ACREL Notes July 2017

Commercial Mortgage-backed Securities Sujata Yalamanchili, Hodgson Russ LLP, Buffalo, NY

Commercial real estate lawyers can debate whether CMBS loans offer sufficient flexibility for hotel and hospitality projects. Meanwhile, Sujata Yalamanchili, a 2015 ACREL fellow, and her colleague Kim Sayoc at Hodgson Russ LLP in Buffalo offer some insights as to what attorneys for hotel owners can expect to see in the term sheets for these loans.

Commercial mortgage-backed securities (“CMBS”) have long been used to finance real estate transactions, including hotel and hospitality projects. CMBS loans are attractive to hotel owners because they may involve lower interest rates and higher loan-to-value amounts. CMBS loans are also typically nonrecourse loans.

CMBS loans are particularly attractive in hotel and hospitality projects because those projects are considered riskier assets. “Rent” is nightly, is not secured by a lease, and is subject to fluctuation. Events such as terrorism can subject the industry to sudden downturns. CMBS loans provide liquidity to an otherwise limited debt market for the hospitality industry, linking providers of capital to those in need.

Despite the appeal of CMBS loans, owners of hotel and hospitality projects should be mindful of the unique aspects of CMBS loans. The loan documents will include customary CMBS provisions relative to securitization, defeasance, and REMIC compliance. In addition, CMBS loans usually require comfort letters from the franchisor for franchised hotels. These letters often require significant lead time and payment of a fee to the franchisor.

CMBS loans often require borrowers to be bankruptcy remote entities. This often requires borrowers (and their counsel) to create new entities and structures, which in turn may require the transfer of the hotel property to the new entity and, in some instances, may trigger real estate transfer taxes. It can also trigger the need for additional legal opinion letters at the borrower’s expense.

Practitioners should be mindful of defeasance requirements of CMBS loans. CMBS loans generally prohibit the borrower from prepaying the loan since prepayment would affect the yield and frustrate the bond holder’s expectations. In order to effectively pre-pay the loan, a borrower can use a defeasance, where the collateral securing the loan is substituted by alternative collateral (typically a portfolio of U.S. Treasury bonds or Treasury bills), and the hotel property is released from the lien of the mortgage. The cash flows generated from the securities will cover all future loan payments.

Many hotel and hospitality projects are structured as ground leases, with the developer owning a leasehold interest. In order to finance a leasehold interest using a CMBS loan, the CMBS lender will often require the ground lessor to subordinate its fee interest to the CMBS loan. This

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ACREL Notes July 2017 can be difficult when the ground lessor is an unrelated party. In lieu of subordination, CMBS lender will require that the ground lease include such provisions as:

• long term – at least 30 years remaining with options to extend; • ground lessor will not modify, amend or terminate the lease without lender’s consent; • ground lessor must give lender notice of any default by ground lessee; • ground lessor must give lender opportunity to cure the default if the ground lessee does not; • if the lender forecloses or takes a deed in lieu of foreclosure, the ground lessor will allow lender, its affiliate or assignee to assume the lease and recognize the successor as the tenant entitled to all of the rights under the lease.

Another common feature of the CMBS loan is a “lockbox” account into which all hotel revenues, including credit card receipts, are deposited. All debt service, taxes, insurance, ground rent, other property expenses and certain reserves are paid from the account before any funds can be disbursed to the borrower. The lock box account is governed by a deposit account control agreement with a bank and is pledged to the CMBS lender.

Practitioners and borrowers should recognize the additional legal structuring, costs and lead time involved with these loans.

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