As published in Scotsman Guide's Commercial Edition, May 2012.
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.
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