As coronavirus disease 2019 (COVID-19) continues to impact the real estate industry, Israeli investors in US commercial real estate are advised to re-familiarize themselves with the primary structures for tranching real estate debt.
Given the increased likelihood of workouts and foreclosures anticipated in the wake of COVID-19, it is important to understand the interplay of multiple creditors exercising different rights under different financial structures.
And Israeli real estate debt funds looking to deploy surplus capital during these uncertain times are advised to have an understanding of the primary methods that lenders utilize to slice, dice and offload distressed real estate debt.
Mortgage loan tranching
Pari passu loan participation
A pari passu loan is one in which the participants share equally in the upside and downside of the mortgage loan. The mortgage loan is divided into multiple tranches either by issuing two or more notes or creating multiple participation interests.
The reasons for using a multiple note structure include a desire to create direct privity of contract with the mortgage borrower to mitigate certain bankruptcy risks, and to classify the participation as “debt” for regulatory and accounting purposes.
All payments on account of the mortgage loan (after payment of certain expenses) are distributed pro rata to the participants in accordance with their ownership percentages.
Lenders’ rights under these structures are governed either by a participation agreement (in the case of participations) or a co-lender agreement (in the case of notes).
The mortgage loan is divided into a senior portion and junior portion. The senior portion is evidenced by either an A note or A participation, and the junior portion is evidenced by either a B note or B participation. For purposes of this discussion, the holder of the A note or A participation is called the “senior lender,” and the holder of the B note or B participation is called the “junior lender.”
Prior to a default, all payments on account of the mortgage loan (after payment of certain expenses) are generally paid in the following order of priority: (i) to the senior lender on account of current interest, (ii) to the senior lender on account of its pro-rata portion of principal, (iii) to the junior lender on account of current interest, and (iv) to the junior lender on account of its pro-rata portion of principal. All other amounts are then split on a senior/subordinated basis.
Following a default, all amounts collected on the mortgage loan or from liquidation of the collateral (net of certain expenses) are paid first to the senior lender until it is completely repaid before the junior lender is entitled to receive any payments.
All tranches of a mortgage loan benefit from a lien on the related real estate. As you will see below, this is not the case for a mezzanine loan.
The rights of the senior and junior lenders, including with respect to the priority of payments, administration of the mortgage loan, foreclosure, cure and purchase rights, are governed by either a participation agreement or a co-lender agreement, as more specifically described below.
Significant risk factors for A/B structures include the following: (i) there is only one mortgage or security interest, and it is typically controlled by the senior lender; (ii) the junior lender is typically “along for the ride” – the only mechanism for it to exercise control is to exercise its right to purchase the senior lender’s position; and (iii) the junior lender will lose consent, consultation and other rights in the event that it is no longer “in the money” (i.e., the value of its position erodes by more than 75 percent through application of an appraisal test) (a “Control Appraisal Event”).
The Controlling Holder
The “controlling holder” is generally the junior lender with significant input in “Major Decisions” so long as a Control Appraisal Event has not occurred. “Major Decisions” typically include the following: (i) any modification or waiver that extends the maturity date; (ii) any modification or waiver of insurance requirements; (iii) any approval of a material lease; (iv) any waiver of a due-on-sale/encumbrance clause; (v) any modification of a monetary term; (vi) any reduction, deferral or forgiveness of interest, principal or monthly debt service; (vii) any substitution or release of collateral or guarantees; and (viii) any sale of foreclosed collateral.
Following a Control Appraisal Event, the junior lender will lose its consent, consultation and other rights and corresponding status as “controlling holder;” provided, however, that the junior lender may negotiate for the right to regain its status as “controlling holder” by providing cash or a letter of credit in an amount sufficient to cover the appraisal shortfall, which cash or letter of credit will be held as additional collateral for the mortgage loan and applied to any loss after the collateral is foreclosed and liquidated.
Remedies of junior lender
When a default occurs, the junior lender will have the right to cure such default within certain prescribed time periods (typically 5-10 business days for monetary defaults and 30 days for non-monetary defaults, subject to extension so long as the junior lender has commenced and is diligently prosecuting a cure of such non-monetary default).
If the mortgage loan is in default, the junior lender also will have the right to purchase the senior lender’s position at a price equal to par, plus accrued interest (generally excluding any yield maintenance), plus reimbursement of various other amounts including accrued expenses and outstanding advances.
Loan participations and A/B structures tend to be best for “passive” investors, and offer less risk of being primed by unsecured trade debt and subordinate liens.
Unlike loan participations and A/B structures, which are directly secured by real estate, a mezzanine loan is secured by a pledge of 100 percent of the equity interests in the mortgage borrower. If the mezzanine borrower defaults under the mezzanine loan, the mezzanine lender may foreclose on its collateral (ie, the equity interests pledged to it), resulting in the mezzanine lender becoming the borrower under the related mortgage loan.
So long as the mortgage loan is not in default, the mezzanine lender is permitted to receive debt service payments. Once there is a default under the mortgage loan, the mezzanine lender will not be entitled to receive any payment on account of its loan until all of the mortgage loan obligations are satisfied (provided that, in the event the mezzanine lender cures any mortgage borrower monetary defaults, the mezzanine lender may continue to receive debt service payments).
An intercreditor agreement between the mortgage lender and mezzanine lender sets forth the relative priority of the mortgage and mezzanine loans as well as the rights of the lenders, as described below.
One significant risk factor for mezzanine loans is that the mezzanine lender is vulnerable to intervening secured and unsecured creditors of the mortgage borrower due to it not having a direct security interest in the real estate.
Certain mezzanine loan features
The mezzanine loan is cross-defaulted with the related mortgage loan − a default under the mortgage loan will cause a default under the mezzanine loan. However, a default under the mezzanine loan will not result in a default under the mortgage loan.
Mezzanine loans are considered to be “structurally” subordinate to mortgage loans in that mezzanine loans are secured by a pledge of the equity in the owner of the real estate, and not the real estate itself. Following foreclosure of the mezzanine loan, the mezzanine lender will remain subordinate to the mortgage debt in that no equity distributions will be permitted to be made unless the related mortgage loan is current. A foreclosing mezzanine lender will also be subject to any other liens on the property, including mechanics’ liens and judgment liens.
Mezzanine loans are considered separate and distinct loans and have their own set of mezzanine loan documents. Mezzanine loans also have their own servicing arrangements, and mezzanine lenders therefore typically have more control over their loans than the junior lender under a tranched mortgage loan structure.
Mezzanine intercreditor agreements
Unlike in a tranched mortgage loan structure, the mezzanine lender has approval rights with respect to many significant matters as set forth in the mezzanine loan documents, including with respect to management of the property and annual budgets. The mezzanine intercreditor agreement attempts to reconcile such approval rights with similar approval rights granted to the mortgage lender under the mortgage loan documents. It establishes the conditions to a sale of the mezzanine loan and a foreclosure of the mezzanine loan, including conditional pre-approval of the mezzanine lender to assume the mortgage loan once the mezzanine loan is foreclosed. The mezzanine intercreditor agreement also sets limits on modifications of the mortgage loan documents not requiring the consent of mezzanine lender, modifications of the mezzanine loan documents not requiring the consent of mortgage lender, and enforcement of mezzanine lender’s claims under any guarantees.
Remedies of mezzanine lender
Upon a default by the mortgage borrower, the mezzanine lender will have the right to cure the default within certain prescribed time periods (typically 5-10 business days for monetary defaults and 30 days for non-monetary defaults, subject to extension so long as the mezzanine lender has commenced and is diligently prosecuting a cure of such non-monetary default).
If the mortgage loan is in default, the mezzanine lender has the right to purchase the mortgage loan at a price equal to par, plus accrued interest (generally excluding any yield maintenance), plus reimbursement of various other amounts including accrued expenses and outstanding advances.
Foreclosure of mezzanine loan collateral
In addition to these cure and purchase rights, the mezzanine lender, unlike the junior lender, has the right to foreclose on the equity interests in the mortgage borrower, subject to certain requirements set forth in the mezzanine intercreditor agreement, including satisfaction of certain financial and experience tests. The mezzanine lender also has the obligation, in the event that it elects to complete a foreclosure of its lien and become the borrower under the mortgage loan, to cure any ongoing defaults on the related mortgage loan and to provide replacement guarantees.
Preferred equity is another form of subordinate financing that has become more prevalent in recent years, especially in the context of construction lending.
Preferred equity is not structured as a loan – instead the “lender” makes a capital contribution to the mortgage borrower in exchange for 100 percent of the preferred equity in the mortgage borrower, with distribution rights that replicate principal and interest and control rights that replicate foreclosure. In fact, the rights and benefits, including control rights, of the preferred equity holder are very similar to those of a mezzanine lender.
A significant risk factor for preferred equity, similar to mezzanine loans, is that while an exercise of remedies may remove the sponsor, it does not extinguish any third-party claims or subordinate liens.
“Active” investors who believe that they can create value through active management often prefer a mezzanine loan or preferred equity structure, but investors should be aware that these structures do carry a greater risk of being primed by unsecured trade debt and subordinate liens.
If you have any questions regarding these new requirements and their implications, please contact a member of DLA Piper’s Real Estate Finance team or your DLA Piper relationship attorney.
This information does not, and is not intended to, constitute legal advice. All information, content, and materials are for general informational purposes only. No reader should act, or refrain from acting, with respect to any particular legal matter on the basis of this information without first seeking legal advice from counsel in the relevant jurisdiction.