Since January, the volume of troubled commercial mortgage-backed securities (CMBS) loans sent to special servicers for resolution has risen a startling 300%, and more losses are expected, according to a new report by New York-based Fitch Ratings.

Because of market conditions, defaulted loans are being resolved more slowly than in the past, and less traditional loan workouts are becoming more common. By the end of the third quarter of 2009, only 10% of loans dispatched to special servicing following delinquencies or defaults had been returned to the loans’ master servicers and categorized as current.

In a major change from earlier practice, special servicers have begun to hold some loans for up to three years in anticipation of a return to liquidity in the commercial real estate market. “This is a departure,” says Fitch Ratings senior director Britt Johnson. In recent years special servicers had a number of options because capital was available to buy property and there was ample motivation among borrowers and investors to proceed with purchases.

“The current environment is more severe than seen in CMBS before,” says Johnson. “Although we can’t be certain what will happen in the future, we estimate that special servicers will have to hold certain properties 24-36 months.”

The pace of defaults is roughly double last year’s pace, says Johnson. Currently, there are $59 billion in specially serviced loans compared with $16 billion at the end of 2008.

“Losses are expected to be more severe due to increased disposition times, higher fees associated with dispositions and an overall decline in commercial property values,” says Johnson. The losses could be closer to 50% in 2009, rather than the traditional 40%.

Because special servicers are dealing with a record backlog of CMBS loans, the time needed to develop loan workouts in general is expected to rise up to three years per loan, according to the study on CMBS losses. “Defaulted loans will take more time to be resolved and losses often will be deferred until maturity.”

In 2008, the average disposition time for troubled loans was 19.4 months, down from 22 months in 2007. Last year, despite the limited liquidity, many buyers of distressed real estate were still able to secure financing. However, since then cash and credit have been even harder to come by special servicers are left with little choice but to hold onto properties until potential buyers can get financing.

Borrowers are strapped

Some borrowers refuse to request loan modifications and wind up with liquidations because their properties have suffered such huge declines in value that even the reduced terms of a workout would be too costly. A separate report issued this week by Moody’s/REAL Commercial Property Price Indices shows that commercial real estate prices have dropped 32.8% from a year ago, and 40% from 2007.

The CMBS loss study shows that some properties are performing so poorly that even after a loan modification the owners are unable to make the payments.

Companies that cannot keep up with loan payments often find their troubles compounded after workouts by special servicers because servicing fees can make their losses even more severe.

In 2008, losses were relatively low as loan servicers resolved $2.2 billion in CMBS loans, a total of 358 loans. That was an increase from the $1.8 billion resolved for 319 loans in 2007. Last year, more than three-fourths (78%) of the loans sent to special servicers were resolved without losses, compared with 55% in 2007 and 60% in 2006.

In 2008, 279 loans totaling $1.7 billion were paid in full, returned to the master servicer or liquidated without losses, compared with $999.1 million in 2007 and $2 billion in 2006, Fitch reports. Last year’s losses amounted to $459.5 million and involved 79 loans. Real Estate Owned (REO) liquidations, note sales and discounted payoffs were the most common methods of disposition.

Expect higher losses

But last year’s low loss level is unlikely to continue when annual figures for 2009 are calculated. “Fitch believes the higher volume of resolutions and high recoveries in 2008 belie the current condition of the commercial real estate market,” the study authors warn.

Among the major commercial real estate property types, multifamily properties represented 71.5% of resolutions for losses in 2008. Multifamily is expected to continue to suffer high defaults because many cities are burdened by high unemployment and an oversupply of properties. Recent multifamily defaults included two loans greater than $100 million and two others greater than $50 million. Throughout the multifamily sector, however, losses were mitigated by refinancings available through Fannie Mae and Freddie Mac.

After multifamily, the office sector recorded the second highest number of loan dispositions, with an annual average loss severity of 67.1%. With no comparable support from financial institutions like Fannie Mae, when office buildings fall into default, the process of disposing of them becomes long and tedious, requiring an average 35 months to resolve.

A few troubled office assets have taken up 55 months to work out. The largest was an REO liquidation in Jackson, Miss. with an original loan of $8.2 million. However, the building actually racked up $11.8 million in losses because of special servicing fees and other charges.

According to Fitch, it took an agonizing 63 months to finalize the Jackson office liquidation, from the time of the borrower’s default to the loan’s eventual disposition.