Read the small print. This has always been good advice, but it is something that investors in subordinated CMBS should particularly bear in mind. In the rush to buy into this asset class in recent years many have bought deals that incorporate available funds caps (AFCs): essentially caps on the amount of interest that can be paid to junior noteholders in the event that available funds are insufficient to meet total interest payments on the outstanding notes in a deal. The impact of such a cap can be very different depending on whether deals pay down in a sequential or pro-rata (whereby senior and junior noteholders are paid off at the same time) fashion. In deals where paydown is sequential, when loans prepay the average funding cost of the remaining notes increases (as the remaining notes are more junior), which might cause the AFC to be triggered. "In the past few months there have been a few transactions that have either triggered their AFC caps or are threatening to do so," says James Martin, CMBS analyst at Merrill Lynch.
"AFCs have definitely become an issue," admits a source on the buy side. "A lot of these deals were done in 2005 and 2004 when the market was really starting to ramp up in force.
