Let’s take a walk down commercial real estate memory lane. In 2007, life was good, you had a nice project throwing off good cash flow, cap rates were low, values were high and you hit the jackpot! You refinanced, you maxed out proceeds, you got cheap, fixed-rate, 10-year money. Heck, you may have even repaid your equity!
Then, later that year and “officially” for the next 18 months (but really, the next five years) came the Great Recession. You heard all the horror stories of failed real estate projects, failed banks, sponsors being sued, but you made it through, you were smarter than those guys, locked into cheap, non-recourse, long-term money, and you were good to go.
Unfortunately, now your loan is maturing and market conditions, such as increased interest rates and a lackluster recovery, are such that you cannot refinance or sell the property and generate the proceeds you need to pay off this wonderful loan. Don’t worry, you are not alone, you are now part of the $192.9 billion “CMBS Wall of Maturities.”
What do you do? Think back again to 2007. The company that originated your loan may or may not still be in business. The person that originated your loan, your “relationship manager,” is nowhere to be found. However, unlike dealing with your local bank, it doesn’t matter because your loan was only “originated” by that loan originator. Your loan was included in a pool of loans that were securitized by an investment bank (who, by the way, made a boatload of fees in doing so) and are now owned by anonymous bondholders.
Who do you call? Your loan is being portfolio-managed or “serviced” by a master servicer. This is the company that sends your monthly bill, collects financial information and monitors covenant compliance. According to the Mortgage Bankers Association, in 2016 the largest master servicers included Wells Fargo, Midland Loan Services, Berkadia Commercial Mortgage and KeyBank National Mortgage. Master servicers have a playbook called the “Pooling and Servicing Agreement” or PSA, that outlines their roles and responsibilities to the bondholders, examples of which include making sure the property is sufficiently insured, ensuring that the real estate taxes are paid, processing capital expenditure reimbursements, collecting debt service payments and, in turn, paying the bondholders. The master servicer also analyzes the property’s financials and will most likely be checking with you via email or phone in the six months or so leading up to your loans maturity date to find out if you have an exit strategy.
What do you tell them? If you are reasonably confident that a sale or refinance of the property is not feasible to pay off the loan at par, the master servicer will ask you to send them an “imminent default letter,” explaining the situation and letting them know that payment in full at maturity is unlikely. Per the PSA, once the master servicer receives this letter they will be required to transfer your loan to a special servicer.
What do you do then? Initially, the special servicer will ask you to provide information and access. The special servicer will typically want to have a discussion with you about the property, its financial performance, the efforts that you have taken to exit the loan and other potential resolution strategies. In addition, the special servicer will almost immediately order third-party reports, including an appraisal, a Phase I environmental report and a property condition assessment (PCA). The special servicer will send you a pre-negotiation agreement to sign. I always recommend that clients hire an experienced workout attorney to review this document to insure that you are not inadvertently waiving any rights that may exist under the original loan documents.
What will the special servicer do? I like to take the Sun Tzu, Art of War approach: “If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself, but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle.” Understanding the special servicer involves researching the composition and historical performance of the securitization and the resolution strategies that the special servicer has employed in the past.
Each month, along with the payment to the bondholders, the master servicer submits a remittance report. The report includes the distribution detail (waterfall), cash and other reconciliations, rating details, loan and property stratification tables, mortgage, NOI, principal payment details and a historical recap of the pool returns.
An analysis of the remittance report mortgage loan detail provides a great overall snapshot of the pool, including the individual loan maturity dates, appraisal reductions and resolution strategies. Because of the bond structure of the securitization, the loans in the pool will generally have maturity dates around the same time.
I recently analyzed a 2007 $750 billion securitization that had 91 percent, or $683 million of loans, maturing between December 2016 and March 2017. Needless to say, the pool had already taken a $100 million appraisal reduction, and 24 of the 78 loans (30 percent of the pool) had been or were in some kind of workout situation. Seventeen had resolution codes that indicated they had previously been resolved.
While the special servicer has several resolution alternatives at its disposal, including modification, extension, discounted payoff, foreclosure, note sale, bankruptcy and deed in lieu of foreclosure, further analysis of the remittance report specially serviced loan detail (which includes an individual narrative on all of the specially serviced loans) revealed that historically, the majority of the specially serviced loans were resolved by foreclosure. However the newer maturity defaults notes typically included the comment “file being reviewed to determine workout strategy going forward,” with a resolution strategy code “TBD.”
At the end of the day, the resolution strategy that a lender will most likely accept is the one that, in its sole opinion, maximizes recovery to the bondholders. This analysis should consider the time value of money and could include a deed in lieu of foreclosure, a foreclosure, a forbearance and/or a discounted payoff. Special servicers appreciate the willingness of a borrower to be forthright about their situation. However, as a carve-out guarantor, one must be cognizant of the obligations and rights afforded under the loan documents and take extra caution to avoid inadvertently triggering recourse obligations. For this reason, in most cases, a team of professionals, including a workout advisor, tax professional and legal counsel, should be consulted to help understand the objectives and likely resolution strategies of the special servicer and to develop an action plan that protects and preserves the valuable indemnification rights and financial interest of the debtor and equity holders.
Debra Jackson serves as a managing director with HDH Advisors and specializes in providing turnaround, restructure, real estate and bankruptcy consulting.