CMBS and JV Structures: Post-Crisis Enhancements

CMBS and JV Structures: Post-Crisis Enhancements

I. CMBS Post-Crisis Enhancements

The global financial crisis of 2008-2009 exposed vulnerabilities in the Commercial Mortgage-Backed Securities (CMBS) market, leading to significant refinements in underwriting standards, deal structures, and transparency.

A. Enhanced Underwriting Standards

Pre-crisis CMBS underwriting often relied heavily on pro forma financials and optimistic assumptions about future cash flow growth. This resulted in inflated property values and unsustainable leverage. Post-crisis, originators and rating agencies have shifted their focus to in-place cash flow and more conservative assumptions.

• Focus on In-Place Cash Flow: Underwriting now emphasizes the current, verifiable income generated by a property rather than projected future earnings.
• Conservative Loan-to-Value (LTV) Ratios: The average stressed-rating-agency LTV for 2007-vintage CMBS deals was approximately 110%. Post-crisis, 2011-vintage transactions have averaged closer to 90%. This demonstrates a significant reduction in leverage.
• Bottom-of-the-Cycle Underwriting: The timing of post-crisis issuance coincided with a market bottom, naturally leading to more cautious underwriting practices.

Example:

Consider two identical commercial properties, A and B.

• Property A (Pre-Crisis): Appraised based on projected rent increases and occupancy improvements over 5 years. Loan amount approved based on the future pro forma NOI (Net Operating Income).

  • Future NOI = Current NOI * (1 + Growth Rate)^Years

  • Property B (Post-Crisis): Appraised based on current rents, occupancy, and historical operating expenses. Loan amount approved based on the stabilized NOI.

  • Stabilized NOI = (Total Revenue - Operating Expenses) / Purchase Price

The loan for Property B will be smaller and considered a safer investment because it is based on real numbers.

B. Reduced Interest-Only Loans and Increased Amortization

The prevalence of interest-only (IO) loans in pre-crisis CMBS contributed to refinancing risk. Borrowers had no principal amortization and required securing a new loan for the full initial amount at maturity. Post-crisis, there has been a significant shift towards fully amortizing loans.

• Pre-Crisis (2007): Approximately 60% of CMBS collateral did not amortize at all, and nearly 90% was interest-only for at least part of the term.
• Post-Crisis: Approximately 80% of newly issued CMBS is backed by fully amortizing collateral, and only about 8% is interest-only for the full term.

Mathematical Illustration of Amortization Impact:

Assuming:

• Loan Term (t) = 10 years
• Amortization Schedule = 30 years
• Coupon Rate (r) = 5%
• Initial LTV = 75%

The Loan Balance at maturity (LB_t) will be significantly lower with amortization.

• Without Amortization: LB_t = Initial Loan Amount
• With Amortization: LB_t < Initial Loan Amount

With a 30-year amortization and a 10 year term at 5% coupon rate the LTV at maturity would be:

LTV_t ≈ 60%

This illustrates the de-leveraging effect of amortization, reducing refinancing risk.

C. Enhanced Credit Enhancement

Credit enhancement refers to the subordination of tranches in a CMBS structure, providing a buffer to senior tranches in the event of loan defaults. Post-crisis, rating agencies have required higher levels of credit enhancement for a given credit rating compared to the pre-crisis period.

• Increased Subordination Levels: AAA and investment-grade subordination levels have increased significantly. For example, AAA subordination averaged 12.0% in 2007, rising to 18.1% for 2011-vintage deals. Similarly, investment-grade subordination increased from 4.3% to 5.8%.
• Thicker Tranches: Tranches are wider to absorb potential losses.

D. Revised Control Rights

Pre-crisis CMBS structures often granted control rights to the most subordinate outstanding class of certificates, even when that class had little or no economic interest in the transaction. This could lead to conflicts of interest, particularly if the special servicer was also the directing certificate holder.

• “Appraised Out” Mechanism: Recent transactions incorporate a mechanism that allows the controlling class to be “appraised out.” If the principal balance, net of appraisal reductions, falls below a certain threshold (e.g., 25% of its initial value), control shifts to the next most junior class.
• Objective: Ensure the directing certificate holder has a significant economic stake in loan workouts and to minimize potential conflicts of interest.

E. Increased Transparency

• Senior Trust Advisors: Many issuers have introduced senior trust advisors – third-party consulting firms – to review the actions of the special servicer.
• Responsibilities: These advisors have consultation rights and, in some cases, can replace the special servicer for cause (subject to a bondholder vote).
• Objective: Provide investors with an independent source of information on loan workouts and offer a remedy if the special servicer is not acting in their best interests.

II. Joint Venture (JV) Structures: Post-Crisis Considerations

Real Estate Joint Ventures (JVs) were less impacted by the crisis than CMBS, however changes in risk aversion and market conditions have spurred innovation to improve returns.

A. JV Types

• Single-Asset JV: Focuses on a single property with a well-defined business plan at the outset. Venture duration aligns with the asset’s life cycle and business plan execution.
• Multi-Asset JV: Involves multiple properties, each identified at the beginning. Economic incentives, particularly incentive fees, are often cross-collateralized across the portfolio.
• Programmatic JV: Establishes a partnership between an operating partner and an investor to source and acquire new deals. While initial assets may be pre-identified, the JV can add new properties over time. Venture duration can span several decades, with mechanisms allowing partners to terminate new investments earlier.

B. Allocation of Cash Flow, Waterfalls, and Incentive Fees

Unlike fund structures, the incentive fee (or “promote”) serves as the primary profit source for the operating partner in a JV. JV operating partners❓ typically are real estate firms managing the properties while fund managers generally are financial institutions.

• Single-Hurdle Waterfall: The operating partner receives a percentage (e.g., 30%) of cash flow after the project achieves a specified Internal Rate of Return (IRR) hurdle (e.g., 10%).

Mathematical Calculation Example:

Initial Investment (I) = $10 million

Cash Flow Year 1 (CF₁) = $0

Cash Flow Year 2 (CF₂) = $400,000

Cash Flow Year 3 (CF₃) = $19,031,250

Asset-Level IRR: IRR = 25%

1. Calculate the cash flow needed to hit the 10% hurdle:
   • This is the future value of the prior cash flows discounted at the hurdle rate.

2. Formula: Hurdle CF_t = -I (1 + r)^t + ∑ CF_i (1 + r)^t-i

   Where:

   • r = Hurdle Rate (10%)
   • t = Year (3)
   • i = Year of Cash Flow

   • Hurdle CF_t = 12,980,000
     3. Excess Cash Flow:*

   • Excess CF = CF₃ - Hurdle CF_t = $19,031,250 - $12,980,000 = $5,951,250
     4. Incentive Fee to Operating Partner (30%):

   • Incentive Fee = 0.3 * $5,951,250 = $1,785,375
     5. Remaining Cash Flow to Investor (70%):
   • Remaining CF = 0.7 * $5,951,250 = $4,165,875

C. Operating Partner Co-Investment

When the operating partner contributes capital to the JV, they become a co-investor.

• Impact on IRR: The operating partner’s overall IRR is typically higher due to a combination of return on/of invested capital, management fees, and incentive fees.
• Disaggregation of Returns: It’s important to distinguish between returns on invested capital and incentive-based compensation for deal sourcing and management.

D. Splits vs. Promotes

Two common methods for articulating incentive fees:

• Promote Formulation: Cash flow is distributed pari passu to investors until a hurdle IRR is achieved. Excess cash flow is then 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 an initial split (e.g., 10% to the operating partner, 90% to the investor) until a hurdle IRR is achieved. Subsequent cash flows are distributed according to a different split reflecting the promote (e.g., 37% to the operating partner, 63% to the investor).

Mathematically, both formulations should result in the same allocation of cash flow.

• 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

Example:

A = 0.1
Pr = 0.3
Sp = .3 + (1-.3) * .1
Sp = .37

E. Multiple Hurdles

Multiple-tier incentive fee structures allow the operating partner to realize a higher percentage of cash flow as asset performance improves.

• Example:

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

Investor-Centric vs. Investment-Centric Hurdles: In most institutional deals, hurdles reflect the net IRR earned by the investor.