Looking back over the last two decades, commercial real estate finance has gotten more complex, but also smarter. CMBS has imposed some unusual measures and discipline. Federal law has played a role too.
If you just look at basic mortgage loans, not much has changed. Each loan still starts with a promissory note, a security interest in real estate and a package of promises to protect the lender's collateral and maximize the likelihood of repayment. Traditional rights and remedies for lenders remain, relatively unscathed by creative arguments made by borrowers and their counsel when deals have gone bad. We still deal with the recording system, the antiquated legal principles that go with it, lien priority and (in New York, at least) a mortgage recording tax. Our documents continue to grow to handle nuances of these traditional and often cumbersome concepts.
But many other things have changed in major ways, and may change in more ways as a result of the unexpected outcome of the November election.
September 11 spawned federal concern on terrorism and money-laundering. The results: new due diligence requirements and delays and new verbiage and disclosures. But deal structures and documents remained about the same.
The 2008 financial crisis led to a spate of new legislation, still working its way through the regulatory and deal-burdening process. That's not necessarily bad, because the federal government ultimately bears the risks of the entire banking system. Remember TARP?
Dodd-Frank, Basel III and today's risk retention regulatory environment have led domestic banks to tighten their purse strings and reduce their risk tolerance. That now suffocates credit decisions on a macro and micro basis, as never before. The new Administration may dial back some of that, but we won't know for a while. For now, the ever-growing regulatory burden on banks has created an opening for less regulated – shadow – lenders, such as private equity or hedge funds, to make first mortgage loans, a business the banks once owned.
Those alternative lenders didn't noticeably exist in real estate 20 years ago. Now they're here to stay. They covet most commercial real estate loans and virtually every asset class. They aren't afraid of their shadows, or the regulators. Today's market gives them ample opportunities.
Alternative lenders are not constrained by regulation. Nor are they necessarily as wary as conservative banks about an ebullient real estate bubble that may be about to burst. Their investment committees are nimble. They offer more loan proceeds – though at higher cost – and compete aggressively for virtually every loan. They can execute swiftly, forcefully and reliably, and they do. All of this makes them a "go-to" source for acquisition and development capital, even at higher (albeit still unthinkably low) interest rates.
Alternative lenders have no fear of the "loan to own" end-game strategy in a cyclical real estate market heading toward a soft landing, perhaps. They welcome it. They lend for it. Twenty years ago, the last thing an institutional portfolio lender – largely banks and insurance companies, the only game in town – wanted to own was its collateral. Alternative lending sources do not have that institutional reticence, at all. That is new.
They view a loan as just a variation on an acquisition, with the alternative possibility, entirely acceptable, that they will get their money back with interest. That mindset is also new.
Hedge funds, private equity funds, mortgage REITS and real estate developers' lending affiliates – regulation-free, risk tolerant and opportunistic – have spread like wildfire in real estate finance. This phenomenon is completely new versus 20 years ago. It changes how real estate loans are originated and enforced. It's here to stay.
As yet another burden on banks, half a decade after the financial crisis the regulators implemented new risk-based capital reserve requirements for high volatility commercial real estate ("HVCRE"), under Basel III, effective January 1, 2015. Those new rules affect acquisition, construction and development loans – and, as a result, most new projects – monumentally. If a loan counts as HVCRE, it's extraordinarily expensive for any traditional institutional lender to make. That lender probably won't make it at all.
To avoid HVCRE classification, before the lender advances a dollar, the borrower must invest in cash at least 15 percent of the "appraised as completed" project value. Land appreciation does not count. If the borrower paid $3 million for a site now worth $50 million, only the $3 million cash investment counts toward the required 15 percent. This runs totally counter to the usual logic of construction lending, which treats land appreciation as part of the borrower's "equity" in the project.
HVCRE regulations also say the borrower must keep its cash investment in the project "for the life of the loan" – whatever that means (completion? stabilisation? conversion to permanent financing? maturity?). The whole thing represents a total "reset" of construction finance, another reason to expect hedge funds and private equity to push aside commercial banks in that universe. Perhaps having a real estate developer as President will introduce some practicality to these new rules, but it's too soon to tell.
After the financial crisis, we heard that CMBS 2.0 would be more rigid and conservative. The new risk retention rules under Basel III, which take effect on Christmas Eve 2016, are changing how we view CMBS, and its pricing and profitability, every day. Smart investment bankers and their smart counsel are creating in each new CMBS transaction new ways for the originator to "hold" on its balance sheet 5% of the debt. The mortgages themselves aren't all that different, though.
Commercial real estate lenders and lawyers also need to deal with workouts and foreclosures, which have ebbed and flowed over the years. Although all documents and deal structures must fully cover the possibility that the borrower will default, the actual frequency of defaults has stayed low, even in the financial crisis.
At one point not too long ago, borrower defaults often led to borrower bankruptcies, where the lender's lien would be "crammed down" to equal the temporarily impaired value of the collateral, with any future upside belonging to the "reorganized" borrower. In the last decade or two, that risk has become almost irrelevant, because lenders learned to demand that the principals of real estate borrowers agree to assume full recourse for the loan if a borrower filed bankruptcy or committed other "bad acts." Until then, single asset real estate bankruptcies were a way of life in distressed real estate. We lived through them, and counseled around them. The bankruptcy was filed – it was an obligatory (some would say automatic) borrower tactic – to avoid receivership or to stop foreclosure, often for years and causing great pain to lenders. For fully non-recourse loans, the "shield" of bankruptcy protection became a weapon, wielded often and very successfully in court and in negotiations.
That changed completely with the advent of non-recourse carve-out guaranties. We now see these guaranties in virtually every commercial real estate loan, even if otherwise non-recourse. Though the carve-outs are negotiated, sometimes heavily (especially in the last few years when excess liquidity chased fewer available projects), and with varying degrees of success, full recourse for a voluntary bankruptcy is sacrosanct and rarely negotiated.
Because courts enforce that full recourse, the carve-out guaranty has essentially eliminated single asset real estate bankruptcies. Sponsors in 2009 knew where to find the bankruptcy courts. But they steered clear then, since then and now. That is fact. The carve-out guaranty works.
Outside of full recourse for bankruptcy, carve-out guaranties have seen more change in the last 20 years than any other area of mortgage loan documents and negotiations. First they ballooned as smart lawyers came up with great new carve-outs. Then those balloons blew up in guarantors' faces when opportunistic loan buyers asserted entirely uncontemplated theories of carve-out liability, often successfully. Many lenders have trimmed the carve-outs to a more sensible level.
Any borrower now knows the first conversation on any loan proposal should cover carve-outs right after rate, proceeds and term. We have recently seen extensive negotiations on scope and magnitude of non-recourse carve-outs. Borrowers and guarantors, having heard the voice of the courts on the side of lenders (a "contract is a contract" even if the results make no sense), have focused on "intentionality." A few courts have held that a subordinate mortgage, or a mechanic's lien, may rise to the level of an impermissible transfer (or encumbrance) triggering full recourse. Mindful of that, guarantors' counsel studiously try to trim back anything that might trigger liability for encumbrances that are otherwise "unintentional" or involuntary. "Single purpose covenants" have also proven to be fertile ground for surprises for guarantors, and hence a major focus in any discussion of carve-outs.
As always, tax has continued to play a role in loan documents and structures. Tax avoidance concerns led to the Foreign Account Tax Compliance Act, which produced new requirements for foreign banks plus a bit of new language in loan agreements. Again, FATCA did not change how commercial real estate finance works.
One risk that seems more manageable these days relates to environmental issues. Lenders and other real estate players seem to have gotten better at understanding, evaluating and quantifying environmental risks. Favorable availability of environmental insurance has helped. So an area that caused massive fear a few decades ago has become more manageable.
We've also seen new developments involving European "bail-in" requirements to deal with bank insolvency (more magic language for loan agreements) and property assessed clean energy "PACE" liens (a new prohibition). Financial innovations such as swap protection and more complex prepayment formulas have also become more prevalent in real estate financing, as it has continued to converge with general corporate financing.
Then there's the capital stack, ever more filled with diverse lenders, interests and economics. Today, unlike 20 years ago, many major real estate finance transactions often include layers of debt far beyond traditional first mortgage loans. Capital stacks with many tranches now stand behind many major deals.
Twenty years ago, commercial real estate finance was far more traditional and simplistic. The loan was secured by a mortgage on the property. The lender held the mortgage in its portfolio. Maybe, just maybe, there was a subordinate mortgage on the property. We hardly remember a mezzanine loan back then. Twenty years ago, when no one had heard of the "capital stack," we analogised the mezzanine loan to the second level in a department store reached by escalator. It was the "level" between the first mortgage lien and the borrower's equity. And today, even though the wounds of the financial crisis have not entirely healed, many tranches of debt – subdivided, packaged, rated and sold – are now often the norm. Any stall on this front five years ago has dissipated, especially when often-conservative first lien lenders will not meet the sponsor's need for loan proceeds. That, too, is likely to remain a core ingredient of real estate finance.
Equity interests in the sponsor entity are likewise sliced and diced and pledged and repledged. Loans are made on loans. Any major deal has co-lenders, with complex contractual relations among them. Agents; co-lenders; servicers; master servicers; special servicers – all with a role, all with rights and obligations, many of them new or at least expanded and made more complex.
Perhaps the biggest change of all in structured or layered real estate loans has been the evolution of the "intercreditor agreement." We once called that agreement a "pancake subordination." We recognized "silent," and identified "disclosed," participants. That was all. The senior lender controlled the collateral and the foreclosure. The second lien lender had no rights; instead, the second lien position had a seat at the table in a foreclosure, refinance or sale of the property, and if lucky would have the "opportunity" to bid at the foreclosure sale on the first mortgage. That was victory enough. The agreement between the senior and junior debt often said that if the junior debt wanted to exercise remedies, it needed to "take out" or repay the senior loan.
How far we have come from this.
The model "intercreditor agreement" has been a creature of the past 10 or 15 years. It has evolved since its initial iteration. The "market standard" intercreditor agreement of 10 years ago is no more. The massive and important Stuyvesant Town decision has changed the landscape and the contract among lenders in the capital stack and their enforcement rights. No longer must the junior lender "cure all defaults" (i.e., repay the accelerated senior loan) before enforcing its remedies. In securitised finance, the junior lien holder controls the loan enforcement.
Negotiations among lenders, participation in the real estate collateral and decision making, enforcement of remedies – all new, all far more sophisticated than 20 years ago. That's why the capital stack endures, from a collateral enforcement perspective.
Beyond mezzanine loans, preferred equity, even more opportunistic, has become a far more prevalent financing form than it was 20 years ago. Real estate mortgage "loans" (whether to capture return on investment, or equity) are now often structured as preferred equity in the sponsor entity. Indeed, in some hybrid transactions one private equity "lender" makes a mezzanine loan to the members of the entity and its affiliate acquires preferred equity in the sponsor.
This way, the private equity shadow lenders described above potentially achieve the outsized return their investors want. This is a pure, and now well recognized, financing device. It did not exist in commercial real estate 20 years ago.
These new sources of capital, new regulatory pressures and other changes in the world have led to sea changes in the market, especially for larger transactions and borrowers that want to borrow as much as they possibly can. That trend has continued unabated and undeterred since the 2008 financial crisis – and in a market that typically experiences cycles no longer than seven years.
Undoubtedly real estate finance structures, participants, underwriting, credit enhancement and remedies have changed in other important ways. Suffice it to say, real estate finance today is a far cry from decades past. To us, this continues to make real estate an exhilarating – and cerebral – asset class to finance.
The authors are commercial real estate lawyers in Manhattan. This article reflects only their views and is not legal advice.