The Impact Of Subordinate Debt on Rating CMBS Transactions

Co-written by Jennifer A McCool

Originally Published In: Real Estate Developments Fall 2001

After several years of prohibiting all forms of subordinate debt, the growth and maturity of the commercial mortgage securitization market has moved to accepting subordinate debt, but only with strict requirements from senior lenders as to acceptable forms of such debt. Aside from certain "permitted debt" such as short-term trade debt and tenant obligations, senior lenders had traditionally disfavored any form of subordinate financing. This concern stemmed from the fact that subordinate debt, whatever the form, would have at least some adverse affect on the credit of the senior debt - including, increasing the likelihood of default on the senior debt, and in some instances, increasing the severity of loss to the senior creditor when a default occurs. However, in today's economic environment, borrowers typically seek capital in property-specific or large securitized loan transactions in such an amount to maximize loan proceeds. One currently acceptable way to maximize loan proceeds, while satisfying strict senior lender requirements as to subordinate financing, is through the use of mezzanine financing.

Mezzanine financing is becoming a widespread means of funding the difference between the first mortgage financing, usually having a LTV between 40%-75%, and the equity participation of the borrowing principals, commonly no greater than 10% of the project cost. Using this form of subordinate debt, a borrower can access additional financing from 50% to 90% of the cost of the project's capital structure. The most common forms of mezzanine financing include providing credit to the partners or other equity holders of a borrower and taking a pledge of such parties' equity interests (including distributions of income), or taking a preferred equity position that is entitled to distributions (in the form of excess cash flow after debt service) ahead of borrower's principals. A "hybrid" loan structure may also be used. Here, the same lender acts as senior lender and mezzanine lender. The structure combines a first mortgage loan with mezzanine financing at a cumulative LTV ratio of 90-95% and may also contain shared-appreciation and/or profit participating features.

As the market for mezzanine lending has grown, the rating agencies have played an increasingly important role in determining the structure of subordinate financing and encouraging the use of...

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