Commercial real estate professionals have always known that resolving distressed CMBS debt situations would be difficult, given the multitude of properties and note holders involved in every deal. A recent debt restructuring completed on the Atlantis Resort and Casino in the Bahamas proves just how tricky CMBS distress resolutions can get.

The restructuring involved a $2.78 billion CMBS portfolio loan taken on by South Africa-based resort developer and operator Kerzner International to expand its sprawling, 2,000-room plus resort property on Paradise Island. The interest-only loan, part of Credit Suisse Commercial Mortgage Trust Series 2006-TFL2, was secured by Kerzner’s properties in the Bahamas and in Mexico, and came with a floating interest rate at 1.23 percent over LIBOR and a rate cap agreement with a LIBOR strike rate of 6 percent for the initial term of the loan, according to Morningstar Credit Ratings LLC.

Counting on a continued increase in tourism numbers, Kerzner wanted to undertake a $1 billion expansion at the Atlantis resort, including the addition of a 600-room hotel tower, a 495-unit condo hotel and 40 acres of new water attractions. The firm completed construction on the project in 2007, but in the aftermath of the global financial crisis, occupancy plunged. When the loan was issued, occupancy at the property averaged 81.4 percent. By 2009, occupancy had fallen to 60 percent, according to a report from Fitch Ratings, a New York-based research firm.

The loan was due to mature in September of 2011, after Kerzner exhausted all three of its extension options, but the firm couldn’t refinance the property because of the still somewhat slow CMBS market and because the resort had taken a significant hit in visitor numbers during the recession. Even though from year-end 2009 through year-end 2010 the net operating income on the asset rose 5 percent, performance was still not strong enough to attract a new lender. Kerzner started discussing its options with its lenders.

Brookfield to the rescue

Then, in a stroke of luck for Kerzner, Brookfield Asset Management, a Toronto-based global asset manager and the junior B-note holder on the debt, came up with a restructuring proposal. Brookfield wanted the opportunity to own the Atlantis, and was willing to forgive its $175 million in debt in exchange for the control of the Atlantis, the Bahamas One & Only Ocean Club and a 50 percent stake in the One & Only Palmilla resort in Mexico. The transaction, along with an earlier $100 million payment on the loan, would shrink Kerzner’s debt to $2.3 billion from $2.6 billion. Kerzner and Brookfield were going to close the deal by December 31, 2011, with Brookfield planning to secure a two-year extension for the loan.

The other B-note holders on the loan, however, weren’t so thrilled with the proposal, feeling that Brookfield was getting a sweetheart deal at their expense. These note holders, which included hedge funds Canyon Capital and Trilogy Capital, filed suit in a Delaware court in January, with the judge issuing a restraining order against the Brookfield/Kerzner deal. Their complaint was that as the junior-most note holder on the debt Brookfield had no right to complete a debt for equity swap. Canyon and Trilogy hold approximately $120 million of B-notes secured by the Atlantis loan. They wanted to ensure that if Brookfield’s proposal did go through, any notes on the loan that were put on the market would be sold at market rate terms and that their investment would be protected if the asset entered bankruptcy.

Luckily for Kerzner, Brookfield and the other note holders were eventually able to reach a settlement. By May, they had agreed to a deal that would allow Brookfield to exchange $175 million in class B4 notes for Kerzner’s stake in its Bahamian assets (Kerzner will continue to manage the properties). The loan was extended until September 2014.

What does it all mean?

However, the legal challenge surrounding the transaction underlines how arduous and lengthy the resolution of distressed CMBS loans can sometimes get, notes Jonathan Mayblum, co-founder of real estate advisory and asset management firm Arcturus, which advised Canyon and Trilogy on strategy, valuation and debt structure during the legal proceedings.

“Each of the parties coming to the table really has different objectives,” Mayblum says. “Some of the people had bought the notes originally and some bought them at a discount [later on]. And then you have someone like Brookfield, who really wanted control of the real estate assets. And you had to negotiate a deal that would solve everyone’s issues and find a solution that satisfied everybody.”

As more and more five-year CMBS loans that were completed in the mid-2000s come due, there will be more of a need for such complex negotiations, Mayblum notes.

The transaction involving the Atlantis loan might be unusually large, but senior and junior CMBS note holders often disagree about the best options for debt restructuring, adds Britt Johnson, senior director with Fitch Ratings. The saving grace is that the CMBS market has recovered enough in recent months to create the possibility for successful resolutions. Year-to-date in 2012, worldwide CMBS issuance has reached $12.7 billion, up from $10.9 billion in 2011, according to Commercial Mortgage Alert, an industry publication.

“While the Kerzner workout is unique, the size of the loan and the fact that a new party is able to take on such a large obligation is a sign that liquidity is returning to the CMBS market,” says Johnson.