CMBS Loan Pooling and Servicing Agreements (PSAs) Explained
Before CMBS loans are pooled together to create a commercial mortgage-backed security, each borrower needs to sign a contract called a pooling and servicing agreement. This is a separate document from the general loan agreement. CMBS pooling and servicing agreements can be complex, so if you’re a borrower, it’s typically a good idea to have an experienced CMBS lawyer review your loan’s PSA before you sign anything.
What do CMBS Pooling and Servicing Agreements Consist Of?
PSAs are generally highly detailed legal documents that define all aspects of a conduit loan, as well as the responsibilities of each party to the loan, including the lender, the borrower, the master servicer, the primary servicer or subservicer (if there is one), the special servicer, and the investors.
A PSA will generally define when a loan has gone into default or technical default. While regular default occurs when a borrower fails to pay their mortgage on time and in full, a technical default may occur for a variety of smaller reasons, such as failing to conduct maintenance on the property, losing an anchor tenant, or letting the property slip below a certain DSCR.
The PSA will also state any “bad boy” carve-outs the loan has. While CMBS loans are non-recourse, meaning that the special servicer cannot attempt to repossess the borrower’s personal property should they default on their loan, “bad boy” carve-outs provide exceptions to this rule.
Common “bad boy” carve-outs include exemptions for fraud, embezzlement, and intentional bankruptcy. However, less common carve-outs could include things as simple as turning in a quarterly P&L (profit and loss) statement late to the servicer. This is why PSA agreements can be so tricky, and the “small text” can often turn what seems like a non-recourse loan into a full-recourse financial instrument.
While this rarely happens in practice, PSAs may include situations in which the CMBS investors can replace the special servicer, should it be found that they are not working in the investors’ best interests.
A PSA will also generally include rules involving the REMIC (real estate mortgage investment conduit), the legal vehicle into which CMBS loans are placed before securitization. REMIC rules typically involve restrictions regarding the collateral (i.e. the borrower’s property) and often restrict any changes from being made to the property via the life of the loan, even if these changes actually enhance the value of the property and increase the overall value of the property (i.e. increasing DSCR and debt yield).
In addition, a pooling and servicing agreement may also include rules involving the property’s required replacement reserves, including the minimum amount required, how and where the reserves will be held in escrow, and how this collateral will be released in the situation that the property needs repairs.
Loan Agreements and a Pooling and Servicing Agreement Can Sometimes Conflict
It should be noted that pooling and servicing agreements are often quite lengthy, sometimes more than 500 pages. Due to their extreme complexity, the definitions and requirements noted in a PSA can sometimes differ from those in a CMBS loan’s actual loan agreement. In general, this means that borrowers need to adhere to both agreements (usually the stricter of the two).
For instance, if the loan agreement states, for instance, that a multifamily property must provide $250 of replacement reserves per unit, per year, and the PSA requires $350, $350 is likely the number that the borrower will have to adhere to without violating their overall responsibilities. In many scenarios, the small details of a PSA can be negotiated, particularly if the borrower is financially strong and the property
Overall, the fact that PSAs are so complex is just one of many reasons that every potential CMBS borrower should have a strong advisory team. This generally means having a good commercial real estate broker and commercial mortgage broker that have done these deals before. However, most importantly, a potential CMBS borrower should get legal representation with specific CMBS experience. This will allow them to navigate the potential pitfalls of CMBS financing and avoid signing anything that could get them in trouble down the line.