Commercial Magazine

Beware Of Lending Traps

When it comes to mortgage agreements, the devil is always in the details

By Ann Hambly

The No. 1 thing that borrowers want in their commercial mortgage is control of their cash flow after the debt is serviced. Borrowers need funds to be able to properly care for their properties.

With retail or office properties, for instance, maintenance and repairs will invariably be required, along with tenant improvements. At the same time, leasing commissions must be paid or brokers won’t help fill the space. If the asset is a hotel, the owner may face consequences if they don’t comply with the property improvement plan.

Mortgage brokers should be aware of these pitfalls and explain them to their clients, who are most likely going into their loan negotiations with a lack of understanding.

Despite these obvious realities, borrowers often have a common complaint about commercial real estate loans: They don’t wind up keeping control of their cash even when their loans are performing well. The reason for this is, at origination, these borrowers signed a springing cash-management agreement, which allows the lender to take control of the property’s cash flow under certain conditions.
Many borrowers agree to this arrangement because they believe that they won’t lose control of their cash unless there is a problem with the property. They believe their asset will perform and therefore this issue will never come up. But that is not always the case. After a loan is funded, many borrowers discover that there were unforeseen clauses in the loan documents that eventually spring into action and transfer control of the cash flow even on perfectly performing properties.

The concept of the DSCR trigger is for the lender to trap all excess cash flow after debt service, which may happen if and when cash flow has trouble.

Commercial mortgage brokers need to advise their clients about such loan covenants and cash-management details. If borrowers don’t understand these clauses correctly, lenders can take control of a property’s cash flow while leaving property owners high and dry.

The cash sweep

This might seem like a rare problem, but many brokers and borrowers will recognize similar situations. Although springing cash-managed loans are common in deals involving commercial mortgage-backed securities (CMBS), this situation also can happen to just about any business-purpose borrower who isn’t careful.
The primary way the lender takes control of the cash is through the debt-service-coverage ratio (DSCR) trigger. The concept of the DSCR trigger is for the lender to trap all excess cash flow after debt service, which may happen if and when cash flow has trouble. This is known as a cash sweep.
Let’s say a major tenant moves out and the lender wants to build up excess cash flow so there are adequate funds to place a new tenant in the vacant space. This plan makes sense and is a main reason why borrowers often agree to a springing cash clause when the loan is originated.
The problem, however, occurs when the DSCR calculation that triggers the cash sweep is not based on the actual DSCR of the property. Instead, it is based on a completely different set of numbers, such as the market vacancy rate, rather than the actual vacancy rate. A debt-service calculation may be based on an amortizing loan, even if the payments are interest-only. Also, the property’s income may not be calculated the same and certain revenue is left out.
When lenders take away income from their calculations — such as by adding an amortizing payment to an interest-only loan, or by using a market vacancy rate even if the subject property is 100% leased — a perfectly performing property can easily trigger the cash sweep. When this happens, borrowers tend to be shocked by the results.

Hidden pitfalls

There are more examples of the cash-management “gotchas” that are hidden in loan documents and can cause owners to lose control of cash flow after debt servicing. A commonly used method is the exclusion of income for tenants that “go dark” and cease operations at a location, even if they are still paying full rent.
This cash-management method was commonly triggered during the early months of the COVID-19 pandemic and today it is tied to the remote-work trend. That’s why borrowers had to get a waiver or extension of the DSCR during the height of the pandemic, even if their tenants were meeting rent obligations.
An example involves a borrower who is dealing with this exact situation, where one major tenant went dark during the pandemic and is continuing to allow its employees to work from home. When this tenant’s rent is deducted, the DSCR — per the loan documents — falls below the trigger level. This has led the lender to hold all excess cash flow and the borrower may not have access to any of the cash generated by the property.
Another common procedure that may trigger a cash sweep is the exclusion of income for tenants that do not provide a notice of renewal at least 12 months before lease expiration, even if the lease does not require the tenant to provide notice of renewal at that time. Going into a cash sweep is quite easy, but getting out of one is very hard. The cure provisions, in this case, are when the tenant has renewed and is paying under the extended lease terms for two quarters. In this scenario, it is possible for a borrower to lose control of cash flow for as long as 18 months, even if tenants renew in accordance with their leases.
This type of event is more common than many might believe. Mortgage brokers should be aware of these pitfalls and explain them to their clients, who are most likely going into their loan negotiations with a lack of understanding about such events or how they happen. Borrowers make logical assumptions based on how they think cash-management triggers work and they don’t expect to experience these difficulties. But the truth is, many will face a cash sweep even though their properties are performing just fine.
Originators and borrowers need to go into every new loan understanding all aspects of the deal. Brokers must make sure their clients read the documents literally and don’t assume anything. Borrowers need to know the meaning of terms such as springing cash-managed loans and cash sweeps. All intent must be clear in the documents. After all, when it comes to interpreting contracts, it doesn’t matter what relationship the borrower may have with the parties involved; the servicer will interpret the documents literally and without regard to intent. That is their job.
As an originator, the focus is often on borrower satisfaction and repeat business. This can best be achieved if all parties understand the documents and the broker works with the borrower to make sure there are no unnecessary snags after closing. No one likes a trap. ●


  • Ann Hambly

    Ann Hambly is the founder and CEO of 1st Service Solutions, a full-service CMBS advisory company with a singular focus on owners and borrowers. Founded in 2005, the company also is the first borrower-advocate company ranked by Morningstar Credit Ratings. Hambly has 30 years of experience heading up some of the largest servicing groups in the industry, including Prudential, GE Capital and Nomura, and has negotiated hundreds of pooling and servicing agreements for CMBS transactions.

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