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New IRS Regulations Might Contain CMBS Defaults, but Won't End the Commercial Real Estate Crisis

As property owners holding commercial mortgage-backed securities (CMBS) funded loans have attempted to address financing concerns over the past 12 months, many have complained of the impossibility of getting special servicers on the phone. Constrained by tax regulations that dictated real estate mortgage investment conduits (REMICs) could not allow modifications to their mortgage pools without incurring tax penalties and the possible loss of REMIC status, servicers told borrowers to wait until they were in default to contact them. That's lead to frustration and a lot of inaction.

As a result, there is now a lot of buzz being generated by the move last week from the Internal Revenue Service and the U.S. Department of the Treasury to loosen the rules to allow for loan modifications and extensions. If all goes well, the relaxed rules will get servicers to work with borrowers on potentially distressed situations earlier in the game, and might stave off a significant number of mortgage defaults, according to market analysts. The measure might even lessen potential losses from defaulting loans, giving servicers the opportunity to hold on to distressed assets until conditions in the investment sales market improve somewhat.

But like the banks’ strategy to “pretend and extend” on traditional mortgages, the new CMBS regulations might only be effective in delaying the problem, not solving it, says Clint Myers, strategist with Property & Portfolio Research, a Boston-based real estate research firm. Plus, analysts remain concerned about the possibility of unnecessary modifications and loss of value for holders of highest rated CMBS securities if the new regulations allow for the forgiveness of principal debt or long-term extensions.

“It doesn’t make problems go away, it delays them for another day with the hope that things will get better in the meantime,” says Myers. “”This will give servicers slightly more flexibility and lengthen out the cycle, making less clear what values are and delaying the bottom.”

The changes, effective as of Sept. 16, will cover loans modified on or after Jan. 1, 2008. They will allow for modifications to the loans’ collateral and guarantees, as well as giving servicers the power to switch non-recourse mortgages to recourse. As a result of the new regulations, servicers will now also have greater discretion in deciding which loans might need modification, enabling them to step into those situations where a loan that’s still performing today has a high likelihood of defaulting in the future.

Overall, according to Federal Reserve data there is $900 billion in outstanding CMBS debt accounting for 25.7 percent of the $3.5 trillion in commercial real estate debt outstanding. In 2010, there will be somewhere about $39 billion in CMBS debt coming due and about $150 billion coming due by the end of 2012. In July, the delinquency rate for CMBS loans reached 3.1 percent, according to Realpoint LLC, a Horsham, Pa.-based credit rating agency. By the end of the year, the firm predicts the delinquency rate will move past 6 percent.

“It’s definitely a positive move, as it will temper the level of distress that we otherwise would project for the securitization market and will indirectly benefit the larger pool of commercial mortgages,” says Sam Chandan, president and chief economist with Real Estate Econometrics, a New York City-based research firm. “But this program will be most effective in cases in which some reasonable modification will allow the mortgage to perform. Some of the most egregiously underwritten mortgages from the peak of the market will not benefit from this program.”

In addition, the new regulations might turn out to be more beneficial for holders of lower rated CMBS bonds than for those who invested in AAA-rated securities. Because AAA-rated bonds are, in theory, backed by highest quality properties, those investors expect to see full repayment of loans at maturity date, says Frank Innaurato, managing director of analytical services with Realpoint. They tend to hold the bonds for the short term and, for them, more modifications might mean lower yields. For investors in AA-rated and A-rated securities, on the other hand, who tend to hold the bonds for a longer-term and who incur most of the penalties in default cases, more modifications mean smaller losses.

“If too much flexibility is granted, you are going to have investors losing money because what is good for the borrower might not necessarily be good for the investor. The position we are taking is that it can be a double-edged sword—it may preclude balloon defaults, but it will increase the risk of extension and modification,” says Innaurato. “Will there be any type of debt forgiveness that will lead to a loss for the Trust? And one of the biggest concerns is how many borrowers with otherwise performing properties and stable cash flows will be in line for this?”

--Elaine Misonzhnik

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