“We should have learned our lesson and sworn off CMBS forever”: McNellis, commercial real estate developer.

By John E. McNellis, at real estate developer McNellis Partners. This essay is taken from his forthcoming 3rd edition of Making it in Real Estate.

I was leaning against the bar at an industry cocktail party a couple weeks ago when a guy walked up to me, stuck out his hand and said, “I’m Ethan Penner”. I asked him who he was. Ethan was taken aback by my ignorance.

“I’m the guy who invented CMBS,” he proclaimed.

“I hate CMBS,” I replied. “I’ll never do another CMBS loan.”

“Yeah, well, it saved CRE.”

“Maybe, but I’ll never do another one. They suck.”

“I wouldn’t either,” said Ethan, and I liked him better. When I asked what he was doing at the function, he said he was trying to raise money for his gubernatorial campaign. I wished him well and he moved off to work more fertile fields, leaving me to ponder CMBS loans.

CMBS actually stands for “commercial mortgage-backed security”. In short, a CMBS loan is one originated by a big bank or financial institution—e.g. JP Morgan Chase and Prime Finance—then bundled together with another 100-150 of its loans into a mortgage pool totaling about $500 million to $2 billion. That pool is securitized by Wall Street and sold as bonds to anywhere from, say, 50 to 200 investors. After securitization, each individual loan in the pool is administered by a master servicer. If things go wrong with a loan, it is transferred to its “special servicer”.

Giving Ethan his due, he may not have saved CRE, but his clever invention did go a long way toward providing our industry badly needed liquidity. About 10-15% of all CRE loans are now securitized by CMBS.

The Bigs love CMBS. Why wouldn’t they? They reap enormous profits from originating these loans—generally 1-2 percent of the total pool—and then selling them off. Their only real risk is that the securitization market goes bad before Wall Street can peddle their pools. If this happens, the originators are stuck holding the bag.

Borrowers love CMBS, too…at least initially. CMBS’s undeniable attraction may be best understood by comparing it with its competitors, life insurance companies and balance sheet lenders. The Life Cos generally have better terms—lower interest rates, longer terms and so on—than CMBS, but they have much higher underwriting standards. This means they wouldn’t even consider a loan that CMBS would be delighted to do. If the two were auto lenders, the Life Cos would lend on Mercedes Benz while leaving the Toyotas to CMBS. Thus, the biggest appeal of CMBS vis-à-vis life insurance companies is its relative availability.

Balance sheet lenders—banks that keep rather than sell off their loans—are not as fussy as the Life Cos and will often compete for the CMBS borrower, but aside from their pricing, their terms are usually tougher than CMBS. The CMBS lender will charge more, but will lend more dollars (say, a 70% loan to value as opposed to 60%), grant a ten-year term, sometimes interest only, and not require a personal guarantee. A bank considering that same loan would likely limit its term to five to seven years and require both principal amortization and a guarantee.

Thus, a CMBS loan is easier to obtain than a Life Co loan and often more attractive—again, at least initially—than a balance sheet loan. In truth, for the beginning developer or the experienced one with a less than stellar project, CMBS may be the only way to go. Both the Life Cos and balance sheet lenders put considerable stock in a borrower’s track record and financial statement.

So far so good, but if you study a set of CMBS loan documents—roughly the length of Moby Dick—you will discover landmines sprinkled throughout, and perhaps have second thoughts about this product’s appeal. Here’s a quick summary of just a few of those traps:

The loan cannot be prepaid during its first two to five years, the so-called “lockout period.”

You will need the master servicer’s approval—which can drag on for months—if you wish to sell the property and have your buyer assume your CMBS loan. Your buyer can only be a “bankruptcy remote SPE”—a single purpose entity formed solely for the purpose of owning the single asset—thereby substantially restricting the buyer pool. You will pay a one percent assumption fee plus all of the servicer’s legal fees, title fees, rating agency fees (everything but their country club dues). These fees can total $25-100,000.

If you happen to default under CMBS—the paths to default are myriad—your base interest rate will leap by five percent or more.

Having done a number of CMBS loans over the years, we knew what we were getting into when we borrowed $6.2 million from Wells Fargo’s CMBS team in 2010 to refinance one of our Safeway centers. As an aside, we went with Wells rather than other CMBS lenders because it had been our primary bank for over 30 years and we’d hoped that our excellent, longstanding relationship would temper our CMBS experience. It didn’t. Why? Because CMBS lenders’ hands are tied by their complex agreements with the bondholders. They have zero discretion in working with borrowers.

This loan slumbered peacefully for five years until a crew of private equity pirates acquired Safeway, took it private and merged it into Albertson’s. Safeway lost its credit rating overnight and alarm bells went off at the master servicer’s offices. The servicer advised us that, pursuant to clause 47 (e) iii on page 67 of the loan agreement, Safeway’s loss of creditworthiness was a “trigger event” and that we would be in default if we didn’t immediately deposit $875,000 to offset it.

We pleaded, arguing that this demand was totally unreasonable. We pointed out that Safeway had never missed a rent payment, and that the loan could hardly be more secure, its outstanding balance less than a third of the project’s value. The servicer was implacable, insisting that we either deposit the funds or be in default. We had no choice but to comply.

Fortunately, we were in a position to do so. A less seasoned developer might have taken a bullet from this trigger event. It’s worth stressing again that there is no negotiating with CMBS servicers. They charge you a small fortune to go strictly by their book. Had this been a balance sheet loan, Safeway’s credit loss would never have triggered such a demand. In fact, none of the traditional lenders who were financing our other Safeway centers at the time batted an eyelash over this issue. Even if they had, we would have been able to hash something out with a real banker instead of dealing strictly by email with impersonal clerks doing a great job of imitating bots.

We should have learned our lesson and sworn off CMBS forever. But we didn’t. We borrowed $4.5 million to finance a Rite Aid in 2018. This loan ticked along quiet as a time bomb until Rite Aid also lost its credit rating. Pursuant to another obscure provision buried deep in the loan documents, the servicer implemented a “cash trap” through which it swept every penny of rent thereafter paid by Rite Aid into a non-interest-bearing account. This meant that we had to come out-of-pocket to pay all of the property’s ongoing bills. As of this writing, Rite Aid is dead, our loan balance is $4,450,000, the servicer is holding $500,000 in that cash trap account, and has charged us $3100 in fees thus far for doing nothing and an additional $660 a month for a loan that has never been in monetary default. We haven’t missed a single payment.

Given these sad tales of woe, you may forgive me for comparing CMBS loans to base jumping. Arguably the most dangerous sport in the world, base jumping—the leaping off buildings or cliffs—has a fatality rate of about one in every 60 to 100 jumps. But this means the daredevils do walk away up to 99 percent of the time. The same is true of CMBS. If everything goes well with your project, if life doesn’t force you to sell early, if your major tenants stay healthy, if you’re able to pay off the CMBS at maturity, then you too will walk away and look forward to your next jump.

Our fatality rate with CMBS was not, however, one in 100, it was two in ten. My point? Do enough of these loans and sooner or later, you just may slam into the rocks at terminal velocity. By John E. McNellis.

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