Navigating the Rental Income Lockbox

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Loans originated for the commercial mortgage-backed securities (CMBS) market typically involve an in-place or springing lockbox arrangement.

Rating entities, CMBS bond investors, and servicers all benefit from the increased security provided by lockbox cash management and are collectively responsible for implementing the lockbox requirement.

As lockbox implementation becomes more common, it is essential to comprehend the various types, the related expenditures, and the complications they can pose for lenders and borrowers. There are three main forms of lockboxes: (i) hard, (ii) soft, and (iii) springing. Each type is described below, along with its advantages and disadvantages. As an initial matter, it should be noted that the typical lockbox used in a CMBS transaction, regardless of type, consists of two different bank accounts: (i) a deposit account that receives the rent payments, and (ii) a cash management account that takes and then disburses the funds from the deposit account under certain conditions.

Hard Lockbox: Borrower Forfeits Cash Flow Control

In hard lockbox setups, all rental income flows through the deposit account into the associated cash management account. Immediately upon closing of the loan, tenants are directed to submit their payments to the deposit account, or, if the property at issue is an apartment building or hotel, the income is paid into the deposit account after being received by the property manager. On each loan payment date, money from the cash management account is swept to the lender to meet the debt service amount and reimburse the borrower for monthly operational costs. Any remaining cash flow generated by the property is usually maintained in a cash-collateral, TI/LC, or replacement reserve account.

The hard lockbox provides the most security for a lender as it gives the lender complete control over the property cash flow right from the start; however, borrowers tend to be extremely resistant to the imposition of a hard lockbox for that same reason.

Soft Lockbox: Borrower Retains Limited Cash Flow Control

Soft lockboxes typically function in one of two methods:

  1. All rental income from the associated property is deposited into the deposit account and swept into the borrower’s operating account until a default occurs, after which the funds in the deposit account are instead swept into the cash management account; or
  2. All rental income is deposited into the deposit account, then swept into the cash management account, where it stays until that month’s debt service payment has been secured, after which the remaining funds are forwarded to the borrower.

The soft lockbox is a middle ground between the hard and springing lockboxes. As with a hard lockbox, the property income gets paid into the deposit account during the entire term of the loan; however, prior to an event of default,t the borrower is still able to control some or all of the funds.

Springing Lockbox: All Parties Execute Lockbox Documents at Closing

For springing lockboxes, the lockbox accounts are not opened at closing, but the lender collects the approvals and documentation necessary to open the accounts should a default occur. Upon an event of default, the lender will provide the pre-selected lockbox financial institution with instructions to open the deposit and cash management accounts in accordance with the approvals obtained at closing. Once the accounts are opened, the lender will impose a hard lockbox.

Springing lockboxes provide much less security for a lender than the other two variants, but they are often preferred by lenders because they do not delay the loan closing (opening the accounts required for hard and soft lockboxes can add significant time to the closing process). Additionally, the springing lockbox does not carry any operational costs until the accounts are opened.

Timing Matters

It is important to note that both hard and soft lockboxes can create cash flow complications stemming from the delay between receiving rent and making a subsequent mortgage payment. Lockbox banks can take between 24 to 72 hours following the receipt of rental payments to provide the funds. Further, the transfer from the lockbox financial institution to the lender must be established a day in advance, which essentially erases a day from the process. In practice, this means that if a loan has a payment deadline on the tenth day of the month, rental payments usually must be submitted by the sixth or seventh day of the month to be utilized for that month’s debt service payment. It is common for cash to get stuck in the lockbox accounts until the next month because the funds were not made available in time to meet the deadline. The lender should carefully coordinate the various payment deadlines with the lockbox structure during set up to avoid persistent cash flow delays over the course of the loan.

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