Special servicers' cure could prolong commercial real estate market's ills

The firms responsible for figuring out the best solution to troubled commercial real estate loans might end up extending the market's problems.

With an estimated $1 trillion in commercial mortgage-backed securities coming due over the next five years, these firms — known as special servicers — are facing extreme financial pressure, which many fear could lead them to extend the loans backing the CMBS instead of defaulting on them.

That's a problem for institutional investors because until CMBS and other commercial real estate distressed debt are allowed to default and be flushed out of the system, there is little hope of recovery.

There are few transactions now because buyers expect that commercial real estate values are still going down and sellers are unwilling to sell at rock-bottom prices.

“Special servicers have a Herculean task. There's an onslaught of bad loans,” said Joseph B. Rubin, principal, transaction advisory unit of Ernst & Young LLC, New York. “It's not only a tidal wave that hits you, but it keeps coming.”

The current financial crisis is the first test of the CMBS market, which exploded between 2004 and 2007. There were $1.4 trillion new CMBS issued in 2007, three times the total issued between 2000 and 2003. Most of the CMBS debt will not be refinanced, and it's up to the special servicer to work out the loans or foreclose on the properties.

But a number of the servicers have cash problems. The value of their CMBS investments is falling and the debt financing those investments is coming due.

LNR Partners, the nation's largest special servicer with $191.7 billion in loans as of Dec. 31, is preparing for a possible bankruptcy, sources said. LNR executives could not be reached for comment by deadline.

LNR and CW Capital Asset Management LLC handle more than 50% of all loans in special servicing, according to corporate finance adviser Navigant Capital Advisors, which analyzed Mortgage Bankers Association data.

The volume of loans in special servicing ballooned to $66.9 billion at the end of 2009, up from $12.8 billion at the end of 2008, according to a Navigant report.

Plus, the newer the loans, the more complex they're likely to be and more likely they are to default or require special servicing, according to a Feb. 8 report by Standard & Poor's. Newer loans — those originated between 2004 and 2009, the period when CMBS issuance exploded — are performing “notably worse than those issued seven or eight years ago. Indeed, newer vintages performed for an average of 2.3 years before defaulting or triggering transfer to a special servicer, compared to an average of eight years for older CMBS,” the S&P report noted.

The test is whether the CMBS investment infrastructure will survive the massive real estate downturn, Ernst & Young's Mr. Rubin said.

Special servicers have a tough job. They are charged with analyzing each bundle of loans, figuring out the strategy to work out the loans and complying with servicing standards, which includes maximizing recovery of defaulted loans, Mr. Rubin said.

Complicating the process is that the bondholders in the CMBS pool have competing interests.

Senior bondholders tend to have enough capital to cover losses in foreclosure, and therefore push to liquidate non-performing and underperforming loans. Junior bondholders — including the special servicers who typically own the bonds that are the first to lose money in a default — generally prefer to extend the loan rather than sell property in a distressed market, explained Mike J. Melody, executive managing director and co-head of real estate investment bank practice in the Houston office of Jones Lang LaSalle Capital Markets.

How special servicers choose to act could impact the duration of the commercial real estate crisis. Special servicers are wedged between a rock and a hard place. They are charged with working out troubled loans that are part of the bundle held by the CMBS, but they have fewer options than traditional lenders such as banks and insurance companies. They must pursue actions that will result in the highest recovery for the collective of bondholders of the CMBS, which sometimes means holding on to properties, rather than selling them at a loss.

“The willingness of special servicers to test historical boundaries of influence and create consensual solutions in the face of uncertainty would serve to accelerate the resolution of the current crisis,” said Edward Casas, senior managing director at Navigant, Chicago.

But this can be tricky. In February, hedge fund Appaloosa Management LP sued to halt the foreclosure of Peter Cooper Village/ Stuyvesant Town in New York. It argued that special servicer CW Capital, should not have foreclosed on the roughly $3 billion in debt after owners — led by Tishman Speyer Properties and BlackRock Inc. and including the California Public Employees' Retirement System — defaulted. Appaloosa, which owns more than $750 million of the bonds, argued that foreclosure exposes the CMBS trust to losses.

With real estate prices estimated to have dropped about 30% in the past two years, the values of most of the loans are exceeding property values. As a result, the roughly $250 billion per year in commercial real estate debt expected to come due over the next four to five years is unlikely to be refinanced, Mr. Melody said.

The idea behind the CMBS contracts was that if special servicers were in the first-loss position, their interests would be aligned with the rest of the bondholders, but “that did not come out the way people thought,” Mr. Rubin said.

As long as special servicers and other commercial real estate lenders put off the pain of foreclosure, the real estate crisis will continue, industry insiders say.

“When loans go to special servicing and get extended, it's kind of like going into purgatory because of all of the uncertainty around it. You can't find a new price,” Mr. Rubin said.

Last year, a “meaningful portion” of CMBS were extended, Mr. Melody said, and so the problems remain and will resurface when the loans come due again, he noted.

Al Rabil, managing partner with Kayne Anderson Real Estate Partners, Armonk, N.Y. said: “If you don't have to put equity down and are taking a "hope note,' you attract the not-well-capitalized looking to see if there is value there down the road. Well-capitalized investment firms want to mark the note down to what it should be and go from there.”

Meanwhile, properties are being held off the market as owners hope for a better day and potential buyers wait for bargains.

Transaction volume for 2009 was 64% lower than 2008, which was 72% lower than the year before, according to Navigant. With few commercial real estate transactions closing, no one really knows what real estate is worth, Mr. Melody said.