14 September 2009
Hotel Lawyer insights on the new CMBS rules — implications for troubled loans today.
On September 15, 2009, the United States Treasury changed the REMIC rules applicable to CMBS to give servicers greater flexibility to modify troubled commercial real estate loans. The changes are effective immediately and are implemented in final regulations under the tax code and a revenue procedure that is designed to provide guidance. In fact, the revenue procedure applies to loans modified after January 1, 2008. What does all this gobbledygook really mean?
Here’s our take.
Insights on the new CMBS rules:
Dawning of a new era, or error of a new dawning?
by Jim Butler
Hotel Lawyers, JMBM’s Global Hospitality Group®
CMBS defaults: A current issue with huge significance to all commercial real estate and real estate finance
More than $615 billion of commercial real estate loans is in the CMBS structure, and defaults are projected to reach more than 5% by the end of the year. Some analysts (such as Morgan Stanley’s group) project that hotel loan default rate in CMBS will exceed 10%. In addition to ballooning monetary payment defaults caused by insufficient revenues to pay regular principal and interest payments to meet current debt service, more than $60 billion of maturities is coming due next year, and another $60 billion following that.
The lawyers at JMBM have been very involved in CMBS debt issues for a long time. We still receive many appreciative comments on the REMIC article that we published in 2001 and has borne the test of time in predicting the difficulties in modifying loans held in REMICs.
Now, we would like to give you our insights on the issues we see with the latest changes to the REMIC rules, applicable to all CMBS loans — whether hotel loans, retail, office, or other commercial real estate. These rule changes at least go in the right direction in terms of addressing some of those difficulties. But do they go far enough or can they even scratch the surface of the pending commercial real estate bust?
New REMIC rules’ target: ability to modify loans without “blowing up” the tax status of the REMIC trust.
Many borrowers have encountered the dilemma that meaningful modifications of a REMIC loan could not be made by the servicers until a material loan payment default had occurred or was imminent. In what may turn out to be the most significant of the rule changes made, the IRS has stated in the revenue procedure that it will not penalize REMICs for making loan modifications when the servicers reasonably foresee a significant risk of default in the future. The other rule changes allow modifications and substitutions of collateral, modifications and additions of guarantees and revisions of recourse status of the loan to be made before a loan default has occurred.
Will these changes in the REMIC rules prevent a massive collapse of commercial real estate, or are there other factors that render the changes almost meaningless? Here is our initial take.
What is different? Liberalizing rules on loan modifications.
Q. Why do REMIC rules affect CMBS?
A. Every CMBS pool is formed with a promise to bond purchasers that the income from the trust holding the bonds will be distributed without a corporate tax at the CMBS pool level. To qualify for this privilege, the CMBS trust must satisfy the strict terms laid down by Congress for so-called real estate mortgage investment conduits or REMICs. Because the tax status drives this entire structure, these rules are set forth in the Internal Revenue Code, as amplified by regulations that the IRS promulgates to interpret the tax code.
Q. What do the new CMBS rules actually say?
A. The text of the new rules are widely available. You can download a pdf of the New CMBS Rules here.
Q. What are the major changes?
A. Industry leaders were concerned about collapsing commercial real estate values and massive loan defaults fueling the economic crisis. Many felt that a few things needed to be “fixed” with the tax rules governing CMBS pools, or loan defaults and fire-sale liquidations would further weaken the economy.
The changed CMBS rules and revenue procedure focus on what loan modifications can be made by CMBS servicers without endangering the critical tax pass through status of a REMIC and when the loan modification can be done. Here is the situation:
- The REMIC rules prohibit a CMBS trust from issuing or acquiring any new loans after the REMIC is originally formed (its startup day). Penalties include a 100% tax on the prohibited loan’s income, and loss of REMIC tax status.
- The old REMIC rules, and interpretations, said that certain changes in the terms of an existing loan — one held from startup day — would be deemed to be a “new loan” (and a prohibited loan) in certain circumstances.
- The old rules had many gray areas as to what change was big enough to trigger the disastrous tax consequences.
- The old rules permitted more extensive modifications only after the loan was in default or a default was reasonably foreseeable, a requirement that servicers have interpreted to mean that the default had to be imminent.
- The new rules have both relaxed some of the strict prohibitions, and created greater clarity on certain permitted loan modifications — changes that will be OK.
- The new rules allow the servicers the flexibility to make the more extensive types of modifications when the servicers reasonably believe that a significant risk of default either at maturity or before exists.
Q. What is your take on the impact of the new REMIC rules, then?
A. At JMBM, we think the new rules provide some welcome clarity and flexibility. But these changes are not a panacea for the commercial real estate crisis. The effect of these CMBS rule changes will be severely limited by other factors:
- The latest CMBS rule changes by the IRS do not override the “Pooling and Servicing Agreements” or PSAs that govern every CMBS pool and which establish binding contractual duties and limitations on what loan modifications can be made by the servicers.
- A CMBS pool still cannot create a new “loan to facilitate” a sale.
- Cash flow mortgages, joint ventures and other types of contingent or participating returns are difficult, if not impossible, to structure.
- The new rules do not affect the often-conflicting interests of different tranches of bond holders and the practical impossibility of amending the PSA or getting agreement on such conflicting issues.
- In the widely anticipated “tranche warfare” amongst classes of certificate holders seeking to recover loan losses from servicers or other certificate holders, deferred sales will likely be viewed as favoring junior note holders over senior note holders. This is particularly true when the servicer making this decision also holds the controlling “B-piece.”
- Greater clarity from the new rules on the ability of servicers to extend loan maturities based upon the significant risk test may be helpful, but the crisis of declining income from commercial properties will limit defaulting borrowers’ ability to service debt, and will raise serious questions about the prudence of deferring asset sales where asset values are likely to continue to erode for a long time. [see The Hotel Owner’s and Hotel Lender’s Dilemma: Sell now or sell later?]
Q. OK, so the CMBS rule changes are helpful. Anything else?
A. Correct. The CMBS rule changes are helpful as far as they go, but external factors prevent these changes from being a Panacea.
Some also see a possible bad impact from the rules. For example, David Loeb of Robert W. Baird & Co., asks in a September 16, 2009 Research Report, if these rules might not backfire by encouraging the “pretend and extend” phenomenon, and thereby actually delaying a recovery in the financial and real estate markets.
We are very interested in your perspectives on the new CMBS rules and issues you encounter as a lender, servicer or borrower. Please contact Jim Butler to explore this further.
This is Jim Butler, author of www.HotelLawBlog.com and hotel lawyer, signing off. We’ve done more than $87 billion of hotel transactions and have developed innovative solutions to unlock value from troubled hotel transactions. Who’s your hotel lawyer?
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