CMBS Real Estate Secured Note Purchases

In the first installment of our three-part series of articles addressing the intricacies of real estate secured note purchase transactions, we addressed the general implications and structure of a note purchase. While the general framework we outlined in part one holds true for all note purchase transactions, prospective purchasers of commercial mortgage backed securities (“CMBS”) notes must be aware of additional issues that make these transactions unique. In order to better understand how CMBS note purchases differ from standard portfolio loan purchases, one must first understand the structure of CMBS lending.

In a CMBS transaction, commercial mortgage loans of varying size, property type and location are pooled together and transferred to a trust. The trust then issues a series of bonds, which are purchased by investors, and each month the principal and interest payments received from all of the pooled loans is paid to the investors in tiers as bond payments based upon the priority of the investor’s bond. The document which controls how these loans are pooled, serviced, paid to the trust and otherwise handled is called the Pooling and Servicing Agreement (“PSA”).

The primary party responsible for operating a CMBS pool is called the master servicer. The master servicer manages the flow of payments and information and is responsible for the ongoing interaction with each performing borrower. So long as the mortgages which make up the pool perform as intended, the trust will continue to operate under the Master Servicer. However, if a borrower fails to meet its payment obligations, or defaults under a separate covenant of its loan, the trust will assign that loan to a special servicer.

The special servicer is responsible for servicing the defaulted loans, whether such servicing involves a workout with the borrower, the acceleration of the debt, foreclosure of the lien, or the sale of the debt to a third party. Because purchasers of CMBS notes will generally be targeting defaulted loans, the special servicer will be the primary party with whom a purchaser interacts. In addition, one other party will have broad discretion over the fate of non-performing debt in the CMBS pool – the trustee.

Although the trustee’s primary role is to hold all the loan documents and distribute payments received from the master servicer to the bondholders, the trustee is often also given broad authority over the management of the loan pool under the PSA. Generally, the trustee will be an active party in the sale of any non-performing asset from the trust.

Purchases of CMBS notes can fall into one of two paths. First, CMBS pools often have classes of securities with certain prioritized rights, including a right of first refusal on the sale of any assets in the pool. If a priority investor elects to exercise its option, no other party will have the opportunity to purchase the non-performing asset. However, if the right of first refusal is assignable by the priority rights holder, a prospective note purchaser may be able to negotiate with the priority rights holder to have the purchase rights assigned to such prospective purchaser. In this scenario, certain notice requirements pursuant to the PSA must be satisfied and the special servicer and trustee will need to consent to the assignment of rights and ultimate sale of the note.

The second path results when no purchase option exists or, if it does exist, is not exercised. These sales tend to more closely mirror unsecuritized note sales. The special servicer will typically accept bids from prospective purchasers which account for not only the price of the note, but also the purchaser’s proposed due diligence timeline, requested representations from the seller, and other terms which will be unique to each offer. Once the bidding process has closed, the special servicer will consider the proposed offers and select a winning bidder. Upon approval from the trustee, the note purchase can begin in earnest, including any due diligence review and final closing document negotiations.

Once a transaction for the purchase of a CMBS note has closed, the purchaser is the holder of the note and the rights which accompany it. The note no longer has a CMBS character, because it is released from the confines of the PSA upon sale. A purchaser may proceed with post-acquisition activities as it would for any note which had never been part of a CMBS pool.

In the final installment of our three-part series on note purchases, we will evaluate the options available to a note purchaser post-purchase, highlight issues which can arise in servicing the note as its holder and in seeking to enforce rights in the property securing the note, and discuss some potential pitfalls for a note holder.

By Jeff Mosteller

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