The secret to fixing CMBS (hint: channel Peter Drucker)

Breaking New Ground


"To satisfy the customer is the mission and purpose of every business." – Peter Drucker

Commercial mortgage-backed securities (CMBS) emerged as a viable business in the commercial real estate (CRE) lending market in the early 1990s by providing 10-year fixed-rate non-recourse loans with the best pricing and proceeds on the street. At its zenith in the mid-2000s, CMBS accounted for approximately 50% of all CRE loan originations.

However, since the Great Recession, CMBS has seen a precipitous decline in its share of CRE loan originations. Government-sponsored enterprises (GSEs) now dominate multifamily lending, and life insurance companies, banks, and alternative lenders continue to gobble up market share. 

Once the preferred financing option for CRE borrowers, CMBS now suffers from an "ABC" or "Anything But CMBS" mentality in the CRE industry. The current market downturn caused by the coronavirus disease 2019 (COVID-19) pandemic has only served to amplify the shortcomings inherent in the CMBS model and the need to fix them.

If business guru Peter Drucker, often hailed as the father of modern management, were here today, what steps would he recommend the CMBS industry take to repair its perception in the CRE community and re-establish itself as an essential player in the CRE finance marketplace?

Here are some thoughts:

Focus on the borrower experience

The narrative must change from “Anything But CMBS” to "all About the Borrower/Customer experience." All decisions around the CMBS process should take the borrower into account. The ultimate customer is the borrower – not the servicer, rating agency, or B-piece buyer. There is no loan transaction without a willing borrower. And to attract willing CMBS borrowers, the industry must undertake a paradigm shift in its approach to documentation and servicing.

Improve the documentation process – standardize, streamline and synthesize (the “3 S's”)

1. Standardize the loan documents

Create industry-standard loan documents (including uniform key terms and securitization provisions) and riders that address features unique to a given transaction. Corporate America has long known the value of brand consistency, building trust, and making customers feel confident. Homogenized loan documents will have a similar impact on the borrower.

2. Streamline the loan documents

  • There was a time when most CMBS loans were closed utilizing a note, mortgage, and ancillary documents – there was no loan agreement! Imagine closing a loan today without a 150-page loan agreement. While not suggesting that the industry do away with the loan agreement entirely, it should simplify it. A good starting point would be offloading provisions from the loan agreement into the pooling and servicing agreement to the extent possible.
  • Eliminate the separate assignment of leases and rents document, environmental indemnity agreement, and various certificates – the other loan documents address the relevant provisions contained in these documents. 
  • Get rid of cash management for multifamily loans.

3. Synthesize borrower-friendly concepts into the loan documents

  • Allow future supplemental financing provided by the original lender or future mezzanine financing, subject to satisfying specific financial tests.
  • Make it easier for the borrower to exit the loan by providing shorter term options, replacing defeasance with the less expensive and time-consuming yield maintenance alternative, and refining the loan assumption process to include a "qualified transferee" concept.
  • Trim special purpose entity (SPE) separateness covenants.
  • Remove independent director requirements - a much stronger disincentive to voluntary bankruptcy is the non-recourse carveout guaranty from a creditworthy person imposing full liability in the case of a voluntary or collusive filing.
  • Eliminate springing member requirements for small-dollar loans.
  • Align the non-recourse carveouts with traditional non-recourse loans.
  • Limit the need for rating agency confirmations and include "deemed granted" language in the loan documents to safeguard against rating agency unresponsiveness.

Implementing the "3 S's" will also help curb loan document negotiations, resulting in lower legal fees and a less contentious and more positive borrower experience.

And as part of the industry’s quest to upgrade the documentation process, it should also address the time-consuming and expensive opinion letter process. The CMBS industry should consider only requiring expensive non-consolidation opinion letters for high-leverage, high-dollar loans (the risk of substantive consolidation of SPEs is rare). And it should reconsider the utility of entity and enforceability opinions and those pesky Delaware springing-member opinions, especially for loans below a specific dollar amount.

Enhance the servicing experience – the holy grail of the CMBS industry

  • Provide mechanisms for the originating lender to remain involved with asset management and servicing throughout the life of the loan, including the ability to set servicing standards, monitor the servicing process, and submit formal guidance to the servicer in connection with borrowers' approval requests.
  • Make the conditions to disbursement for reserves and the consent rights for leasing activities, alterations, transfers, and other matters in the loan documents more objective –limit servicer discretion.
  • Include "deemed approval" language in the loan documents wherever possible.
  • Increase the servicer's base compensation and eliminate transaction-specific payments.
  • Broaden the menu of "permitted transfers" that do not require the servicer's consent.
  • Bring servicing in-house.

And consider consolidating other services to reduce borrower costs and increase economies of scale. The network of independent service providers involved in any given CMBS transaction may include the lender, broker, correspondent, loan seller/depositor, issuer, trustee, master servicer, special servicer, rating agencies, investors, data providers, accountants, and law firms, including loan origination counsel, securitization counsel, local counsel, bankruptcy counsel, and Delaware counsel. There are too many cooks in the CMBS kitchen!

CMBS is at a crossroads and must adapt to survive. GSEs, life insurance companies, banks, and alternative lenders have successfully incorporated many of the recommendations above into their respective business models – the CMBS industry can do the same! While demand for CMBS loans may never return to its pre-Great Recession high, it can continue to serve an important niche in the CRE lending space by channeling Drucker's teachings.