No one expected it. Delinquent commercial mortgage-backed securities (CMBS), which amounted to less than $20 billion in October of 2008, mushroomed to a mind-boggling $65.2 billion at the end of November 2009, according to commercial real estate data and analytics firm Trepp LLC.
Few seasoned investors would have projected that CMBS delinquencies could reach 9% by the end of 2010, either. Yet the volume of loans in special servicing — including performing loans in imminent trouble — could reach $90 billion to $100 billion this year, according to Trepp. That mounting distress is creating a renewed sense of urgency among the special servicers who must support its weight.
“For those loans headed into default, where the cash flow is insufficient and the value is low, it can be pretty costly for the special servicer to maintain payments on those loans,” says Matthew Anderson, a partner at Oakland, Calif.-based researcher Foresight Analytics. “I suspect what we'll start to see with CMBS is an acceleration in resolving defaulted loans one way or another.”
One reason for the sheer volume and velocity of CMBS debt sliding into special servicing is an avalanche of maturities in a market that is largely unable or unwilling to provide replacement financing. Last year, some 60% of the $248 billion in maturing commercial mortgages were given one-year extensions, according to Foresight Analytics. CMBS made up just $46 billion of last year's maturing loans, but CMBS loans slated to come due from 2009 through 2014 total $288 billion.
Even if sufficient credit were available, it wouldn't solve the problem of property values, which have fallen by 43% across the board, according to a Moody's/REAL Commercial Property Price Index report published in January. Billions of dollars in U.S. mortgages are now underwater, meaning the loan balance is higher than the value of the underlying asset. To a potential lender, that's about as appetizing as a peanut butter and mayonnaise sandwich.
The right resolution
Special servicers have a number of tools at their disposal to help resolve troubled loans. These methods generally fall under two distinct workout strategies: A sale or liquidation of an asset (or its note); or working with the borrower to help him keep his property.
There has been plenty of talk of loan modifications in the commercial real estate industry, but not so many modified loans, according to Tom Fink, a senior vice president with New York-based Trepp. “When you look at what's going on in terms of the resolution strategy, it's still predominantly foreclosing and taking over the asset.”
Indeed, to dispose of troubled loans, special servicers now favor liquidation strategies that include foreclosure, bankruptcy, REO, deed in lieu of foreclosure and note sales. From Sept. 30 to Nov. 30, 2009, there was an 18.3% increase in such strategies, representing 1,387 loans, up from 1,172.
The decision about which workout strategy to pursue, however, isn't arbitrary. A special servicer will employ the resolution method prescribed in the pooling and servicing agreement that established the CMBS trust. This document defines the roles, responsibilities and obligations of the special and master servicers.
Within the pooling and servicing agreement is a provision called the “servicing standard,” explains Stacey Berger, an executive vice president with special servicing giant Midland Loan Services. The servicing standard requires the special servicer to execute the strategy that gives bondholders the highest recovery on a net-present-value basis.
“We look at all of the alternatives — whether it's a foreclosure, restructure, workout or note sale, on what yields the highest recovery on the net present value basis,” says Berger, whose Overland Park, Kan.-based company operates as a subsidiary of PNC Financial Services Group. As of Sept. 30, 2009, Midland held 9,627 loans in special servicing with an outstanding balance of $104.5 billion.
In a hypothetical example, a special servicer identifies two options to resolve an underwater mortgage that has reached special servicing. One is a discounted payoff, in which the borrower pays the special servicer the current value of the property. A payoff of $70 million, for instance, would be substantially less than the balance on the original loan.
The other alternative for the special servicer would be to foreclose, a protracted, fee-laden process that might only yield a net value of $60 million. In such a case, the special servicer would select the first option.
See the wizard
Ann Hambly, president of 1st Service Solutions based in Grapevine, Texas, started her business four and a half years ago after devoting more than 30 years of her career to commercial real estate special servicing at Prudential, Bank of America, GE Capital and Nomura. Hambly contends that lenders are often ill equipped to handle a borrower's request for help on a securitized loan.
When something goes wrong with a borrower's asset — perhaps an anchor tenant leaves and the borrower can no longer make mortgage payments — the property owner calls his master servicer to seek some kind of relief. The master servicer, however, simply collects rent, and cannot help the borrower with a workout or offer to restructure the CMBS loan in any way.
“So that's when the borrower gets stuck, that early in the process,” Hambly explains. “The person they need to be talking to is the special servicer and that's kind of like the Wizard of Oz behind the black curtain.”
Even if a borrower did know the name and phone number of his special servicer, there is a protocol to making that contact. The borrower is only permitted to work with the special servicer if the mortgage is either in default, or if the master servicer is convinced that the borrower is on the brink of defaulting.
About 99% of CMBS loans are non-recourse, meaning the lender cannot come after the borrower's personal assets in the event of default. Yet many borrowers face major tax consequences if they go into foreclosure or hand the keys over to the lender.
For instance, if the special servicer forecloses on the property and sells it, resulting in a $1 million loss to the bondholders, the borrower will receive a Cancellation of Debt (COD) form from the Internal Revenue Service and must pay income tax on the $1 million written off by the bondholders.
“The COD is based on your income tax rate, so it could be 39%,” notes Hambly. “It's a big number.”
The COD issue is also why borrowers and special servicers are not striking deals to pay off debt at 50 cents on the dollar, an arrangement that also comes back to haunt the property owner in the form of taxes.
So what's an upstanding borrower who has, until now, paid on his loan on time for 10 years to do? In the worst of all scenarios, the borrower has negative equity on the loan, his biggest tenant has moved out and his mortgage is approaching maturity and cannot be refinanced.
“Fresh equity gets you an extension,” advises Dan Gorczycki, managing director of New York-based Savills. “Putting nothing in gets you foreclosed.”
Rather than asking the special servicer to kick the can down the road with an extension of the loan term in hopes that the market will turn around, Hambly believes that breaking the debt into two parts through a restructuring is a better solution.
The first chunk of debt is “right-sized” into a mortgage the borrower can afford based on current cash flow. The second part of the debt is then held out into the future, at which point it can be refinanced when business and the economy improve.
The solution is far from an easy out, Hambly warns. “You have to clearly as a borrower show numerically, economically, how everyone gets out of this at the end of the day,” she says. “You have to have a clear exit strategy.”
Some critics say that special servicers are less than stellar performers when it comes to on-the-ground property management. Pundits also intimate that the quality of work is hampered by the massive volume of loans falling into the hands of special servicers, many of whom are too young to have workout experience from the Resolution Trust Corp. days, some 30 years ago.
“A large part of the problem is that the special servicers are way overworked and were never trained as special asset marketers,” says David Dreiling, a managing director at the Nashville office of Sperry Van Ness and a member of the firm's distressed asset team.
Dreiling cites an example of a $138 million, 600-unit condominium development begun in Florida in 2006. The two-building project was 95% sold, but because Florida law allows buyers to back out of a project that takes more than two years to finish, by 2008 sales on only 28 units had closed. Predictably, the borrower went into default.
The second building, not quite completed and now in the hands of the special servicer, was not air-conditioned because it was empty, resulting in a mold infestation. The last offer Dreiling received on the property was $28 million, which the bank refused.
“What is happening now is there's a continual deterioration of thousands of vacant properties across the country, and of some occupied properties,” Dreiling says.
And while professionals like Dreiling make accusations of property mismanagement, others, like Fink of researcher Trepp, say motive is important when making such an assessment.
“Is the reason the money is not being put in the property because the special servicer is sitting on the cash?” Fink asks. “Or is the reason that the money is not being put into the property because the property is not generating enough money to put any money into it?”
No guessing games
Stephanie Petosa, a managing director for New York-based ratings agency Fitch Ratings, says her firm has begun issuing reports that rate special servicers by staffing, the volume and vintage of loan transfers, financial health of the special servicer, as well as recovery rates with and without losses, among other metrics.
“One of the things that we're monitoring very closely is the assets per asset manager,” says Petosa. “For the most part, we've seen that average around 16, at least as of the third quarter.” One “asset manager” within a special servicing firm includes a senior asset manager, a junior asset manager and an analyst, she says.
What investors can expect in the coming year, according to Petosa, is that 2006 and 2007 vintage loans will continue to flood into special servicing. By property type, the majority of CMBS-backed properties falling into distress in order will be hotel first, then retail, closely followed by office as the economic impacts ripple through that sector, Petosa predicts.
And there's no question that special servicers will be challenged in the coming year. One major hindrance will be valuing properties, Petosa says. “I've even seen appraisals have date stamps on them. You know the appraisal is only good for 90 days,” she says. “We've never seen anything like that before.”
Sibley Fleming is managing editor.