Real estate intercreditor agreements: lessons from adversity

Intercreditor agreements, which regulate creditor relationships, have become more sophisticated post-2008 financial crisis, catering to diverse creditors and increasingly complex debt structures. Simple priority or subordination deeds are no longer sufficient. 

The fallout from the crisis saw both senior and junior lenders frustrated by the intercreditor documents in place at that time, and a desire in the loan market to achieve some level of standardisation.

It culminated in the Loan Market Association (LMA) publishing its precedent intercreditor agreements, including the intercreditor for structurally subordinated real estate finance (REF) transactions in 2014 and more recently in 2018, the intercreditor for contractual subordination. In the years following the financial crisis, greater caution around leverage in general and strict capital adequacy rules increased the number of REF transactions requiring senior and mezzanine debt. The LMA REF intercreditor agreements have been widely used; however, a prolonged period of low interest rates and low inflation resulting in an influx of capital and a market awash with liquidity has, in recent years, somewhat dampened the need for expensive mezzanine debt, particularly for prime or "in-vogue" assets.

The industry is starting to see the market shift again. The geopolitical and economic environment of the past few years, combined with a rapid value correction for real estate assets, has led to dampened senior lender appetite for whole loans and more conservative loan[1]to-value levels. As such, the authors anticipate (and are starting to see) an increase in transactions which need a senior/mezzanine capital structure. This article sets out the significant intercreditor considerations for senior and mezzanine lenders as documented in the LMA REF intercreditor agreements.

Structural/contractual subordination

On a basic level, debt liabilities can be subordinated structurally or contractually. The traditional approach for structural subordination necessitates senior debt being lent to a property-holding senior borrower (Senior Borrower), with mezzanine debt lent into a mezzanine entity (Mezzanine Borrower) sitting at least two levels above. The mezzanine debt is funnelled down the structure to the Senior Borrower (by way of intra-group debt) for refinancing or acquiring the relevant property.

The debt is structured in this way for several reasons, but primarily to keep the senior and mezzanine structures remote from each other, to avoid unintended cross-contamination between the structures and to enable the mezzanine lender to exercise its "acquisition right". The security taken from the Senior Borrower and its shareholder (including security over the relevant property) is common security held by a security agent for the benefit of both the senior and mezzanine creditors.

Alternatively, the liabilities can be contractually subordinated, with the debt from both senior and mezzanine lenders being advanced to the same borrower. The security can be common security held by a common security agent, or two identical sets of security granted for the benefit of each lender with the priority being governed by the intercreditor agreement.

Other than the acquisition right, which is a feature of structural subordination, the mezzanine lender will enjoy similar cure and buy-out rights as with structural subordination. A senior lender will want to ensure that it retains total control over the asset-level security and exercises its rights as it sees fit. Particularly in a scenario where the mezzanine lender is "out of the money", a senior lender will want to minimise the rights the mezzanine lender has and their ability to frustrate the process if an asset has become distressed and requires restructuring.

Generally, a senior lender should, and will, have relative freedom to deal with the senior documents subject to certain entrenched provisions which may only be changed in certain circumstances. These entrenched provisions broadly fall into the category of transaction economics, i.e., any changes which would push the mezzanine lender further up the capital stack and reduce the likelihood of being able to recover.

Acquisition/buy-out rights

Historically, mezzanine lenders have found themselves frustrated by their lack of control and influence over the structure, particularly given their riskier position and lower chance of recovery in a distressed scenario. The LMA REF intercreditor agreements are drafted such that the mezzanine lender is offered certain key rights, making its position in the capital stack more palatable. The first (and relevant in structurally subordinated transactions) is the "acquisition right".

This is the right of the mezzanine lender in certain circumstances (to be negotiated by the parties) to enforce its mezzanine-only security and step into the structure, taking out the existing sponsor and fundamentally assuming control of the property. This right can be critical to the underwriting process of a mezzanine lender, particularly those with the expertise to realise value in the asset and, potentially, a better return. It also provides the mezzanine lender with its "stick" against an obstructive or uncooperative sponsor.

The second is the "buy-out right". This is the ability of the mezzanine lender to buy out the senior debt and take control of the entire secured capital stack. The senior lender will seek to ensure it recovers in full, including prepayment or exit fees which would otherwise be payable on a refinance/prepayment in the ordinary course.

'A/B' intercreditor arrangements

While subordination of mezzanine loans on a contractual or structural basis remains prevalent in the market, the authors have also seen an increase in structures where whole loans are tranched behind the scenes.

These are referred to as "A/B" intercreditor arrangements and are sometimes more appropriate where the lending structure involves multiple junior lenders with different risk appetites and pricing requirements. From the borrower's perspective, they are advanced a whole loan with a blended interest rate. From the lenders' perspective, the intercreditor agreement allocates interest and fees under the commercial agreement between them to suit each lender's return/risk requirements.

The intercreditor agreement also regulates all the usual positions between the lenders: who has priority, who can give instructions, how payment waterfalls are operated, etc., This structure is useful on larger transactions intended to be syndicated as they can be entered into after the debt has been advanced.

Greater variety of capital structures

Market conditions are such that, whether for acquisitions or refinancing, the authors expect a greater variety of capital structures than what has been seen over recent years in the REF market. Senior lenders may find themselves more commonly "round the table" with mezzanine lenders, each negotiating ferociously to protect their position in a challenging market.

This aritcle was first published by Thomson Reuters Regulatory Intelligence.