Leveraged Breakdowns

When Real Estate Private Equity Investments Go Bad (CMBS Part 1)

Your Big Bet on Last-Mile Industrial

Let’s imagine a scenario where a real estate equity investment doesn’t go quite as planned. Let’s say you’re two years into an investment you made in 2020, committing fund equity into a 30-property last-mile industrial portfolio. Back then, industrial real estate was hot and cap rates were only going down. People were making money hand over fist, and demand for the product type was soaring. There was no end in sight, so it was easy to convince your fund to commit the equity into this portfolio.

In 2022, Last-Mile Industrial is a Flop

But now it’s the year 2022, and last-mile industrial real estate has been a giant flop. A mixture of oversupply, technological obsolescence, and a general flattening of ecommerce sales growth has driven cap rates back up and applied downward pressure on occupancy. Similarly, local tax regimes have been tightening their belts amid revenue losses and are squeezing landlords to counterbalance their budget deficits. In short, your portfolio is caught in the middle of increasing cap rates, decreasing revenues, and increasing operating expenses.

Your Three Sub-Portfolios

These tailwinds have affected your portfolio to varying degrees. To assist your analysis of asset performance, you have split the properties into three sub-portfolios, described below:

  1. Group A (Core): Ten of the buildings are worth less than when you bought them, but have decent WALTs and creditable tenancy. These buildings still generate healthy cash flow, but the sector-wide cap rate expansion has driven values so far down that you’d be lucky to recoup your initial equity on these three by the end of your hold period.
  2. Group B (Breakeven): Another ten properties are worth significantly less than when you bought them. Similar to Group B, they still generate some cash flow. However, their NOI margins have compressed so far down that they are hardly breaking even. Soon, these properties could slip into Group C.
  3. Group C (Default): The final ten properties in this group are currently in default and have entered special servicing. They do not generate enough cash to cover their debt service, and some are even falling short on operating expenses.

Commercial Mortgage-Backed Security Debt

These properties are each encumbered by commercial mortgage-backed security (CMBS) loans. These CMBS loans are special and differ from traditional, single-lender bank loans. The important factor here is a traditional bank loan allows you to negotiate with a single lender as your one-stop-shop. But a CMBS securitizes the loan, which means it chops it up into lots of tiny pieces that are then sold to numerous investors. So unlike bank loans, you don’t just deal with one party. Now, we’ll explore the complexities that emerge when your real estate equity investment defaults on its CMBS loan.

How Cash Flows from a Property to its CMBS Lenders

To better understand CMBS, let’s first look at how cash flows from a healthy portfolio, like Group A, to its lenders. First, the buildings generate revenue. Then, they pay off their operating expenses like utilities, taxes, insurance, and personnel. After that, they will also pay for one-off capital items such as tenant improvements, deferred maintenance, or leasing commissions. After all of those cash flows, we arrive at cash flow available for debt service (CFADS). Once your cash has flown down to CFADS, the lender has full claim on the cash until they receive their entire debt service amount. After the lender has been paid, the equity holder may distribute the residual cash to its own accounts.

But stepping back, to whom does the property specifically send its debt service? In a projection model, you just write “interest expense” and “amortization” and call it a day. But in real life, the group who collects the debt service on a CMBS during the ordinary course of business is called the master servicer. On the flip side, for a single-lender bank loan, you would just pay the bank. But for CMBS loans, which are securitized across many lenders, the master servicer is a necessary intermediary that receives the debt service in full and then disburses the proceeds to the many CMBS lenders.

The master servicer wears a few hats. They will of course clip the coupon on the debt service, but they’re also responsible for approving capital expenditures, approving leases, and monitoring casualty and condemnation proceedings to name a few. The specifics of a master servicer’s duties varies by property, but is always spelled out in the pooling and service agreement (PSA). 

When Special Servicers enter the Fray

In a perfect world where private equity real estate returns only go up, CMBS lenders would only ever need a master servicer to perform the more mundane tasks. But when things get spicy, that’s when a special servicer steps in. For instance, shen the Group C properties default and cannot meet their debt obligations, the situation has evolved outside the responsibilities of a master servicer. Thus, the loan is put into special servicing. The specific terms and criteria of transfer from master servicer to special servicer are detailed in the PSA, but generally it’s when a property begins struggling to meet its debt obligations.

Special servicers have a lot of privileges and powers that master servicers don’t have; they have a lot of flexibility and bandwidth to modify loans. Our goal as the real estate private equity firm dealing with the special servicer will be to minimize our losses. There are many paths to exit special servicing, highlighted but not limited to the below:

  1. Hand the keys to the special servicer, giving them the property
  2. Negotiate a discounted pay off, where you pay a portion of the full principal to fully cancel the debt
  3. Enter bankruptcy (not desirable)

We’ll stop here and pick up the discussion next time with a continued focus on this special servicing phase. We’ll touch on the concept of recourse, its varieties (as of losses vs. full recourse), why full recourse is a worst-case scenario, and how to avoid it by paying close attention to waste clauses, etc.

Not everything goes right in real estate private equity, and understanding the mechanics of CMBS loans in default can better prepare you to negotiate favorable contracts before things go wrong, so you’re in the best position possible if and when your private equity real estate returns turn sour.

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