Co-written by Jennifer A McCool

Originally Published In: Real Estate Developments Fall 2001

After several years of prohibiting all forms of subordinate debt, the growth and maturity of the commercial mortgage securitization market has moved to accepting subordinate debt, but only with strict requirements from senior lenders as to acceptable forms of such debt. Aside from certain "permitted debt" such as short-term trade debt and tenant obligations, senior lenders had traditionally disfavored any form of subordinate financing. This concern stemmed from the fact that subordinate debt, whatever the form, would have at least some adverse affect on the credit of the senior debt – including, increasing the likelihood of default on the senior debt, and in some instances, increasing the severity of loss to the senior creditor when a default occurs. However, in today’s economic environment, borrowers typically seek capital in property-specific or large securitized loan transactions in such an amount to maximize loan proceeds. One currently acceptable way to maximize loan proceeds, while satisfying strict senior lender requirements as to subordinate financing, is through the use of mezzanine financing.

Mezzanine financing is becoming a widespread means of funding the difference between the first mortgage financing, usually having a LTV between 40%-75%, and the equity participation of the borrowing principals, commonly no greater than 10% of the project cost. Using this form of subordinate debt, a borrower can access additional financing from 50% to 90% of the cost of the project’s capital structure. The most common forms of mezzanine financing include providing credit to the partners or other equity holders of a borrower and taking a pledge of such parties’ equity interests (including distributions of income), or taking a preferred equity position that is entitled to distributions (in the form of excess cash flow after debt service) ahead of borrower’s principals. A "hybrid" loan structure may also be used. Here, the same lender acts as senior lender and mezzanine lender. The structure combines a first mortgage loan with mezzanine financing at a cumulative LTV ratio of 90-95% and may also contain shared-appreciation and/or profit participating features.

As the market for mezzanine lending has grown, the rating agencies have played an increasingly important role in determining the structure of subordinate financing and encouraging the use of preferred equity and pledges of equity interests forms over subordinate mortgage financing. Subordinate mortgage financing is not employed in securitized loan transactions since it is commonly unratable in a property-specific loan or can adversely affect the capital structure in a pool transaction. In determining just what impact subordinate debt of any kind will have on the senior mortgage loan, rating agencies consider factors such as: the form of the subordinate debt; the rights of the borrowers and holders of the subordinate debt under the loan documents; whether the subordinate loan is recourse to the principals of the borrower of the senior loan; the total debt on the property and the size of the junior debt relative to the senior debt; the identity of the borrower and the subordinate lender and their expertise in property management; and portfolio effects in a pooled senior debt transaction. As mentioned above, rating agencies generally favor the preferred equity and pledges of equity interests forms over a second mortgage. This preference is due to the fact that the preferred equity and pledges of equity interests forms of subordinated debt more closely resemble pure equity and exercising remedies associated with them are less likely to result in harm or expense to the property.

Other factors that are favored by the rating agencies when analyzing the quality of the subordinate debt include:

  • The actual borrower of the subordinate debt cannot be the borrower of the senior loan, but must be an equity holder in the borrower of the senior loan (or any other equity holder taking the form of a special purpose bankruptcy remote entity, with the exception of a bankruptcy remote general partner of a limited partnership and a bankruptcy remote member of a limited liability company).
  • The amount of the subordinate loan must be limited and is based, in part, on the amount of the senior indebtedness.
  • The borrower of the senior loan must deliver to the senior lender a substantive non-consolidation opinion with respect to the borrower of the subordinate loan being "separate" for bankruptcy law purposes from any upper-tier entities.
  • Prior approval by the rating agency of the subordinate lender (due to the risk that the subordinate lender may become the controlling equity holder of the borrower of the senior loan as a result of the subordinate lender’s exercise of its remedies).
  • Subject to certain exceptions, the subordinate loan may not be transferred without written confirmation by the rating agency that such transfer will not result in a withdrawal, downgrade, or qualification of the existing rating on the certificates issued in connection with the securitization of the senior loan.
  • Subject to certain exceptions, if the subordinate loan is secured by a pledge of equity, the subordinate lender’s rights under the pledge are subject to written approval by the rating agency that the new equity structure of the borrower resulting from such exercise will not result in a withdrawal, downgrade, or qualification of the existing rating on the certificates issued in connection with the securitization of the senior loan.
  • The senior lender and the subordinate lender should enter into an intercreditor agreement containing all required restrictions set forth by the rating agency, as well as an agreement to cooperate in the event the rating agency conducts a "reunderwriting," and such agreement should be delivered to the rating agency for approval at the time of the securitization of the senior loan.
  • Any control rights over the borrower of the senior loan granted to the subordinate lender through various covenants and agreements made by the borrower of the senior loan in the subordinate loan documents shall be carefully analyzed, and subject to certain exceptions, the subordinate lender should enter into a subordination and standstill agreement to ensure that the subordinate loan has no greater rights than the holder of the senior loan.
  • The subordinate lender’s right to purchase the senior loan or cure a default of the senior loan may be only for a commercially reasonable amount of time after said default.
  • The senior lender should utilize a hard lockbox into which all rent from the property is swept directly from tenants.
  • If the transaction is structured to allow the subordinate lender to advance the subordinate loan outside the securitization, such advances should be subject to the standard appraisal reduction mechanism (i.e., the method by which an appraisal will be obtained to determine if the property value justifies further advances by the master servicer; if the value falls below the loan balance plus authorized advances, the master servicer will reduce principal and interest payments to the trustee, who will then reduce principal and interest payments to certificate holders in order of priority).
  • In the "standard" trust structure where the subordinate debt takes the form of low-rated certificates, all distributions are pooled and allocated in order of priority of senior-junior certificate holders, and similarly, all loan losses are allocated upward beginning with the bottom certificates, acting as a form of credit support for the senior debt; however, if the transaction is structured so that the subordinate loan is held outside the securitized loan pool ("de-pooling"), this can have a "de-pooling effect" on the senior debt causing loan losses to more likely reach the senior debt and reducing the credit support that the subordinate debt would have provided had it been held inside the trust.
  • If the intercreditor agreement provides that the master and special servicing of the subordinate loan is the same as the senior loan, the servicing standards should be applied equally to the senior and junior loans to ensure that the subordinate loan receives the attention necessary to maintain its value as credit support for the senior loan; if, however, the subordinate lender is granted certain rights to control the special servicing of its loan, these rights should be terminated when the balance of the subordinate loan is reduced to below 50% of its initial balance in order to reduce the control of the subordinate lender and match the transaction to the "standard" securitization form (when the entire debt is deposited into the trust and the most subordinate certificates control the special servicer).
  • Sellers of senior loans should be required to make certain representations in the purchase and sale documents regarding the structure of the loan and the rights and obligations of the senior and subordinate debt (i.e., existing subordinated debt, bankruptcy waivers, lien and payment priority, transfer and pledge restrictions, and stand-still agreements).

The negative impact of subordinate debt on the ratings of senior debt may be partially offset if either the holder of the subordinate debt is highly rated or has particular expertise in real estate operations and management. This is important because if the subordinate lender exercises its rights under the pledge of equity, it could become the controlling party of the borrower. As a result, the subordinate lender’s ability to operate the property and its overall credit may affect the recovery of the senior debt. Also, a bankruptcy of the holder of the subordinate debt can impair or delay the foreclosure of the first mortgage if the subordinate security is foreclosed prior to the first mortgage.

Obviously, certain increased risks remain for a senior mortgage lender by virtue of additional debt exposure such as decreased equity in the borrower, additional cost of debt service, risk of the borrower being unable to refinance, and deferring maintenance of the property in favor of a subordinate lender. However, the rating agencies have helped structure the forms of additional financing arrangements in a way that protects lenders and decreases, at least to some extent, the impact of such subordinate debt, while allowing borrowers to maximize the financibility of their property.

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© 2001 Schulte Roth & Zabel LLP