Post-Crisis CMBS and JV Structures: Enhanced Protection and Returns

Post-Crisis CMBS and JV Structures: Enhanced Protection and Returns

CMBS: Lessons Learned and Structural Enhancements

The 2008-2009 financial crisis exposed critical vulnerabilities within the CMBS market. Post-crisis, significant changes were implemented to enhance protection for investors and promote more sustainable market dynamics. These changes spanned underwriting standards, deal structures, and control rights.

Conservative Underwriting Standards

A key contributor to the crisis was the prevalence of overly optimistic underwriting, particularly regarding cash flow projections. This led to inflated property values and underestimated leverage. Post-crisis, a shift towards more conservative underwriting occurred.

• Focus on In-Place Cash Flow: Originators and rating agencies now prioritize verifiable in-place cash flow rather than relying on speculative pro forma financials. This reduces the risk associated with unrealized growth expectations.

• Lower Leverage: Loan-to-Value (LTV) ratios for new CMBS issuances are significantly lower. Deals issued in 2007 had stressed-rating-agency LTVs close to 110%, while 2011-vintage transactions averaged closer❓ to 90%. This provides a greater cushion against potential property value declines. We can represent this as:

  LTV = (Loan Amount / Property Value) * 100

  A lower LTV indicates a smaller loan relative to the property’s value, reducing the risk of default.

• Reduced Interest-Only Loans: The prevalence of interest-only (IO) loans contributed to refinancing risk during the crisis. In 2007, approximately 60% of CMBS collateral did not amortize at all, and nearly 90% was IO for at least part of the term. Post-crisis, the proportion of fully amortizing collateral has increased significantly. Recently issued transactions are, on average, backed by approximately 80% fully amortizing collateral, and only 8% is interest-only for the full term.

  • Amortization and Refinancing Risk: Amortizing loans reduce the principal balance over time, thus decreasing refinancing risk at maturity. For example, consider a loan with a 10-year term, 30-year amortization schedule, and a 5% coupon rate, originated at an LTV of 75%. At maturity, the LTV will be significantly lower, in the low 60s (ignoring property appreciation or depreciation). This is because the principal has been paid down over the loan’s term.

    Remaining Principal = Original Principal - Cumulative Principal Payments

    A lower remaining principal at maturity makes refinancing easier and less risky.

Credit Enhancement and Deal Structure

New issue deal structures are more conservative, with rating agencies requiring more credit enhancement at a given credit rating than before the crisis.

• Increased Subordination Levels: AAA and investment-grade subordination levels have increased. For example, subordination levels increased from an average of 12.0% and 4.3% in 2007 to 18.1% and 5.8%, respectively, for the 2011-vintage.

  • Credit Enhancement Definition: Credit enhancement refers to the subordination levels within the CMBS structure. A higher subordination level means that a larger portion of the deal must absorb losses before the higher-rated tranches are affected. This provides greater protection to senior bondholders.

  • Tranche Thickness: Tranches are thicker than they were at the peak of the market, providing additional protection.

Control Rights and Transparency

Control rights and transparency have been significantly improved to protect investors and align interests.

• Appraisal Reduction Trigger for Control Shift: A critical change is allowing the controlling class to be ‘appraised out’. 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. This ensures the directing certificate holder has an economic interest in loan workouts and avoids potential conflicts of interest.

  • Conflict of Interest Mitigation: Historically, control rested with the most subordinate outstanding class, even if that class had little to no economic interest after price declines. This could lead to special servicers maximizing cash flow and fee income to the detriment of senior bondholders. The appraisal reduction trigger addresses this conflict.

• Senior Trust Advisors: Many issuers have introduced senior trust advisors to enhance transparency. These third-party consulting firms review the actions of the special servicer, have consultation rights, and can, under certain circumstances, replace the special servicer for cause (subject to bondholder vote).

  • Transparency and Oversight: Senior trust advisors provide investors with an alternative source of information on loan workouts and a remedy if the special servicer is not acting in their best interests. This increases accountability and reduces the potential for mismanagement.

Joint Venture Structures: Optimizing Returns and Managing Risk

Real estate joint ventures (JVs) are commonly used for development or redevelopment projects. Understanding the nuances of JV structures, particularly post-crisis, is crucial for maximizing returns while effectively managing risk.

JV Structure Types

• Single-Asset JV: Involves one asset with an established business plan.
• Multi-Asset JV: Includes more than one asset, identified at the outset, often with cross-collateralized economics.
• Programmatic JV: An operating partner and an investor form an entity to seek out new deals, adding assets over time.

Cash Flow Allocation, Waterfalls, and Incentive Fees

Unlike fund structures, the incentive fee is often the primary source of profit for the operating partner in a JV. Incentive fees (promotes) are earned for exceeding pre-defined return hurdles.

• Single-Hurdle Waterfall:

  1. Initial investment: \$10,000,000
  2. Operating cash flow: Limited during development.
  3. Sale of the asset (Year 3): \$19,031,250.
  4. Incentive Fee Structure: 30% of cash flow after the project achieves a 10% internal rate of return (IRR).

  • Calculating the Hurdle: The cash flow needed to hit the 10% hurdle in Year 3 can be calculated by finding the future value of all prior cash flows using a discount rate equal to the hurdle rate.

    FV = Σ CFt * (1 + r)^(n-t)

    Where:

    • FV = Future Value (at the point of the final distribution)
    • CFt = Cash Flow at time t
    • r = Discount Rate (Hurdle Rate)
    • n = Total number of periods
    • t = Time period of the cash flow.

    In the example, FV = \$10,000,000(1.10)^3 - \$400,000(1.10)^1 = \$12,980,000

• Operating Partner Co-Investment: When the operating partner also provides capital, the operating partner’s return consists of:

  1. Return of/on invested capital.
  2. Management fees.
  3. Incentive fees.

• Splits vs. Promotes: Two common formulations for describing incentive fee structures:

  • Promote Formulation: Cash flow is distributed to investors pari passu until each has received a specified IRR. Subsequent cash flow is distributed according to the promote split (e.g., 30% to the operating partner, 70% to the investors).

  • Splits Formulation: Cash flow is distributed according to a pre-defined split (e.g., 10% to the operating partner, 90% to the investor) until each has received a specified IRR. Subsequent cash flow is distributed according to a different split, which effectively incorporates the promote.

  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

• Multiple Hurdles: Incentive fee structures can include multiple tiers, allowing the operating partner to realize a greater percentage of the cash flow as the underlying asset performance improves. For example:

  • Tier 1: 30% over a 10% IRR
  • Tier 2: 50% over a 20% IRR

  Multiple hurdles are used in practical applications: When disagreement exists between an operating partner and an investor as to the proper level of incentive-fee compensation.

Investor-Centric vs. Investment-Centric Hurdles

• Investor-Centric: Hurdles are applied to the net IRR earned by the investor after all fees and expenses. This is the most common approach for institutional deals.
• Investment-Centric: Hurdles are applied to the IRR of the overall project, regardless of the investor’s specific returns. This approach is less common but may be used in certain situations.