRE CDO transactions in order to provide context.
Collateral and Collateral Management
For the bulk of CMBS deals, collateral and collateral management are relatively easy concepts to digest. First, the collateral consists almost exclusively of mortgage loans that satisfy the Internal Revenue Code’s definition of a “qualified mortgage.” Code § 860G(a)(3). Second, the relevant mortgage loans are identified and included in the deal at closing (and generally remain there, without substitution or material modification, unless the collateral is defeased or the loan paid off). Third, there is no meaningful “asset management” unless a loan goes into default. Loan servicing is undertaken by specified entities under fairly rigid standards, without the exercise of meaningful discretion. Loans that have not been fully funded are not permitted to be included in a CMBS deal. Principal payments that are received are applied against the trust’s outstanding debt, with the most senior bonds being paid first.
Compared to this relatively black-and-white CMBS world, the CRE CDO presents a multi-colored rainbow of collateral types and collateral management rights. As noted in Part 1, permissible CRE CDO collateral includes not only assets that might be included in a CMBS deal such as fixed or floating rate mortgage loans, but also could involve co-ownership or participation interests of varying priorities in such loans, as well as a host of real-estate-related securities. In most CRE CDOs that have included mortgage loan collateral, the loans are floating-rate loans such as bridge or interim loans, B-Notes, and mezzanine debt, with two- or three-year terms (shorter than CMBS loan terms) and relatively brief (12-to-18-month) lockout periods. In the past year or so, a number of deals have been done with 100% or almost 100% loan collateral.
Loans with future funding requirements are often encountered in CRE CDOs because of the transitional nature of many of the assets. Future fundings are permitted if one of several available structures is employed. The rating agencies dictate these structures to address problems that could arise with a borrower and a loan if the lender fails to make a required future funding, thereby creating stress on the project and potentially subjecting the CDO to offset or lender liability claims. These structures typically take one of the following three forms:
• First, the loan may be transferred to the CDO together with the proceeds that would be required if the borrower satisfied the future funding conditions, effectively creating a funded reserve. This approach creates a “negative carry” concern for the collateral manager because the conservative investments in which the reserve funds may be invested are not likely to generate a spread as high as that payable on the associated CDO bonds.
• A second approach is for the future funding obligation to be held outside of the CDO, with the funding obligor providing a guaranty and indemnity from an appropriately rated entity. Generally, indemnity documents must provide for collateralization of the obligation, or the replacement of the guarantor, if the funding obligor does not maintain a required rating.
• Finally, the rating agencies may also accept a direct indemnity from a funding lender that is not adequately rated, provided that it is coupled with an agreement from the borrower that it will not seek the future funding from the CDO issuer and that it waives any set-off or other rights against the CDO if the funding does not occur. Recently, this third approach has been limited to deals with small buckets of future funding loans (5% of the pool balance, for example), unless the collateral manager also includes some sort of additional enhancement, such as a reserve (which may to some extent be funded over time from proceeds otherwise payable to the CDO equity holder), a letter of credit, or access to a line of credit.
If the funding obligation is not acquired by the CDO, such as in the second and third approaches above, the future funding lender must acquire its participation interest in the loan before
In CMBS transactions, the collateral pool is identified at closing and will remain the same during the life of the deal. In many CRE CDO deals, the final collateral pool has not been fully acquired (or even identified) at closing. Although bonds are still sold in anticipation of acquisition of the remaining assets (which allows the deal sponsor to spread the transaction costs over a somewhat broader base), the collateral manager must undertake a “ramp period” of approximately six to nine months to “fully ramp” the deal. For example, it would not be unusual for $500 million of bonds to be sold, even though the CRE CDO might have acquired only $450 million of assets. The remaining $50 million of collateral would need to be acquired during the ramp period.
Getting fully ramped is very important to a collateral manager because, under the indenture, the funds received from the bond issuance at closing can be invested only in very conservative investments, leading to what can be a meaningful negative carry situation for the collateral manager during the ramp period. If the manager does not achieve the ramp, the negative carry continues until the collateral manager’s first opportunity to redeem bonds, generally not until two years after closing. Getting “ramped” can be a real challenge, as the collateral manager must not only acquire the collateral needed to achieve the ramp, but must also replace any assets that may have been paid off unexpectedly during the ramp period. The short-term, floating rate nature of most of the loans makes payoffs fairly commonplace and somewhat unpredictable. In addition, if the CRE CDO is not structured as a REIT, the required seasoning period for affiliate acquisitions can dramatically reduce the actual time available to identify assets.
Collateral Quality Tests
On achieving a full ramp, the collateral manager must seek final confirmation from the rating agencies of the ratings that were originally assigned to the CDO’s bonds. Among other things, this process requires the collateral manager to prove up the collateral pool’s compliance with the various constraints negotiated with the rating agencies, including all of the collateral quality tests (CQTs). The CQTs are portfolio tests that are designed to assure that the collateral pool maintains certain critical characteristics during the life of the transaction, most of which are focused on the quality and diversity of the pool. For example, most transactions will contain limits on the amount of the pool that can involve any particular asset type (such as CMBS, whole loans, and mezzanine loans), property type (such as office, retail, industrial, multi-family, or hospitality types), geographic location, vintage, and issuer or borrower. Within a particular limit, such as asset or property, sub-limits or “buckets” can be very detailed. The author is aware of a recent CRE CDO that contained a significant amount of loan collateral. In that transaction, the portion of the collateral pool secured by multi-family, office, retail, hospitality, and health care properties was limited to 70%, 50%, 40%, 25%, and 25%, respectively, with a sub-limit on health care loans that involve assisted-living or skilled nursing properties of 10% (or 40% of the allowable health care bucket). Other critical CQTs include a maximum weighted average ratings factor (WARF), which is Moody’s metric for assessing credit quality or collateral “riskiness”; a minimum weighted average spread (WAS) for floating-rate assets, or weighted average coupon (WAC) for fixed-rate assets, which seek to mitigate the risk that the cash flow from the collateral will not cover the CDO’s required payments to bond investors; a weighted-average life test; and a minimum Herfindahl score (Moody’s measure of collateral diversity).
Reinvestment of Proceeds
During the reinvestment period, which typically lasts for five or six years, the collateral manager is permitted to reinvest principal collected from the collateral pool cash flow in new assets, provided that all of the relevant tests have been met, including over-collaterization and interest coverage tests (discussed below) and the CQTs. Before acquiring a particular asset, the collateral manager must also determine that the asset satisfies a lengthy list of specified “eligibility criteria,” which can impose meaningful constraints on the type of assets that can be acquired. Some requirements are fairly general, such as the requirement that each asset be rated by the applicable rating agencies (which includes a requirement for a “shadow rating” of each new loan) and that each asset be secured by or related to commercial real estate. Other criteria can include very specific constraints such as limitations on the term of an individual loan or even on the terms of the underlying loans that are backing any CMBS or other CRE CDO bonds included in the collateral pool.
Just as in the ramp period, during the reinvestment period, the collateral manager also has a significant economic incentive to promptly invest any available proceeds because of the negative carry that the “under-invested” cash can create. It is possible that market conditions can change sufficiently during such a lengthy reinvestment period, so that the collateral manager may determine that satisfactory collateral cannot be identified and acquired. In such event, if certain rating agency conditions are satisfied, the collateral manager may be able to elect a “special amortization” that allows the application of such principal to effect an optional pro rata redemption of CDO bonds (as opposed to a less favorable, and more customary, sequential paydown, which requires payment on the senior bonds—the least expensive financing—first).
Sale of CDO Collateral
Together with its reinvestment rights, the CRE CDO collateral manager generally enjoys the right to sell defaulted and credit-impaired collateral. In more recent deals, the manager also has obtained the right to sell some or all of the collateral whose credit has improved, with the proceeds that exceed the asset’s par value either being reinvested (thereby increasing the transaction’s collateralization for the benefit of the CDO investors) or, in some instances, distributed as interest through the CDO payment waterfall. (Such distribution may be perceived by some investors as inappropriate “leakage” of cash flow from the structure because, if there are no asset issues, the funds will most likely be characterized as excess interest, distributable to the equity holder.) Increasingly, collateral managers also are being given the right, on a discretionary basis, to sell certain collateral for any reason or no reason, subject to strict limitations on the amount of the collateral pool (often 15% or less) that can be so transferred in any single year. Although in the past this discretionary transfer right was granted only for securities, more recently it has expanded to include loans and interests in loans.
A frequent borrower complaint about CMBS transactions is how inflexible the loan servicer can seem when confronted with what appears to be a very reasonable request for modification of the loan terms. The perceived rigidity of the servicer is often a result of the servicer’s need to satisfy the REMIC rules that govern almost all CMBS deals, particularly the rules governing mortgage modifications. See Treas. Reg. § 1.860G-2(b). In an effort to insulate itself from the adverse effects of “blowing the REMIC,” a CMBS servicer will generally proceed very conservatively in considering modification requests. Operating outside of a REMIC overlay, the CDO collateral manager and loan servicer have much greater flexibility to address unexpected borrower needs, so long as the actions that they take are consistent with the negotiated servicing standard.
Applicability of Adviser’s Act
In addition to mitigating the tax concern that an affiliated originator is not a “conduit” for the CDO, the presence of an independent advisor on the CDO’s advisory committee also assists in addressing the Investment Adviser’s Act concern that advisers not engage in “principal trades.” 15 U.S.C. § 80b-6(3). The CDO model certainly does not resemble the typical Adviser’s Act client/adviser relationship, and the Act’s applicability to CDOs is not altogether clear, so most institutional collateral managers have taken a conservative approach and incorporated a requirement for the approval of an independent member in asset acquisitions from affiliates. Although the potential for a variety of conflicts of interest clearly exists in a CDO structure, including the fact that assets may be acquired for the CDO from parties related to the collateral manager, these conflict scenarios are fully disclosed to all investors in connection with the bond offering. All investors are required to acknowledge the potential conflicts in connection with their acquisition of CDO bonds. The presence of an independent party that approves such affiliate transactions provides some additional comfort against subsequent challenges.
Structural Protections for Investors
In CMBS transactions, the cash flow generated from the underlying mortgage loans is distributed through a waterfall that makes clear distinctions between interest and principal. Interest payments are applied to pay fees and expenses, and then current interest due and payable to the various classes, starting with the highest-rated (AAA) bonds and moving down the waterfall. Principal payments are applied to reduce outstanding principal, with the most senior class being paid first until it is paid in full and subsequent classes being treated similarly. Excess interest that is not needed to pay interest on the bonds is sold to investors as a separate “interest only” (or I-O) bond. If cash flow from the underlying loans is not sufficient to pay the interest on the bonds, the master servicer will typically advance the necessary amounts to keep the interest payments current, subject to certain conditions, including a determination by the servicer that the advances will ultimately be recoverable. Principal losses that are experienced on the underlying loans are borne by the first-loss class (the “B-piece” buyer), until its interests are extinguished and then by the next-lowest-rated class.
A CRE CDO structure also has distinct interest and principal waterfalls, but cash flow may be used interchangeably to address cash flow shortfalls that result in breaches of the over-collateralization (OC) and interest coverage (IC) tests. The OC and IC tests are structural protections that provide additional credit enhancement to CRE CDO investors. The tests are applied at different levels of the CDO’s waterfall. The OC test is intended to measure the relative leverage of the CDO, comparing its assets to its liabilities, and seeks to ensure that a specified minimum amount of collateral is available to secure the rated notes. The OC of a CRE CDO is generally measured by dividing the net outstanding portfolio collateral balance by the sum of the par value of the bonds that are pari passu or senior to the tranche for which the test is named. For example, most CDOs have OC triggers set for the A/B classes (generally, the AAA and AA bonds), the C/D/E classes (A through A- bonds), the F/G/H classes (the BBB bonds), and the J/K classes (the BB bonds), with each trigger being set progressively lower. The IC test seeks to measure the debt-servicing ability of the CDO, comparing the interest due from its assets with the interest payable on its liabilities, and IC is normally measured by dividing the current period’s interest collections from the collateral less any net hedge payments, senior expenses, and fees by the current period’s accrued interest on the bonds that are pari passu or senior to the tranche for which the test is named.
Interest proceeds from the CDO assets are applied to pay current interest due on the bonds in sequential order (the AAA bonds first, then AA, and so on), as long as the OC and IC tests are being met. If an OC or IC test fails, the available cash flow is diverted from its normal course down the waterfall and used to “de-lever” the transaction by paying down principal on the most senior tranche of debt until the test is cured or the class is repaid, with similar treatment for the next-most-senior tranche and so on. Principal proceeds also are applied sequentially, again as long as the OC and IC tests are met. If the interest diversion noted above is not sufficient to cure a breach of the OC or IC tests, principal that would have otherwise been available for reinvestment by the collateral manager may be diverted as needed to redeem bonds until the coverage tests are satisfied.
Advancing requirements are also different in a CDO structure. In a CMBS transaction, all of the collateral consists of loans and the standard structure requires that the master servicer agree to advance debt service, and other amounts that go unpaid by borrowers, to assure that the CMBS bondholders receive the payments due on their bonds. Some of a CRE CDO’s assets, in particular any CMBS securities, may already have access to advancing benefits through the underlying CMBS transaction of which they are a part. If the CRE CDO has large amounts of non-CUSIPed collateral that does not have master servicing advancing (most mortgage loans, for example), an advancing agent will be required in the indenture. If cash flow is insufficient to pay the CDO bond coupon, however, the specified advancing agent is only required to advance the interest that is payable on those bonds that are “non-PIKable,” which are generally just the highest-rated classes, those rated AAA and AA. The remaining bonds are considered “PIKable” and the unpaid interest is “paid in kind” (PIKd), either in the form of additional bonds or by an increase in the principal balance of the existing bonds, essentially capitalizing the interest shortfall.
Payments on the CDO’s equity are made from excess spread only after the payment of the interest on the CDO’s issued bonds and its other expenses. For this reason, the cash flow diversion that occurs if the OC or IC tests are not satisfied comes at the expense of the equity holder, with a consequent reduction in its expected returns.
With the continued growth in CMBS volume, which topped $200 billion in 2006, and the recent surge in the issuance of CRE CDOs, especially actively managed deals involving loans rather than securities, securitized lending is on the brink of becoming perhaps the principal means of financing commercial real estate, further advancing the move “from Main Street to Wall Street” that commenced in earnest just 10 or 12 years ago. Real estate lawyers who have only recently familiarized themselves with conduit lending and CMBS transactions now confront the additional challenge of unpacking yet another complex financial structure, the commercial real estate collateralized debt obligation.