Structuring CMBS Deals and Joint Ventures: Incentives, Controls, and Transparency

Structuring CMBS Deals and Joint Ventures: Incentives, Controls, and Transparency

CMBS Deal Structure: Incentives and Controls

The structure of a CMBS deal profoundly impacts the incentives of various parties involved and dictates the controls in place to manage risk. Recent market trends highlight a shift towards more conservative and investor-friendly structures.

1. Reduced Leverage

One of the key changes post-financial crisis is a significant reduction in leverage.

• Historical Context: Loans originated in 2006-2007 often had stressed-rating-agency Loan-to-Value (LTV) ratios close to 110%. This high leverage amplified losses when property values declined.

• Current Standards: 2011-vintage transactions averaged closer to 90% LTV. This difference reflects a more conservative underwriting approach focused on in-place cash flow rather than pro-forma financials.

  Formula: LTV = (Loan Amount / Property Value) * 100
  * Scientific Principle: Risk is directly proportional to leverage. Higher leverage magnifies both potential gains and potential losses.

2. Amortization and Interest-Only Loans

The prevalence of interest-only loans, which defer principal repayment and increase refinancing risk, has decreased significantly.

• Historical Context: In 2007, approximately 60% of CMBS collateral did not amortize at all, and nearly 90% was interest-only for at least part of the term.
• Current Standards: Recently issued transactions are, on average, backed by approximately 80% fully amortizing collateral, and only about 8% is interest-only for the full term.

• Impact of Amortization: Amortization de-levers the loan over time, reducing refinancing risk at maturity.

  Example:
  Consider a 10-year loan with a 30-year amortization schedule and a 5% coupon rate, originated at a 75% LTV. After 10 years, the LTV will be significantly lower (in the low 60s). This decrease in LTV is due to the loan amortization.

3. Credit Enhancement and Subordination Levels

Credit enhancement is used to protect senior bondholders❓❓ by providing a buffer against losses. This is achieved by subordinating certain tranches of the CMBS.

• Historical Context: In 2007, AAA and investment-grade subordination levels averaged 12.0% and 4.3%, respectively.
• Current Standards: For 2011-vintage CMBS, these levels increased to 18.1% and 5.8%, respectively. This increase in subordination provides greater protection to senior tranches.
• Scientific Principle: Tranche thickness impacts credit ratings and bond yields. Thicker tranches imply greater credit enhancement and thus lower yields for bonds of the same rating.

4. Control Rights and Special Servicers

Control rights determine who has the authority to direct the special servicer, the entity responsible for managing distressed loans. This is a critical aspect of CMBS governance.
* Historical Context: Traditionally, control rested with the most subordinate outstanding class of certificates. However, this could lead to conflicts of interest if the controlling class had little or no economic interest in the transaction due to price declines.
* Current Standards: Recent transactions include provisions that allow the controlling class to be “appraised out.”

*   **Appraisal Out Clause:** If the principal balance net of appraisal reductions falls below a certain percentage (e.g., 25%) of its initial value, control shifts to the next most junior class of certificates.
*   **Purpose:** To ensure that the directing certificate holder has an economic interest in loan workouts, aligning their incentives with those of senior bondholders.

5. Transparency and Senior Trust Advisors

To improve transparency and oversight, some CMBS issuers have introduced senior trust advisors.

• Role: These third-party consulting firms review the actions of the special servicer, have consultation rights, and under certain circumstances can replace the special servicer.
• Objective: Provide investors with an alternative source of information on loan workouts and a mechanism to address concerns if the special servicer is not acting in their interests.

Real Estate Joint Ventures: Incentives, Controls, and Transparency

Real estate joint ventures (JVs) are partnerships between an operating partner (e.g., a developer or property manager) and an investor (e.g., a pension fund or private equity firm) to undertake real estate projects. Structuring JVs effectively requires careful consideration of incentives, controls, and transparency.

1. Types of Joint Ventures

There are three major types of JVs:
* Single-asset JV: Involves just one asset, generally with an established business plan, which is known at the inception of the venture. The duration of the venture would be based on the nature of the asset and its business plan.
* Multi-asset JV: Includes more than one asset, with each asset identified at the outset. From an economic standpoint, it is little more than an amalgamation of single-asset JVs but with the economics – particularly incentive fees❓ – likely cross-collateralised.
* Programmatic JV: An arrangement where an operating partner and an investor form an entity which will seek out new deals. Although some early assets might be pre-identified, new assets can be added from time to time. The duration for this type of JV can be several decades, although in all probability there would be a mechanism for the partners to terminate new investments earlier, if desired.

2. Cash Flow Allocation, Waterfalls, and Incentive Fees

A waterfall defines the order in which cash flow from the JV is distributed to the partners. Incentive fees are designed to reward the operating partner for exceeding performance targets.

• Management Fees: These are fees paid to the operating partner for managing the JV’s day-to-day operations.

  • These often cover the expenses of the operating partner
  • Incentive Fee (Promote): The operating partner’s primary source of profit in a JV, acting as a reward for “sweat equity.”
  • Splits vs. Promotes:
  • Promote - First cash flow is distributed to investors, pari passu until each has received a 10 percent IRR. After reaching the 10 percent IRR hurdle, cash flow is distributed 30 percent to the operating partner and 70 percent to the investors.
  • Splits - First cash flow is distributed 10 percent to the operating partner and 90 percent to the investor until each has received a 10 percent IRR. Any subsequent cash flows will be distributed 37 percent to the operating partner and 63 percent to the investor.
  • Formulas:
    Sp = Pr + ((1 -Pr) × A)
    Pr = (Sp -A) / (1 -A)
    where:
    Sp is the incentive rate using the split formulation
    Pr is the incentive rate using the promote formulation
    A is the operating partner co-investment

  • Hurdle Rate: A minimum rate of return that the investor must achieve before the operating partner is entitled to an incentive fee.

  • Formula for Calculating Cash Flow Needed to Hit Hurdle:

    • NFV = Σ CFt / (1+r)^t
    • Where:
      • NFV is the Net Future Value of prior cash flows
      • CFt is the cash flow in period t
      • r is the hurdle rate
  • Waterfall Structure:
  1. Return of capital to investors
  2. Preferred return (hurdle rate) to investors
  3. Incentive fee to operating partner
  4. Remaining cash flow split between investor and operating partner

3. Operating Partner Co-Investment

It is common in institutional JVs for the operating partner to provide a capital to the JV, making the operating partner also a co-investor.

• Impact on Incentives: Requires separation of returns on investment vs. the incentive fee.

• Different Approaches to Calculating Operating Partner IRR:

  • All operating partner cash flow
  • All cash flow except management fee
  • Only return on/of co-investment capital

4. Multiple Hurdle Structures

Multiple tiers of incentive fees are generally created to allow the operating partner to realize a greater percentage of the cash flow as the underlying asset performance improves.

• Structure: Two or three tiers.
• Example:
  • Incentive fee Tier 1: 30 percent over a 10 percent IRR
  • Incentive fee Tier 2: 50 percent over a 20 percent IRR
• Key Data:
• Profit dollars (the sum of cash flow after
  management fees)
• Amount needed to meet the 10 percent IRR threshold in final year
• Amount needed to meet the 20 percent IRR threshold in final year
• Amount in excess of 20 percent hurdle

5. Investor-Centric vs. Investment-Centric Hurdle

• The definition of “hurdle” matters.
• Most institutional deals, hurdles reflect the net IRR earned by the investor.

• In some cases, there may be disagreement between an operating partner and an investor as to the proper level of incentive-fee compensation. In such a circumstance, it is instructive to compare the results from two alternative structures:

  • ‘Compromise’ single-hurdle structure: 30 percent of profits above a 10 percent hurdle
  • ‘Compromise’ multi-hurdle structure: 20 percent of profits over a 10 percent IRR hurdle and 50 percent of profits over a 20 percent IRR hurdle