Commercial mortgage brokers may sense a feeling of despair among clients who hold commercial mortgage-backed securities (CMBS). The prospects of the CMBS markets are not promising: Collateral property values have deteriorated and your clients’ sense of being stuck has legitimate grounds. If you’re aware of the alternatives available to tackle their individual distress situations, however, you can help them make knowledgeable decisions about what courses of action they should take.
The first step for you and your clients is to diagnose the problem. See which of the following six scenarios best describes a given client’s situation:
- Scenario 1: The value of the property is less than the debt.
- Scenario 2: The loan is approaching its maturity.
- Scenario 3: There are no funds to recapitalize the property.
- Scenario 4: The client anticipates impending cash-flow shortfalls.
- Scenario 5: The client wants to sell the property, but the value is less than the debt.
- Scenario 6: The client just wants to “hand in the keys.”
Before jumping into possible solutions, it is important for you and your clients to understand the different roles of the parties involved in a CMBS-restructuring deal.
- The master servicer primarily is responsible for the management of cash, data and reporting. It is the main point of contact for the owner throughout the life of the loan — as long as the loan is performing as agreed. The master servicer cannot modify a loan payment.
- The special servicer is the specialist that is tasked with all decisions on modifications and defaulted loans and is appointed by the controlling class representative (CCR) of the bondholders. The special servicer often is a related entity to the CCR. Note that the CCR changes as losses are passed through the bond structure, so the special servicer can, and does, change during the life of a loan.
Because a loan can be modified only by the special servicer, the first step in any modification is to get the loan transferred to a special servicer. This only can be done in one of two instances: an actual default or a clear potential future default — called an imminent default.
In cases without an actual default, the master servicer and the special servicer must agree that a default is imminent to transfer the loan to the special servicer.
Before you consider taking your client on a tough trail — defaulting on a CMBS loan — check what the options are. The following options are general in nature, and there are variations that can be considered for each scenario. That is why it is crucial that your client works with an experienced professional to navigate this process
If the value of the property is less than the debt, it is critical to decide the likelihood that the property value will recover to reach the debt amount by the maturity date. If that recovery seems unlikely, then you need to find a solution that allows everyone to get out today with the least amount of loss possible. This can be a discounted pay off, a note sale or another form of real resolution. The days of pretending and extending are over.
If the value of the property has the potential to recover, then a more likely solution will be a bifurcation and deferral of the existing debt. This strategy is commonly referred to as an AB structure because the existing debt is bifurcated into an A note that is serviced through maturity and a B note that essentially becomes a hope note. These structures were created as a way to allow everyone to potentially get out whole or, at least, with the smallest amount of loss.
The special servicer is bound by a servicing standard and is obligated to maximize the recovery of the loan to the bondholders based on an analysis of collection alternatives using a net present value methodology. One collection alternative that is always available to the special servicer is foreclosure and ultimately selling the property as a real estate owned (REO) property. Make sure your client, the owner, offers a solution that will result in a better outcome to the bondholders than that alternative for the special servicer.
If your client is counting down to an upcoming maturity, there are only three real options to consider:
- Pay off the loan in full;
- Pay off the loan at the current value of the property where the property value is less than the debt; or
- Seek an extension of the term of the loan. An extension of the term of the loan is not a cheap option and only should be considered if there is no other option available. A one-year extension typically will cost a full point and will require a significant pay down of the existing loan. Several one-year extensions can be granted in some instances.
This is a case when a property is in need of new capital, the value of the property is equal to or greater than the loan, and your client does not have the funds. There was a flurry of distressed real estate funds that were created in anticipation of this very scenario in the period between 2008 and 2010. Most of these funds thought that they could save the day by bailing out an owner and taking control of the property. Because the industry took a wait-and-see approach rather than executing a swift correction, however, these funds did not have the opportunities that they had hoped for.
Many of these funds have come to realize that it’s far better to work with the borrower than try to bail out the owner and take the property away. The special servicer always would rather work with the borrower on a solution, as well.
There are funds available to assist a borrower in these situations. The funds do come with a high price tag, so consider them a last-resort option if the owner does not have adequate funds. These funds do, however, have the advantage of keeping the owner in control of the property and allowing the owner to avoid any tax consequences associated with losing the property through foreclosure.
Commercial mortgage brokers may come across property owners who are struggling with imminent cash-flow shortfalls and may not know the right time to approach their servicers. The best advice is to notify the master servicer of any potential cash shortfalls as soon as possible in the process.
Remember, the special servicer is the only party that can entertain a modification of the loan, so the first step in this process is to be fully transparent with the master servicer that these shortfalls are looming, and that your client does not intend to continue to make payments without a modification of the loan. Only then can you possibly discuss a potential modification to the loan.
The type of modification can vary greatly and will ultimately depend on the present value of the property, as well as the projected value of the property at maturity.
If it is likely that the property value will be at least equal to the loan amount at maturity, a modification likely will be considered. If it is unlikely that the value of the property will equal the loan amount by maturity, other options will need to be considered.
Many owners spend all their money covering the shortfalls, thinking they are doing the right thing. When they get to the point where the funds run out, they approach the master servicer only to find that it is too late to fix the problem.
If your client wants to sell a property and its value is less than the debt, a good solution may be an equivalent of a short sale. The CMBS master servicer and the special servicer won’t call it a short sale, but it will act, look and smell like one — think residential short sales.
It is important that you follow the right process when approaching this solution. Remember that the loan first needs to get transferred to the special servicer. The special servicer will get its own determination of the market value of your client’s property by getting an appraisal and a professional broker’s opinion.
Once the value is determined, the special servicer may consent to a discounted pay off, allowing your client or someone else to pay off the loan at a discounted amount. That is the amount that will need to be paid to the special servicer for complete satisfaction of your loan. It is possible for the new buyer to pay more than this and, in that case, your client will be able to retain the excess proceeds.
Because CMBS loans are nonrecourse and there are no tax consequences to the owner, the right solution may be to “hand in the keys,” if this is what your client wishes. This solution used to be called “jingle mail” where the keys actually were put in an envelope and sent to the servicer. The process is not as simple as it appears, but it is possible to work with the special servicer cooperatively in handing back the keys to the property.
Before resorting to this solution, advise your client to consider other options. A short sale, for example, will make it possible for the owner to get something in the process — whether that’s a walk-away fee, profit or a hope note. This is an individual choice, but it is important to know that there are options.
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In each and every scenario, there are options that a savvy mortgage broker must be aware of. Some solutions are more painful than others and may not be worth the alternative, but a full understanding of the available routes is the best way to help a client make the right choice.
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