There has been increasing use in Europe by non-bank lenders of warehouse finance in the commercial real estate (CRE) lending market. These private financing structures are used by non-bank CRE lenders such as real estate debt funds or real estate investment trusts (REITs) to lower their cost of funds and boost returns through leverage provided by banks. With commercial real estate investors and lenders concerned about the prolonged real estate cycle and record-high property values, we explore in this article some of the potential outcomes and considerations that market participants in structured commercial real estate debt should bear in mind in the event of distress in the CRE lending market.

CRE warehouse debt defined

There are various types of financing which could be considered ‘warehouse finance’ or ‘warehouse financing’ in the CRE lending market. The common feature of the structures discussed in this article is that they involve a bank (the finance provider) advancing finance to a non-bank CRE lender (the borrower) on the basis of a maximum advance rate or maximum percentage of the value of the underlying CRE loan(s) (the collateral assets), which form the collateral for the financing provided. The borrower will use the financing provided by the finance provider to originate, acquire and/or refinance a participation in collateral assets, which are usually first-ranking mortgage loans secured on European CRE.

We have extensive experience in advising borrowers of warehouse finance such as real estate debt funds and REITs in respect of the following products:

• loan-on-loan finance (where the finance provider advances funding in the form of a secured revolving credit facility to the borrower);
• CRE repo finance (where CRE loans (which may or may not have been repackaged into a note, cleared in the clearing systems) are used as collateral in a repo financing provided by the finance provider (using e.g. a master repurchase agreement or a GMRA);
• private securitisations (where a small number of CRE loans are sold to a vehicle which funds the purchase price of that CRE loan using tranched debt, with the senior tranche advanced by the finance provider and the junior tranche by the borrower); and
• derivatives (e.g. a total return swap where the finance provider provides leverage in exchange for passing through the cashflows on the underlying loan).

For discussion purposes, in this article we will focus on concepts found in European CRE loan-on-loan technology, although such concepts may also be applicable to the other products listed above, the structure of which often depends on the internal requirements of the finance provider (including the regulatory capital treatment associated with holding such a product). We would also note that structured CRE debt which involves a public issuance of securities, such as CMBS, or warehouse finance which is funded by the capital markets, such as CRE CLOs, lies outside the scope of this article.

Considerations for the borrower and finance provider of structured CRE debt in a distressed scenario relating to the underlying CRE loans

Impact of a lower valuation on the underlying CRE

In circumstances where the value of the underlying real estate securing the collateral assets has reduced based on the latest applicable valuation relating to the real estate, resulting in a breach of the LTV covenant in the underlying CRE loan, typically this would have the result of reducing the advance rate applicable to the warehouse finance provided against that loan. This will be the case where the advance rate mechanics include a “look through” loan-to-value element. This represents a more objective standard for allowing the finance provider to make a margin call to rebalance the facility (if applicable). We discuss margin calls in more detail below. From the borrower’s perspective, it is key to protect against the finance provider determining market value in its sole discretion or for subjective reasons.

Asset value/market value adjustments

In certain warehouse financings (especially where the amount of leverage available to the borrower is >60% of the value of the underlying collateral assets) there may be mark-to-market provisions in the finance documents. If this is the case, the definition of “Market Value” or “Asset Value” (or equivalent) is typically subject to extensive negotiation at the time that the warehouse finance is put in place. As the collateral assets form the security package for the financing, the finance provider may seek to ensure that any valuation of those collateral assets can be determined by it in its sole discretion in the event that such collateral assets become defaulted, thereby triggering a margin call payment by the borrower. Discussions in this regard will focus on the definition of defaulted and the time period of any non-payment (e.g. 180 days).

It is incumbent upon borrowers to ensure that the finance provider’s ability to determine value in the event of adverse valuation events relating to the underlying loan is as objective as possible and that the finance provider acts in accordance with a commercially reasonable standard. For example, the mere occurrence of a capital markets event should not be enough to allow the finance provider to mark the value of the loan down, and the finance provider’s ability to determine market value should be based on a list of factors taken in the aggregate, by reference to the base case assumptions relating to the underlying real estate (as the same may be updated from time to time) – this is particularly important in a transitional lending scenario where the occurrence of a negative event relating to the asset may actually have been factored into the underwriting decision taken by the borrower. For example, if the borrower’s base case relating to collateral asset envisages a period of rental voids, then the occurrence of such rental voids should not therefore result in the finance provider marking the value of that loan down. Other considerations for borrowers include catering for the impact of a margin call where the relevant collateral asset is held in a number of funds or managed accounts, some of which positions have not been levered, in situations where the fund required to make the margin call is subject to some kind of liquidity issue. Orrick has advised borrowers on the structuring solutions available in such a scenario to keep the structure intact without prejudicing the investors in the unlevered funds.

See the discussion of margin calls below for more information.

Guarantee/equity injection

Assuming the level of defaults relating to the collateral assets is sufficient to result in a potential payment default at the warehouse finance level itself, the borrower (acting via the fund or REIT) would be incentivised to keep its warehouse financing current by injecting cash to cure any potential default at the warehouse level. This is because the waterfall of payments in the warehouse financing will typically provide for portfolio cashflows to be credited to a bank account which is secured or otherwise controlled by the finance provider, with any surplus being returned to the borrower; i.e. the borrower is in the first loss position. It is therefore incumbent upon the borrower to ensure that there are no limits to the number of equity cures in the form of subordinated debt or equity injections that can be made by the fund/REIT parent.

These cure rights are in addition to the typical fund guarantee for warehouse financings (typically between 20% and 50% of the total amount of the outstanding debt under the warehouse financing, with the ability to ratchet down in certain circumstances). We have seen this form of recourse structured as either a remedy of last resort of the finance provider (i.e. the finance provider cannot call the guarantee prior to enforcing its security interest over the collateral assets unless a material event of default such as an insolvency or a breach of financial covenant occurs in respect of the fund or REIT) or with differing guarantee coverage applying to different collateral assets financed by the warehouse financing.

Exiting the collateral asset in a distressed scenario

Warehouse financings in the form of revolving CRE loan-on-loan facilities are typically not transferable by the finance provider (absent an event of default). There are good reasons for this, notably because the freedom to transfer at any time would enable other non-bank competitors of the debt fund/REITs (in the capacity of potential transferees of the debt) to gather sensitive information about their competitors’ loan books and potentially adopt aggressive strategies with regards to their competitors. Even in an event of default scenario, however, the borrower may wish to ensure that the original lender of the warehouse finance maintains a minimum hold (such that the original finance provider is required always to hold e.g. 34% of the loan and/or commitments to be able to veto “Majority Lender” decisions).

To the extent a warehouse facility does contain a right of the finance provider to transfer the loan, we would typically expect to see the borrower requiring that key credit matters such as the right to consent to a waiver of a default on the collateral asset remains with the original finance provider (such that only the original finance provider has the ability to consent to material decisions, even if it has transferred its loan and/or commitments).

In the event that the “music stops” and the finance provider wishes to enforce on the collateral assets, it could adopt any of the following strategies: (1) transferring the collateral assets into its name or the name of an affiliate or third party buyer (this could be achieved by the finance provider taking and holding a transfer certificate/assignment agreement (in the form annexed to the underlying CRE loan) as a condition precedent to advancing the warehouse financing which is signed by the real estate debt fund/REIT as borrower prior to drawdown, which the finance provider can date and serve on the underlying facility agent at the point of enforcement on the collateral asset); (2) stepping into the shoes of the real estate debt fund/REIT as borrower and exercising the rights assigned to it pursuant to the security documents for the warehouse financing (which would enable the finance provider, for example, to exercise the rights of the real estate debt fund/REIT as borrower to sell the collateral assets); or (3) enforce on the shares in the borrower (which is the lender of record of the collateral asset). This last approach may be more appropriate where the facility documentation relating to the collateral asset includes a consent right or a consultation right of borrower of the collateral asset to transfers and assignments thereof.

Certain finance providers will insist on being able to control or sell 100% of the collateral assets on termination of the warehouse financing, irrespective of whether they have financed 100% of the collateral assets (for instance, where the borrower splits its holding in the collateral asset across funds, some of which can take leverage in the form of warehouse financing and some of which cannot). Orrick has advised borrowers on how to structure warehouse financings to accommodate finance providers’ requirements in this regard.

Borrowers will want the ability to dispose of collateral assets freely, on short notice to the finance provider provided that the warehouse finance borrowed against that collateral asset is repaid in full. Usually finance providers will restrict such ability where an event of default is continuing or would result from the disposal. We would typically expect strong borrowers of warehouse finance to have the ability to voluntarily prepay the warehouse finance on short notice (typically one business day) which could be a useful tool for a borrower where there is an element of distress on the horizon at the collateral asset level. We have, however, seen finance providers imposing checks and balances on this ability to voluntarily prepay by providing that any voluntary prepayment below a certain threshold results in the loss of that headroom when the borrower levers back up (e.g. if the overall advance rate relating to the warehouse financing is 60%, and the borrower voluntarily prepays down to 48%, the finance provider may provide that any voluntary prepayment below e.g. 50% results in a reduction of the overall advance rate by 2% (the difference between 48% and 50%) such that the new maximum advance rate is 58% rather than 60%. Orrick has a depth of experience advising borrowers on achieving the optimum position possible on the prepayments regime in warehouse financings.

Material modifications and enforcement

Warehouse financings typically contain a negotiated set of “material decisions” or “material modifications” in respect of the collateral asset that the borrower may not take without the consent of the finance provider. There are clear reasons for this, not least that the finance provider would not want the borrower to take potentially value-destructive decisions in respect of the collateral asset (which is the security for the warehouse finance) in a distressed scenario. In the context of potential distress at the level of the collateral asset, the borrower should insist on retaining the right to accelerate and/or enforce on the collateral asset. This is because, as borrower of the warehouse finance, the borrower is in the first loss position relating to the collateral asset, so the decision to accelerate and/or enforce will be matters that directly affect its entitlement to the proceeds of enforcement. As a compromise, the borrower may give the finance provider the right to waive an event of default on the underlying CRE loan, but enforcement matters should remain with the borrower. These provisions are likely to be hotly negotiated, and the finance provider may seek to protect its position in a distressed scenario relating to the underlying collateral asset by insisting that any breach by the borrower of the material decisions regime results in a mandatory prepayment event. Orrick has a depth of experience advising borrowers on achieving the optimum position possible on the material modifications regime in warehouse financings.

Wind-down/sweep mechanics

Assuming a sufficient number of collateral assets are in distress such that there is not enough cashflow to service the warehouse financing, and absent a cure by the parent fund/REIT or payment on the guarantee, any unblocked general account of the borrower will typically be immediately locked up and operable only by the finance provider via the agent. The general account is typically the account into which surplus cashflows from the collateral assets are paid after repayment of all sums due to the finance provider have been paid off in accordance with a pre-ordained waterfall of payments. Borrowers will want to ensure that the trigger for blocking the general account (which may also be the trigger for sweeping any surplus monies to the finance provider in repayment of the warehouse financing) will be acceleration by the finance provider or, at the very least, a declared payment event of default.

Margining

If applicable to the warehouse financing in question (and typically where the amount of leverage available is >60% of the value of the collateral assets), a major concern of borrowers is the ability of finance providers to make a margin call. From the perspective of the borrower, the determination of market value should exclude any reference by the finance provider to loan pricing, loan sales and/or capital markets events. If the finance provider does make a margin call, borrower protections which we have experience of negotiating include whether the borrower has the ability to cure by transferring margin availability from other collateral assets, i.e. a pooled test or an asset-by-asset test; a sufficiently high threshold amount (to avoid de minimis margin calls); introducing an element of objectivity to the determination of value by e.g. requiring that the lender refer to independent indices; a margin call holiday; and allowing the borrower to re-lever if asset value later improves. This is not an exhaustive list, and there is no “one size fits all” approach to the margining provisions.

Conclusions

The above discussion is not intended to be exhaustive and sets out just some of the considerations that borrowers and finance providers of warehouse finance should consider when putting in place a warehouse financing. A finance provider, at the point of negotiating a warehouse financing, will obviously be evaluating the recovery value of collateral assets in a distressed scenario, so the above considerations are applicable even absent imminent distress in the CRE lending market.