Cash Management, Lockboxes, and Reserves, explained

Lenders use three primary mechanisms to control a property’s cash flow and prevent it from “escaping the system.” Understanding those mechanisms – cash management, lockboxes, and reserves – is essential for a borrower obtaining financing.

When a lender makes a loan that is secured by real property, it oftentimes will require that the borrower grant a security interest in the cash flow generated by the real property. After all, the cash flow from the property is what gives the real property value, and what the lender underwrites to assess the risk in making the loan. Therefore, the lender will take certain measures to ensure that the property has sufficient cash flow to cover certain operating expenses and ultimately repay the loan. The lender’s primary goal is to safeguard against funds “escaping the system” (and ending up in the pocket of the borrower) unless the property has sufficient funds to operate in the ordinary course of business and repay the loan. There are three principal ways that a lender achieves this goal: (1) reserve accounts, (2) a lockbox, and (3) a cash management “waterfall.”

Bank Accounts

A real estate financing will involve one or more bank accounts in the name of the borrower, with a grant to the lender of a security interests in each of such accounts.  The following is an example of a typical account structure:

Example of cash flow for a financed operating property.

As explained below, there are different types of lockbox accounts. The reserve accounts would typically be book entry sub-accounts of the lockbox account. The bank for each of the operating account, the lockbox account, and the cash management account can be the same or different, although it’s fairly typical for the lockbox bank and cash management bank to be the same. Some lenders will require that one or more of the accounts be opened with the lender.

While the lender will always maintain a security interest in the lockbox and cash management accounts, a lender usually will not have a security interest in the borrower’s operating account. In effect, once funds are disbursed to a borrower’s operating account, the funds have “left the system,” which is why lenders will want to ensure that there are sufficient reserves and robust tests (such as failure to maintain a certain debt yield or debt service coverage ratio (DSCR)) that “trigger” the cash management provisions (such as the “waterfall” discussed below), and prevent the cash from escaping the “system” if the property is not producing sufficient cash flow to cover its operating and loan costs.

Reserves

As explained below, there are different types of lockbox accounts. The reserve accounts would typically be book entry sub-accounts of the lockbox account. The bank for each of the operating account, the lockbox account, and the cash management account can be the same or different, although it’s fairly typical for the lockbox bank and cash management bank to be the same. Some lenders will require that one or more of the accounts be opened with the lender.

While the lender will always maintain a security interest in the lockbox and cash management accounts, a lender usually will not have a security interest in the borrower’s operating account. In effect, once funds are disbursed to a borrower’s operating account, the funds have “left the system,” which is why lenders will want to ensure that there are sufficient reserves and robust tests (such as failure to maintain a certain debt yield or debt service coverage ratio (DSCR)) that “trigger” the cash management provisions (such as the “waterfall” discussed below), and prevent the cash from escaping the “system” if the property is not producing sufficient cash flow to cover its operating and loan costs.

Lockboxes

A “lockbox” account (sometimes referred to as a deposit or DACA Account) is an account opened by the borrower. The borrower grants the lender a security interest in the lockbox account, and provides certain control rights to the lender pursuant to the Deposit Account Control Agreement (DACA) entered into by the borrower, the lender, and the lockbox bank.

Pursuant to the terms of the loan agreement, the borrower is required to deposit all income generated by the property (i.e., rents or other income) into the lockbox account when received (and typically are required to instruct tenants to make payments directly into the lockbox account). Funds will then be disbursed daily or monthly to either the borrower’s operating account or through the cash management waterfall, depending on the type of lockbox, as discussed below.

There are three main types of lockbox (1) a hard lockbox, (2) a soft lockbox, and (3) a “springing” lockbox.

Hard Lockbox

A hard lockbox is “hard” because it gives the lender the most control over the cash flow generated by the property (it is “hard” on the borrower). In a hard lockbox structure, revenue is deposited into the lockbox, then “swept” (usually monthly) into the cash management account, where it runs through the cash management “waterfall.” Once the funds run through the waterfall, excess funds are typically maintained in an excess cash flow reserve account, where they may be distributed through the waterfall upon the next sweep.

As you can see, under a hard lockbox, the cash generated by the property never escapes the “system,” and therefore provides the most security to lender (and the least likelihood of borrower misappropriation of funds).  An example diagram of a hard lockbox is below.

Example of a hard lockbox.

Soft Lockbox

In a soft lockbox structure, revenue is deposited into the lockbox, then “swept” (usually monthly) into the cash management account, where it runs through the cash management “waterfall.” However, in a “soft” lockbox, after funds run through the waterfall, excess funds exit the “system” and are distributed to borrower’s operating account under borrower’s control. As noted above, lender typically has no security interest in borrower’s operating account and cannot trap any funds remaining therein.

Therefore, a soft lockbox is less secure than a hard lockbox, because where in a hard lockbox excess funds would be trapped in a reserve account and could be used to cover future shortfalls, in a soft lockbox, the borrower has control of such excess funds and could elect not to apply such funds towards the payment of debt service and expenses (which would likely result in an Event of Default, but if the property is trending down, a borrower may elect to default which places the lender in a tough position).

Example of a soft lockbox

Example (Hard Lockbox versus Soft Lockbox):

Month 1: The property generates revenue of $100,000 which is deposited into the lockbox. After running through the cash management waterfall, there is $20,000 of excess funds.

Month 2: A major tenant defaults on its payments, resulting in a $30,000 decrease in revenue generated by the property (for a total of $70,000).

In a hard lockbox, the $20,000 of excess funds from Month 1 was maintained in a reserve account controlled by lender, and when combined with the $70,000 in funds generated during Month 2, is sufficient to cover all costs paid through the waterfall (and results in excess funds of $10,000 that are then deposited in the excess cash reserve once again).

In a soft lockbox, the $20,000 of excess funds from Month 1 was distributed to the borrower, and the borrower may have distributed such funds to its investors (in other words, such money has “left the system” and may very well already be spent). The $70,000 of revenue generated during Month 2 is run through the waterfall, but actually results in a deficit of $10,000, which the borrower is required to fund. However, if the borrower fails to fund such amount, the lender’s sole recourse is to declare a default on what could be a depreciating asset. Therefore, while providing some security to a lender by trapping funds each month, a soft lockbox is less secure than a hard lockbox.

Springing Lockbox

In a “springing” lockbox structure, revenue is deposited into the lockbox, then, absent a “trigger event” (typically borrower’s failure to maintain a certain debt yield or debt service coverage ratio (DSCR) or the actual or foreseeable loss of a major tenant) or an Event of Default, “swept” (usually daily) into borrower’s operating account; therefore, in a “springing” lockbox, all funds exit the “system” unless a trigger event or Event of Default occurs.

If a trigger event occurs, the cash management account “springs” into action, at which point the structure mimics a hard lockbox until the trigger event concludes (typically, lender will require that the event that caused the trigger event be cured for a period of two consecutive quarters). For so long as the trigger event is outstanding, funds from the lockbox are swept into the cash management account, where the funds runs through the cash management “waterfall.” Once the funds run through the waterfall, excess funds are maintained in an excess cash flow reserve account, where they may be distributed through the waterfall upon the next sweep or released to borrower upon the conclusion of the trigger event.

As may now be clear, a “springing” lockbox provides the lender with the least amount of security.

In each of the foregoing lockbox types, once an Event of Default occurs, the lender will typically have control of the funds and not be required to run them through the waterfall, and instead distribute such funds as lender decides in its sole discretion.

Example of a springing lockbox.

Cash Management “Waterfalls”

In each of the lockbox types described above, a cash management “waterfall” is applied. A cash management “waterfall” describes the flow of funds in terms of priority (essentially, what expenses get paid in what order), hence the term “waterfall” (referring to the funds cascading down the steps of a waterfall):

Money flows through the various accounts, cascading like water through a waterfall

The following is an example of a typical waterfall provision in a loan agreement:

On each Payment Date during the continuance of a Trigger Event, provided no Event of Default is continuing, Lender shall transfer amounts from the Cash Management Account, to the extent available therein, to make the following payments in the following order of priority:

1. 1. 1. to the Tax Reserve Account, an amount equal to 1/12 of the Taxes that Lender reasonably estimates, based on information provided by Borrower, will be payable during the next ensuing 12 months;
      2. to the Insurance Reserve Account, 1/12 of the insurance premiums that Lender reasonably estimates, based on information provided by Borrower, will be payable during the next ensuing 12 months;
      3. to Lender, the amount of all scheduled or delinquent interest and principal on the Loan and all other amounts then due and payable under the Loan Documents (with any amounts in respect of principal paid last);
      4. to the payment of the Budgeted Operating Expenses for the month in which such Payment Date occurs;
      5. to the TI/LC Reserve Account, the amount, if any, required to be deposited therein;
      6. to the Capital Improvements Reserve Account, the amount, if any, required to be deposited therein; [clauses (5) and (6) describe payments into reserve accounts. These will vary depending on the terms of the loan]
      7. to the payment of any Extraordinary Operating Expenses for the Property approved by Lender in writing (not to be unreasonably withheld, conditioned or delayed) for the month in which such Payment Date occurs;
      8. [until Lender shall have received notice from Mezzanine Lender that the Mezzanine Loan has been repaid in full, to Mezzanine Lender, all scheduled interest then due and payable or past due and payable to Mezzanine Lender under the Mezzanine Loan Agreement, as specified by Mezzanine Lender pursuant to Mezzanine Lender’s written instructions to Lender] [if a Mezzanine Loan exists];
      9. all remaining amounts to the Excess Cash Flow Reserve Account.

In the example above, debt service (amounts payable pursuant to clause (3) above) are paid before budgeted operating expenses (amounts payable pursuant to clause (4) above). This is typically the most negotiated provision of a waterfall – whether operating expenses are paid before or after debt service. The argument by borrower is that the property needs to continue to operate. The argument by lender is that the lender should be paid first. Similarly, where there is a mezzanine loan, mezzanine lenders will also try to negotiate higher priority in the waterfall (for the same reason as the senior lender – the mezzanine lender wants to be repaid), but as you can see in this example, mezzanine payments are often lower in the waterfall since mezzanine loans are riskier loan products that charge higher interest rates.

Lender’s Perfection of Security Interests in the Accounts

Unlike with most types of collateral, filing a UCC-1 financing statement does not perfect a lien on a lockbox account. A lender can only perfect a lien on a borrower’s lockbox account by having “control” over the account, which requires one of the following arrangements: (1) the borrower maintains the account directly with the lender; (2) the lender becomes the actual owner of the borrower’s lockbox account with the borrower’s lockbox bank; or (3) the parties enter into a DACA, which is most common. Therefore, lender’s control of the lockbox and cash management account is necessary for lender to perfect its interest in those accounts.

These requirements are in addition to the loan documents by which the borrower actually grants the lender an interest in its lockbox and cash management accounts.