TransactionsTerry Buquicchio and Jenny Story

Loans originated for securitizationoften include provisions that restricta borrower from incurring debtin addition to the first mortgage.However, Fitch Ratings periodicallyrates commercial mortgage-backedsecurities (CMBS) secured by firstmortgages that allow or have alloweda borrower to obtain additional debt.The additional financing can bestructured in the form of preferredequity, partnership or mezzaninedebt, a second mortgage, or as anNB or NB/C note, in which the firstmortgage is bifurcated into seniorand junior components.

CMBS transaction, which mayor may not include therelated senior mortgage. The methodology used by FitchRatings to rate uansactions that include secondary debt ormezzanine financing differs somewhat from thc proccssused to rate first mortgages. This report also outlines FitchRatings' rating process for CMBS transactions that includevarious forms of additional debt as collateral.

BuquicchioTyPES OF ADDITIONAL DEBT

The different types of additional debt are discussed indetail in the following sections in the general order ofincreasing risk to the first mortgage.

Story:A preferred equity interest is

generally an equity interest in theborrowing entity that receives a preferred return prior to thecommon equity but is not a debt instrument. Mezzaninedebt does not directly encumber the property; however, it issecured by a pledge of limited partner (LP) or membershipinterests in the first mortgage borrower. In contrast topreferred equity and mezzanine debt, Band C notes andsecond mortgages are both forms of additional debt that aresecured by a lien on the property.

Whether rating a single-borrower or multi borrower firstmortgage transaction, Fitch Ratings assumes that addedleverage in any form puts greater suess on the cash flow ofa property and increases losses in the event of default.Therefore, Fitch Ratings adjusts credit enhancement levelsaccordingly. To determine the degree to which creditenhancement levels should be increased, Fitch Ratingsevaluates how the additional debt is suuctured and assessesany control rights held by the additional debt lender orpreferred equity investor. This report outlines Fitch Ratings'methodology for evaluating different types of additionaldebt and the related risks borne by the first mortgage loans.

PERMITTED INDEBTEDNESS

In most CMBS transactions, loan documents generallyprohibit botrowers from incurring any additional debt thatmay hinder the borrower's ability to support and maintainthe asset in the future. However, limited amounts of tradepayables are allowed. Typically, trade payable debt isunsecured, limited to 5% or less of the outstanding principalbalance of the rated first mortgage debt, and is payablewithin 60 days. These limitations are in place becausecertain types of trade payables can create liens that becomesenior to the first mortgage (such as mechanics ormaterialmens liens). Also, unsecured debt in general canincrease the likelihood of involuntary bankruptcy. In eithercase, the repayment of the first mortgage may be impaired.

Additionally, recent transactions have been proposed thatwould securitize the additional leverage as pan of a larger

28 CMBS WORLDh

Evaluating Additional Debt in Commercial Mongage Transactions (cont.)

Therefore, Fitch Ratings may require increased creditenhancement to the first mortgage if limitations on theunsecured debt are not in place.

PREFERRED EQuITYOne alternative financing option for mortgagors is

preferred equity. In a preferred equity arrangement, theinvestor makes a capital contribution to the first mortgageborrowing entity. In exchange, the preferred equityholderreceives an equity interest in the borrowing entity. Thisinterest generally carries a preferred return and paymentpriority over the common equity.

of the direct or indirect equity interestS in the first mortgageborrowing entity. The mezzanine loan should not be securedby a lien on the property, an assignment of leases and rentS,a guarantee from the first mortgage borrowing entity, or anyother structure that would impede the first mortgageborrower's ability to pay itS debt service or violate any specialpurpose entity (SPE) covenants. Since SPE covenantsrestrict a borrowing entity from incurring additionalfinancing, the first mortgage borrower may not be the namedobligor for mezzanine debt.

Because preferred equity is not a debt instrument, it hasno maturity date. In addition, the preferred equity investordoes not have any control rights that could hinder repaymentof the first mortgage. The only right the preferred equityinvestor has is the ability to terminate propertymanagement, subject to rating agency confirmation, and tosell the property (see Chart 2).

Mezzanine Borrowing EntityTypically, the first mortgage borrower is either a limitedpartnership consisting of at least one LP and a SPE generalpartner (GP) or a limited liability company (LLC) consistingof at least one non-managing member (NMM), as well as aSPE managing member. In either of these structures, themezzanine debt will generally be secured by either the LPsor NMMs (whichever is applicable) ownership interest inthe first mortgage borrower, and the LP or the NMM will bethe mezzanine borrower.

The preferred equity documents should provide for andthe preferred equiryholders should acknowledge that afailure to make preferred equity payments will not create adebt obligation on the partnership. Distributions to thepreferred equity investor should be subordinate to all debtand property expenses. The initial preferred equiryholdershould be disclosed to Fitch Ratings, and any transfers ofpreferred equity should be subject to rating agencyaffirmation.

If the first mortgage borrower is a limited partnership, theGP should not be an obligor or guarantor for mezzaninefinancing, nor should it pledge its ownership interests in thefirst mortgage borrower as security. Any of thesearrangements introduce consolidation risk and additionalcreditors to the first mortgage collateral. However, the ownerof the Gp, such as a stockholder, can pledge its ownershipinterest (or shares) in the GP as security for the mezzaninedcbt. ldcally, the sccuriry should consist of a plcdge of

PARTNERSHIP OR MEZZANINE FINANCING

Another common form of additional leverage ispartnership or mezzanine debt.

SecurityThe only security for a mezzanine loan should be a pledge

SPRING 2002 29

Evaluating Additional Debt in Commercial Mortgage Transactions (cont.)

equity in both the GP (by its parent) and the LP interestS inthe first mortgage borrowing entity (see Chart 3), such thatupon a default of the partnership debt, the mezzanine lendercan foreclose on itS security and become the owner of boththe LP interestS in the borrowing entity and the owner of theGP.

A securitized first mortgage with mezzanine debt placedoutside of the trust should have certain structUral featUres inplace that ensure the security of the first mortgage andprevent consolidation risk. First, a nonconsolidation opinionbetWeen the mezzanine borrower and the first mortgageborrowing entity should be in place regardless of whether ornot the mezzanine borrower is a SPE. This reduces the riskof a bankruptcy of the mezzanine borrower affecting theassets of the first mortgage borrower. Additionally, the GP ofthe first mOrtgage borrower (or at least one of the GPs ifthere are several) should be structured as a SPE. and anonconsolidation opinion betWeen the GP and its parent isnecessary to reduce risk.

If the first mongage borrower is a LLC, the individualmembers may pledge their NMM interests in the firstmortgage borrower as security for the mezzanine loan. It ispreferable to have all the NMMs pledge their interests assecurity. Additionally, the parent of the managing membermay pledge its ownership interest in the managing memberas security. Under this structure a nonconsolidation opinionbetWeen the mezzanine borrower and the first mortgageborrower (even if the mezzanine borrower is a SPE) shouldbe in place, as well as a nonconsolidation opinion betWeenthe managing member and its parent (see Chart 3).

from freely transferring the loan without rating agencyconfirmation. Since the transferee could ultimately controlthe first mortgage borrower, Fitch Ratings reviews theproposed transferee in the same manner in which it wouldreview the initial mezzanine lender. The mezzanine loandocuments should clearly state that any transfer of themezzanine loan requires rating agency affirmation withrespect to the existing ratings on the CMBS transaction inwhich the related first mortgage is included. These transferrestrictions reduce the risk of a non-creditworthy orinexperienced entity assuming control of the first mortgagebortower.

Mezzanine lender

Fitch Ratings conductS a thorough evaluation of the initialmezzanine lender since it has the ability to foreclose on theequity interests of the mezzanine borrower and assumecomplete control of the first mortgage borrowing entity. Theevaluation includes a review of senior management,ownership structUre, financial condition, lending, workout,and overall real estate expertise.

Frequently, mezzanine loan documentS may provide fora "permitted transferee" to whom the mezzanine debt maybe transferred. A permitted transferee is generally definedas a major money center bank, life insurance company, orinvestment-grade real estate investment trust withpredetermined levels of capital and extensive real estateexperience with the respective property type. Fitch Ratingswill review the definicion of a permitted transferee.

If the mezzanine debt is held by more than one lender,the likelihood of competing interestS in a workout scenariois increased. This could lead to delays in achieving aresolution, which could cause a further decline in an asset'svalue and result in higher loan losses. The participationshould be structured so that only one lender retains controlduring a workout. In addition, a predetermined timelimitation for negotiations betWeen participantS should beestablished. Without these structural features, creditenhancement will reflect the increased risk associated witha mezzanine loan that is structured as a participation.

Servicing ConflictsIf the master or special servicer (or any controlling parry) fora CMBS transaction is a mezzanine lender on any loans inthe trust, a conflict of interest could arise. For example,during a workout scenario, the special servicer, which isobligated to protect the interests of all of thecertificateholders, may be required by the trust documentS

Transfer RestrictionsWhen rating a first mortgage that has mezzanine debtassociated with it, the mezzanine lender should be restricted

30 CMBS WORLD~

Evaluating Additional Debt in Commercial Mortgage Transactions (cont.)

to implement a recovery plan that could result in a loss tothe mezzanine lender. Therefore, certain servicing andadvancing requirements should be stipulated in the trustdocuments to ensure that the certiticateholders' interestsare protected. Appointing an independent party to servicethe affected loans is one way the risk of conflict can bemitigated.

Control Rigftts of the Mezzanine LenderGenerally, a mezzanine lender wants additional controlrights over a borrower and property operations to furtherprotect its interests. Examples may include cross-defaulting the mezzanine loan with the first mortgageloan; retaining the right to terminate propertymanagement; and having the right to approve the firstmortgage refinancing, the property budget, the sale of theasset, new leases, amendments to the senior loandocuments, or amendments to the borrower'sorganizational documents. Control rights held by themezzanine lender that impede the repayment orrefinancing of the first mortgage or are not subordinate tothe senior lender will be reflected in increased creditenhancement levels.

Overall Leverage

When rating single-borrower first mortgage transactions,Fitch Ratings reviews the total leverage associated with atransaction, including the first mortgage and any additionaldebt a borrowing entity has or may incur. To test thesolvency of the transaction, Fitch Ratings calculates anaggregate debt service coverage ratio (DSCR) using theFitch Ratings adjusted cash flow, the Fitch Ratingsstressed refinance constant on the first mortgage and thehigher of the actual constant, the Fitch Ratings stressedrefinance constant or the accrual rate (if applicable) on themezzanine debt. When tranching a first mortgagetransaction that has mezzanine debt, the DSCR sizingparameters for each rating category is increased. If thecombined DSCR for the first mortgage plus the mezzaninedebt is less than 1.0 times, then the DSCR sizingparameters will be further increased at each rating category.

[vents of DefaultThe mezzanine debt should be structured to limit theevents of default solely to monetary defaults resultingfrom a missed current payment or balloon payment on themezzanine debt. With the exception of fraud, nocovenants in the mezzanine loan documents that cantrigger a nonmonetary default should be allowed.Furthermore, the mezzanine debt should not be cross-defaulted with the first mortgage. It is acceptable that anevent of default on the rated debt trigger an event ofdefault on the mezzanine debt.Payment Priority

When rating first mortgages that allow or have mezzaninedebt, specific cash management procedures should be inplace. Ideally, a hard lock box should be in place at thebeginning of the first mortgage term and remain in placeuntil the first mortgage is fully repaid. The paymentpriority of the property's cash flow should be clearlydefined so that the mezzanine debt lender is paid fromexcess cash flow after the following items are paid: taxes,insurance, ground rent (if applicable), first mortgage debtservice, operating expenses, all capital reserves, and anynecessar")' or discretionary capital items approved by theservicer. If the first mortgage has an anticipated repaymentdate (ARD) or other events that trigger a cash trap, anypayments on the mezzanine loan after the ARD date orcash trap trigger must accrue, as all excess cash flow fromthe property should be used to pay down the first

mortgage.

RemediesThe only remedy available to the mezzanine debtholdershould be its right to foreclosure upon its ownershipinterests in the first mortgage borrower. The mezzaninelender generally accomplishes this through a UniformCommercial Code (UCC) foreclosure. After theforeclosure. the former mezzanine lender becomes theowner of the first mortgage SPE borrowing entity and,therefore. the first mortgage borrower. In addition to itsright to foreclose upon its UCC interest. the mezzaninelender generally has limited rights to terminate themanagement company. subject to rating agencyconfirmation.

AIB AND AlBIC NOTESAnother method of providing additional financing is

through an NB or NB/C note structure. Generally, in thisstructure, the entire debt is secured by a first mortgagethat is bifurcated into component notes: an A note, a Bnote, and a C note component. Although considered to bein a senior position, the A note typically receives itsproportionate share of interest and principal pari passuwith the Band C notes as long as the whole loan isperforming. However, upon an event of default, the Anote component becomes senior to the Band C notecomponents and receives all cash flow until it is fullyrepaid. The holder of the C note component (or B note ifonly two components exist), has the right to buy the Anote out of the CMBS transaction at par but otherwise

MaturityThe mezzanine debt can mature up to tWo years prior tothe maturity of the first mortgage but only after the lock-out period on the first mortgage has expired. However, ifthe mezzanine debt is structured as a balloon loan and it isco-terminus with the first mortgage, a minimum of tWoone-year extension options should be available at themezzanine borrower's option. The ability of the firstmortgage holder to release its lien cannot be contingentupon the satisfaction of the mezzanine debt. FinalIy, themezzanine debt should have no lock-out periods orpenalties for prcpayment, either in whole or in pan.

SPRING 2002 31

Evaluaring AddirionaI Debt in Commercial Mortgage Transactions (cont.)

must "stand still" during an event of default. In addition,the holder of the C note (or B note if only tWO componentsexist) is allowed a limited role in advising the specialservicer with respect to a workout strategy, which is subjectto the servicing standard.

pursue legal proceedings, such as foreclosure, to prevent orrecover losses and complicate the workout process,potentially drawing out the foreclosure and increasing thelikelihood of higher losses. If the second mortgage isstructured as a "soft second," which minimizes the addedrisk to the first mortgage, the additional credit enhancementrequired will be reduced.Although the A note component is often rated

investment-grade and placed in a CMBS pooledtransaction, Fitch Ratings' rating of the A note componentdepends on the specifics of the whole loan structure. Theloan is structured so that the entire debt amount (the A, B,and C note components combined) is secured by a firstmortgage, and any nonpayment to any noteholder results ina default of the entire loan.

A soft second is a second mortgage that contains asubordination and intercreditor agreement betWeen the firstmortgagee and second mortgagee and restricts theactions the second mortgagee can take in the eventof default. For a loan to qualify as a soft second,the subordination and intercreditor agreement shouldcontain a standstill clause that prohibits the subordinatelender from exercising any remedies, including thecommencement of foreclosure proceedings while the firstmortgage is outstanding. The subordinate mongagee mayforeclose only if it first purchases the senior mortgage at aprice of par plus any accrued interest and trust expenses. Inaddition, the second mortgage should only be paid out ofexcess cash flow. Furthermore, the second mortgageeshould agree to subjugate its voting rights to the seniorlender in the event of bankruptcy. Finally, the juniorlienholder should be willing to subordinate to a refinancedsenior mortgage. If any of the aforementioned restrictionsare not in place, credit enhancement levels will reflect theadditional risk associated with the lack of structUral features.

The same process that is used to rate stand-alone singleasset deals is used when rating single asset transactionsinvolving an NB or NBIC structure. Credit enhancementlevels are based on the Fitch Ratings stressed DSCR which

RATING ADDITIONAL DEBT AS CMBS COLLATERAL

Fitch Ratings' methodology for rating CMBS pools thatinclude additional debt as collateral follows the processused for rating CMBS pools of first mortgage debt.Similarities include the ways in which pool level issues,such as geographic, borrower, and loan conccntrations, arcevaluated.

Second Mortga,. -.ecured by prvperty

is derived by applying the Fitch Ratings net cash flow to theFitch Ratings debt service for the whole loan and loan tovalue ratio (LTV). If an NB or NB/C loan is ratednon-investment-grade, credit enhancement levels at eachtranche will reflect the additional leverage associated withthe NB or NB/C structUre. Fitch Ratings also considersthe rights afforded to B or C note buyers through theintercreditor agreementS.'

Additionally, Fitch Ratings uses a similar methodology toderive its stressed DSCR and LTV for individual loans.This process includes re-underwriting property cash flowsto derive a stabilized Fitch Ratings net cash flow and thenapplying a Fitch Ratings stressed refinance constant to thedebt. As with single-borrower transactions, the totalleverage that encumbers the associated property must beevaluated. Therefore, Fitch Ratings combines the stresseddebt service on the first mortgage and the higher of theactual or stressed debt service on the additional leverage todetermine the total debt service that the property mustsupport. This combined debt service is then applied to there-underwritten cash flow to arrive at an aggregate FitchRatings stressed DSCR. In instances where accrual and payrates on the debt exist, Fitch Ratings will apply the higherof the Fitch Ratings stressed refinance interest or accrual

rate.

SECOND MORTGAGE DEBTA second mortgage is a loan that is subordinate to the

first mortgage debt but secured by a lien on the property(see Chart 5). This additional debt could place stress on theproperty, particularly during an economic downturn whenthe property's cash flows may not support a junior debtservice payment. In this case, the mortgagor could defaulton the secondary debt and declare bankruptcy, which wouldnegatively affect the performance of the first mortgage. Inaddition, the presence of other secured creditors canincrease the likelihood of default on the first mortgage sincea default on the junior debt may cause the creditors to

Fitch Ratings stressed DSCR is the primary determinantof probability of default for mortgage loans (followed by

(continued on p. 89)

CMBS WORLD~

Mezzanine Debt: Suggested Standard Form of lnterrreditor Agreement (conlinued from p. 26)

mezzanine financing, will require a much more stringent loan transactions with mezzanine debt. In some cases,intercreditor agreement.) certain language may be modified due to the specifics of

the transaction. The form intercreditor agreement isSignificant issues that have been addressed in the form available in electronic format on the CMSAc website,

intercreditor agreement include permitted transferees of www.cmbs.org and at www.dechert.comthe mezzanine loan, conditions to taking title to thepledged equity interests, limitations on modification to thefirst mortgage loan and the mezzanine loan, rights of themezzanine lender to cure defaults on the first mortgageloan, rights of the mezzanine lender to purchase the firstmortgage loan, certain control rights and financing of themezzanine loan. These issues have been sticking points inmany mezzanine loan intercreditor agreement negotiationsand the source of the most inconsistencies. The formattempts to reach a middle ground on these issues andreflects where market participants have often ended up inrecent transactions after extensive negotiations. Standard& Poor's and Fitch Ratings have indicated that this formwill generally be acceptable for most securitized mortgage

Widespread use of the form by market participantsshould ultimately benefit all CMBS participants bycreating a higher level of consistency in intercreditoragreements and reducing the time, expense anduncertainty associated with negotiating mezzanine loanintercreditor agreements. 0

Dovid ~ Forti and Timothy A. Stafford are members of theFinance and Real Estate Group of Dechert. The authors wouldlike to thank the over 30 market panicipanrs thot contributed tothe creation of the form intercreditor agreement.

Evaluating Additional Debt in Commerr:ial Mortgage Transactions (continued from p. 32)

adjustments for collateral and pool level issues, as thosementioned above}. The lower the Fitch Ratings stressedDSCR, the greater the probability of default. Since it iscalculated on an aggregate basis, the Fitch Ratings DSCRfor additional debt is lower than that for the related firstmortgage. Therefore, additional debt included in a CMBStransaction receives a higher probability of defaultassumption than the respective first mortgage CMBScollateral.

debt that is junior to an already highly leveraged firstmortgage loan. Furthermore, a pool consisting of additionaldebt may not meet the higher level of loan divers icy neededto tranche up.

First mortgage loan transactions with additional debtplaced outside of a CMBS trUst are subjeCt to increasedcredit enhancement, depending on how the additional debtis strUctUred. However, the strUctural features of additionaldebt utilized to reduce the risk posed to the rated firstmortgage debt may increase the credit enhancementrequired for additional debt when it serves as collateral for aCMBS transaction. 0

Another difference between rating additional debt andfirst mortgage debt is the loss severity assumption thac isapplied to each loan. As che LTV increases on a FitchRatings stressed basis, additional losses are attributed to aloan. Therefore, when rating additional debt, Fitch Ratingscalculates its stressed LTV by combining the first mortgagedebt and the additional debt, which resultS in higher lossseverities. Fitch Ratings will generally assume a loss severityof 100%.

Terry Buquicchio is Senior Director; and Jenny Story is ManagingDirector; at FitchRatings.

IFor more details, see Fitch Ratings Research on "ABCs of AlBICNotes-EvalUl1ting AlBIC Note StroctZIres in Commercial MortgageTransactions," dated December 10, 2001, available at the FitchRatings website: wwwfitchratings.com.

CMBS transactions that include additional debt may havelimitations on how high they can be tranched given thejunior position of the additional debt. Fitch Ratings wouldbe unlikely to give significant tranching benefit to additional

SPRING 2002 89