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Fourteen years ago this September, I distinctly recall attending a conference hosted by the European CMSA that was focussed on the advent of CRE CDO’s. At the time, the emergence of these structures was seen as an extremely exciting development as it marked a natural progression for the maturing CRE finance market (following the success of the product in the US). Additionally, it showed there was an overriding need for the asset class as a means of absorbing the ever increasing numbers of B-Notes, CRE mezzanine loans, CMBS bonds and other forms of structured CRE debt that was beginning to flood the market.
Despite there being a general acceptance that this was a natural and welcome step in the evolution of European CRE finance, a number of issues were raised such as the lack of standardisation and the availability of suitable underlying collateral. The chief concern though was around prepayment risk, which was a very real issue at that point in time on account of escalating interest rates coupled with the exponential growth of CMBS issuance that provided increasingly favourable pricing for borrowers.
Although the heightened level of prepayment risk was not cataclysmic for CMBS, this issue was construed as a fly in the ointment. From an investors perspective prepayments were certainly not welcome, especially if redemptions happened relatively soon after issuance. From the structurers point of view, given this was an issue that was very much under the spotlight, it created a structural nightmare in terms of devising how principal should be applied. This was especially true in those transactions that featured multiple loans of varying quality, a difference in interest rates and a wide geographical spread of underlying properties. The modified pro-rata application of principal repayments really went through the structuring mill, which manifested itself with some hugely complex CMBS structures as the structurer sought to ensure that principal was applied in such a way to ensure that credit enhancement erosion for the senior notes was limited, that the weighted average rate on the notes was kept in check whilst at the same time ensuring that the class X would not be adversely impacted.
In essence, prepayments were a necessary evil and were a natural by-product of the economic forces at the time. For the greater good of the product, measures were taken to mitigate prepayment risk through a combination of lock-out periods and prepayment fees. Although a useful deterrent, there are two important points to be mindful of. Firstly, there was no absolute prohibition on prepayment after the lock-out period had burned away. Secondly, prepayment fees were invariably for the sole benefit of the Class X or the loan seller as deferred consideration and thus not shared with those noteholders who suffered from the pain and inconvenience of the early redemption.
If we turn to CMBS 2.0, this in-equitable distribution of prepayment fees has sought to be addressed through noteholders now being entitled to a quantum of the prepayment fees and therefore a vast improvement from the previous status quo. Although credit should be given to CMBS 2.0 for this more equitable division of the spoils, one thing that has become clear is that how these prepayment fees are allocated varies widely:
- Some transactions allocate a percentage (say 50 per cent.) of prepayment fees to the noteholders, where other transactions just stipulate that all amounts should be paid to the noteholders.
- Other transactions include a detailed formula which ensures that the prepayment fees are split between the Class X and the noteholders in the same ratio as interest on the underlying collateral is applied between the two classes of investment. An enhancement to this (from the Class X perspective) has been to exclude administrative costs from the formulation, thus increasing the amount that benefits the Class X.
- Another structural nuance (which benefits the noteholders) is that following the occurrence of a Note Acceleration Event, 100 per cent of the prepayment fees are directed to the noteholders at the detriment of the Class X.
- A further modification has been the application of a cap to the amount of prepayment fees that a certain class of notes is entitled to receive, the quantum of which ratchets down over time.
The treatment and application of prepayment fees can therefore be said to be one of the bedrocks of innovation for CMBS 2.0. Indeed, like other aspects of CMBS which I have written about (CMBS 2.0 – Standardisation the fuel for exponential growth; CMBS 2.0 – Class X – variety is not always the spice of life; CMBS 2.0 IN FOCUS: Liquidity Facilities – the wild child of CMBS 2.0), this is yet another area of the structure that would certainly benefit from greater standardisation. Although for now CRE CDO’s have been confined to the history books of European structured CRE debt prepayment risk certainly has not, and although the equitable distribution of prepayment fees has been a huge leap in the right direction, the standardisation of this would be the icing on the cake.