Conduit loan considerations

(Or, You "Conduit" if You Know What You're Doing!)

By Sally L. Galati, Esq.

Conduit loans offer many attractive features that are not otherwise attainable in a typical portfolio loan transaction. However, before any potential borrower signs on the conduit line, it is important that the borrower consider the many different pros and cons of utilizing the conduit loan structure in its real estate transaction before proceeding. This article will explain a typical conduit loan, discuss the pros and cons of using such a lending structure as compared to using a traditional portfolio loan, and identify considerations for the typical commercial borrower to consider prior to entering into such a transaction.

Conduit Loans

A traditional or “portfolio” loan is one in which the lender originates and holds the loan on its balance sheet through maturity and takes care of the entire lending process throughout the life of the loan. In contrast, a conduit loan is a type of loan that is originated with the specific purpose of securitizing the loan for a future investment offering, with each stage of the loan handled by a variety of different servicers. Also known as commercial mortgage backed securities (“CMBS”), these loans are combined with many other single mortgage loans of varying size, location and property type, and are then pooled and transferred into a trust. The trust can then group the loans into a series of bonds that will vary with different assigned credit ratings to various bond classes, which are provided to investors who choose which types of CMBS bonds to purchase based on the investors’ risk levels. Investors are paid the interest from all of the pooled loans on a monthly basis, based on the bond rating. A real estate mortgage investment conduit (“REMIC”) is the typical way commercial real estate loans are securitized. A REMIC is not subject to tax at the trust level, and requires strict compliance with REMIC regulations in order to retain the tax status it enjoys.

Conduit loans are fairly standardized across the industry because of the requirement that they will be combined with other loans that are similar in nature. While providing benefits that will certainly seem attractive to a commercial borrower, to retain their favorable tax status at the REMIC level, these loans deprive the borrower of flexibility through several key provisions. Therefore, it is important that a borrower thoroughly explore all of the benefits and limitations of a conduit lending device prior to deciding that a conduit loan is the correct lending vehicle for the borrower.

Differences Between Traditional Lending and Conduit Lending

Traditional lenders tend to operate locally with a focus on their local business areas. As a direct result, traditional lenders tend to have stronger relationships with borrowers and are well versed in the local real estate market in which they operate. Conversely, conduit lenders are more typically national, with less involvement in local markets and less specific knowledge regarding those real estate markets. Traditional lending is relationship oriented while conduit lending is transaction oriented. The traditional lender is interested in developing a relationship with a borrower because of the opportunity for future business between the parties. A conduit lender is simply interested in the specific transaction at hand, with no future view toward further business.

Other differences between traditional lenders and conduit lenders are that conduit lenders are more likely to offer a fixed-rate loan than would a traditional lender; conduit lenders generally include non-recourse guaranty provisions in the loan whereas traditional lenders infrequently include non-recourse guarantees; conduit lenders almost always include a prepayment penalty which can be incredibly harsh to the borrower, whereas only half of the traditional lenders include prepayment penalties; and conduit lenders require that a special purpose entity be formed as the borrower whereas traditional lenders do not have such a requirement.

Conduit loans are considered to be more “efficient” because of their standardization. What this means to the borrower is that there is very little, if any, flexibility. Traditional lending is less efficient because these types of loans are not as standardized, which allows for more flexible loan programs for borrowers.

Conduit Loan Prepayment: Defeasance

Typically, conduit loans contain what is known as a “lock-out period,” which means that the loan cannot be prepaid for a certain amount of time. Conduit loan lock-out periods are typically two or three years from the time of securitization. Even though the loan may be prepaid after the end of the lock-out period, most conduit loans contain penalties (frequently one percent (1%) of the principal amount of the loan) to make such a prepayment. In other instances, conduit loan restrictions may require that the borrower substitute collateral for the property secured by the conduit loan. This substitution of collateral is known as a “defeasance.”

Defeasance is the requirement that the borrower substitute government securities for the collateral property. Defeasance is not prepayment because in a defeasance, the note remains outstanding but is instead repaid by the cash flow from the government securities that have been purchased, rather than through cash flow generated by the original property collateral. In this way, the borrower is able to release its property from the mortgage lien, even though the borrower remains liable for the income stream. The practical effect is that the investors’ risk after a defeasance is low because the investors rely on the income stream from government securities, which are less likely to default. Defeasance is required to protect the bond investors by providing another form of compensating payment that matches the investors’ expected yield.

A prepayment is different from a defeasance because in a prepayment, the note is actually paid off and then removed from the trust. The typical one percent (1%) prepayment penalty is designed to compensate the bond investors for the loss of their expected yield, and is referred to oftentimes as “yield maintenance.”

Non-Recourse Loan

Conduit loans are normally “non-recourse,” meaning that an individual borrower has little to no personal liability in the event of a default. On a default, the lender can foreclose on the collateral, but the lender cannot pursue a deficiency judgment for any deficiency that may exist between the loan balance and the property value from either the borrower or the guarantor.

Non-recourse loans typically include what are known as “bad boy” exceptions. A borrower’s bad acts including fraud, material misrepresentation, waste, or misappropriation of tenant rents or security deposits, for example, constitute exceptions to the non-recourse loan. Each loan may vary slightly as to the definition of bad acts, but the concept is generally the same.

Conduit Loan Servicer

Conduit loan servicers are the administrators of securitized loans, and they typically administer these loans with a minimal amount of customer service. Servicers are required to follow the loan document as written, with no deviation. Oftentimes, there are layers of servicers that the borrower must contact for any special request. Because conduit loans are very standardized in the market, servicers have streamlined (read, “reduced”) their administration so that it is difficult for a borrower to communicate directly with a person regarding loan servicing issues. This is the downside of the efficiency gained by a conduit loan, and the end result is that the borrower will not be successful in revising the loan documents after the documents have been executed. Beyond that, after the loan has been securitized, the borrower is not permitted to do anything that would result in a change to the collateral, including expanding the property or granting additional easements. For these reasons, a conduit loan may not be the best choice for developments that are planned to be constructed in phases.

Summary

The benefits to a conduit loan borrower include a lower interest rate, longer loan maturity and amortizations, non-recourse provisions, larger maximum loan amounts, and higher maximum loan-to-value ratios. On the other hand, the costs to the borrower include the standardization of the loan itself, prohibiting flexibility for the borrower; impersonal loan administration; a lack of borrower bargaining power; additional costs resulting from the requirement that the borrower form a special purpose entity; the additional reserve allowances that are required by conduit lenders to cover future costs such as taxes, insurance, tenant improvements and capital replacements; and finally, the costs of a defeasance or prepayment penalty should the borrower want to exit the loan for any reason prior to the loan’s maturity.

While conduit loans can be the perfect loan for certain borrowers, they may become a nightmare for other borrowers who are unaware of the differences between traditional lending and conduit lending.