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A Way Out of the CMBS Quagmire

New sale structure may boost opportunities to buy distressed projects.

A few years ago, when it became clear that the commercial real estate market would suffer a steep decline and that recently financed properties often were significantly overleveraged, many investors envisioned numerous opportunities to buy distressed assets at bargain prices from overwhelmed special servicers in the commercial mortgage-backed securities (CMBS) industry.

For various reasons the transaction volume for distressed securitized assets has been less than anticipated. An emerging transaction structure may help unclog the deal flow pipeline. Special servicers have started using court-appointed receivers to sell properties in transactions in which the purchaser assumes a reduced loan. For purchasers, this structure can offer advantages over both REO and note sales, most notably attractive coupled financing.

For example, in a recent receiver sale the special servicer reduced the principal amount by 48%. The purchaser assumed a five-year loan for 80% of the purchase price that requires payments of interest only for the first three years.

Special servicers may utilize receiver sales with greater frequency to expedite the resolution of burgeoning troubled loan portfolios.

The delinquency rate for CMBS loans has increased an average of 25 basis points per month during the last 12 months and reached a record 9.34% in January, according to Trepp LLC.

Standard & Poor's recently reported that almost $49 billion in CMBS loans will mature in 2011. Many likely will end up in special servicing as borrowers often may be unable to refinance given current valuations.

Benefits of receiver sales

Purchasing REO properties from a special servicer has certain drawbacks. Due to tax laws, CMBS special servicers cannot provide seller financing. As such, the purchaser may need to pay all cash, resulting in a greater initial outlay and a lower rate of return. The special servicer also may lack customary property documents given the circumstances under which it acquired ownership.

Note sales present the same drawbacks and more. For example, a “loan-to-own” note purchaser may not be afforded access for property inspections. Also, its ability to acquire the property could be impaired if the borrower files bankruptcy or contests the purchaser's foreclosure.

Note purchasers also need to consider the tax consequences of the market discount rules applicable to debt purchases and those loan administration actions that can trigger phantom tax liabilities.

Receiver sales almost always will be conducted with the borrower's cooperation. As such, the purchaser should expect an unimpeded path to ownership and that it can conduct its desired due diligence. Most importantly, the purchaser can assume the existing mortgage loan, reduced to reflect the current value and purchase price.

Special considerations

Receiver sales generally present the same issues and utilize the same documentation as traditional sales, but there are some differences.

  • Closing conditions — The closing will be contingent upon court and lender approvals, so the closing date will be uncertain. Thus, the purchaser may want the right to terminate the sale without forfeiting its earnest money if the closing has not occurred by a particular date.

  • As is, no recourse — While “as is” sales have been the norm for many years, most such sales have provided the purchaser with property-related representations and limited remedies for breaches. In a receiver sale, the purchaser should not expect significant property representations or recourse against the receiver for breaches discovered after closing.

    For pre-closing breaches, the purchaser's remedies may be limited to specific performance or terminating the sale and recovering its deposit, with no right to recover damages.

  • Post-acquisition liabilities — In a traditional sale, the seller typically gets a liability release from the purchaser, but does not receive broad purchaser protection against third-party claims. A receiver may seek indemnification for environmental and other liabilities.

  • Tax concerns — The purchaser should involve tax counsel or another tax advisor to review the loan assumption language and avoid having the loan write-down trigger cancellation of indebtedness income.

It is uncertain how widespread the use of receiver sales may become. A special servicer likely will pursue that strategy only if it procures the borrower's cooperation and deems it preferable to other resolution options, such as a modification, discounted payoff or foreclosure and subsequent REO sale.

Nevertheless, the practice is gaining momentum and investors may soon find increased opportunities to acquire distressed assets on acceptable terms.

Edward Hagerott is a partner with Goodwin|Procter LLP and is based in Los Angeles.

He can be reached at [email protected]

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