by Nick Silbergeld
Capital Markets Insight has been focusing on familiarizing readers with the terminology and mechanics of the CMBS market as well as the reason for its current demise and attempts to revive it. George Smith Partners closely follows developments in the financial markets and reforms proposed by the leading regulatory bodies overseeing the restoration of the financial markets. The reforms serve as a roadmap for the private sector to revive the commercial real estate capital markets as well as laying a foundation for the new rules by which industry professionals will have to live.
Introduction
In the last edition of Capital Markets Insight we discussed the extensive proposal put forth by the Treasury Department to initiate reform of the financial markets and highlighted points focusing on the commercial real estate capital markets and securitization. The Internal Revenue Service has now taken the next step in putting forth new guidance for servicers and modifying the REMIC tax laws that are one of the primary factors in determining the way the securitization process works.
New IRS Guidance
Property owners and investors who leveraged their properties with CMBS loans which are now in distress have been facing a conundrum for quite a while; they see their grim near-term prospects with decreasing cash flows and struggling tenants but they have been unable to speak with the loan servicer about a solution to their impending crisis. While performing, loans are serviced by a Master Servicer who has a very limited ability to discuss a resolution for a loan that is heading towards default. Only once the loan has been transferred to the Special Servicer is the borrower able to begin discussions regarding a resolution, including a loan modification, forcing the borrower to negotiate from a distressed position.
However, the recent IRS announcement has given servicers new leeway in negotiating loan modifications and has provided borrowers with a new opportunity to stave off defaults and save their properties by giving them more time to negotiate a loan resolution. Previously, Master Servicers were only allowed to transfer a loan to the Special Servicer when the loan had defaulted or the default was reasonably foreseeable in the immediate future. The new guidance allows Master Servicers to take more preemptive action if they believe that default is a likely scenario, even if the default would occur a year or two from the time the borrower wants to initiate discussions. Most importantly, the guidance clearly states engaging in these negotiations and enacting an anticipatory modification would not jeopardize the CMBS trust’s tax status as a tax-free REMIC.
What does this mean for borrowers? The new flexibility gives servicers the ability to take a more proactive approach and consider the state of the financing markets as a major determinant as to whether refinancing is achievable given a property’s current and future situation. Borrowers can now engage servicers as they see problems developing rather than being forced into a corner before being given a chance to negotiate.
As has been highlighted by the headline grabbing bankruptcy cases, , borrowers were forced to wait until the 11th hour to begin workout negotiations with servicers at which point the property and sponsor’s situation had become significantly worse. The new guidance provides the borrower ample time to prepare a thorough turnaround strategy and the servicer time to review and analyze the solution before the property deteriorates. The result is a better outcome for borrowers, more time to review and negotiate for the servicers and potentially higher loss recoveries for bondholders.
The hope is that by addressing a loan that is headed towards distress early, a borrower can present a turnaround strategy in tandem with an agreed upon modification leaving all parties better off than waiting to address the loan once it has defaulted. Market participants hope this will encourage borrowers to be more inclined to proactively engage in workout negotiations early and steer away from the bankruptcy option.
Despite the clear benefit the new guidance provides borrowers and servicers, many institutional CMBS investors have voiced concern over the new framework provided to servicers. One issue that will need to be clarified, or determined through practice, is whether the roles of the Master and Special Servicer’s will change. Previously the Master Servicer had a clear mandate directing them when to begin scrutinizing a loan and when to transfer the loan to the Special Servicer. The Master Servicer now has far more responsibility to analyze a resolution for a potentially troubled loan and must negotiate with the borrower more extensively to properly determine whether a loan is worthy of being transferred proactively to the Special Servicer. Some investors and observers are worried whether servicers are prepared to handle the potentially huge influx of requests from borrowers to begin workout discussions and servicers are building their staff in anticipation.
Another major concern of participants on the bond side of the CMBS market is that the new freedom provided to servicers could exacerbate a conflict of interest that has been plaguing the market. Special Servicers often own the first-loss tranche of a CMBS pool and some believe that they are inclined to act in accordance with preserving their position rather than in the benefit of all certificate holders of the pool. This “tranche warfare” would be primarily at the expense of the senior bondholders and has been a contentious point since the turmoil in the CMBS market began. This issue will be discussed more in depth in the next installment of Capital Markets Insight.
In summary, the new IRS guidance has opened a window of opportunity for borrowers to try and resolve pending defaults in advance thereby reducing the pressure on the massive maturity wall that we discussed in our very first article. The looming threat of hundreds of billions of dollars in CMBS loans coming due with insufficient debt in the commercial real estate capital markets has been hanging over the real estate markets and has become the major concern for the Treasury in trying to revive the economy. These changes may be the tool needed to help work through this seemingly insurmountable task and start an orderly deleveraging process without completely ravaging borrowers and bond investors. Despite some of the concerns and confusion created by this new proposal, it could be one of the most significant and truly helpful developments the commercial real estate market has seen since the crisis began. For a successful restructure, borrowers need to have a knowledgeable and experienced team to work with to create a strategy that will both get the servicers’ attention and achieve results. George Smith Partners has joined forces with law firm, Manatt, Phelps & Phillips, LLP to provide a full service advisory platform to analyze, strategize and negotiate with the servicer thereby ensuring that the borrower has the best chance at achieving a successful outcome.
