Action Matters
Winning Back the CMBS Market
As we enter 2012, three non-traditional owner groups control the special servicing rights for approximately 74 percent1 of non-performing CMBS loans. More importantly, due to this consolidation of special servicer ownership, control is no longer in the hands of traditional lenders and mortgage servicers whose primary goal was to provide a loan servicing function with a single-digit rate of return. Specifically, control is now held by special servicers of opportunity fund groups Vornado (and its institutional partners), Island Capital and Fortress – each of which has different profit expectations and varied interests overall.
The wave of industry consolidation has produced concerns of real and perceived conflicts of interest by some investors that were not contemplated during the origination of CMBS deals prior to 2009, now known as CMBS 1.0 transactions. For the CMBS market to be a viable and sustainable source of real estate capital, market participants must address the current challenges of special servicing, including the realization of full value recoveries and information transparency, as well as the assurance there are no real and perceived conflicts of interest.
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As a result of the current ownership of CMBS special servicers, some investors are concerned that the high-return targets demanded by the new owners will take priority over their responsibilities to the CMBS trust. With principal investment capabilities and ancillary service lines (brokerage, management, etc.), these new owners have the ability to channel opportunities from the CMBS trust potentially to the detriment of investors. Furthermore, continued industry consolidation across related service lines can reduce visibility into the servicing process, making it even more difficult for investors to evaluate their returns. A recent example from the BACM 2002-02 transaction illustrates this possibility.
In March 2011, two mortgage loans secured by two office buildings in Livonia, Michigan, with a combined original appraised value of $71.6 million, faced imminent vacancy and were transferred to C-III’s special servicing group. As of last June, the then unoccupied properties were given an “as-is” appraised value of $8.4 million. On October 14, 2011, after seven months in special servicing, the building owner (affiliated with an executive of the brokerage firm Grubb & Ellis) executed a discounted payoff to acquire both of the properties for $5.9 million with the caveat that the transaction needed to close by the end of October. On October 17, C-III announced a $10 million strategic investment in Grubb & Ellis. Two days later, the building’s ownership announced the successful re-leasing of 91 percent of the buildings. A CBRE appraisal estimated that the combined stabilized value of the assets would have been approximately $23 million after the re-leasing transaction. Losses to the CMBS trust completely wiped out the control class certificates and impacted the non-control K class above them with a $1.9 million realized loss.
Addressing the Issues
As the industry continues to rebuild a sustainable CMBS market after 2009 (CMBS 2.0), certain issues within the special servicing process are being addressed through structural protections in the trust documents, as well as legislation and regulation, such as Dodd-Frank. Market participants across the debt stack must have the ability to access data and perform analysis to justify the servicing actions considered and, ultimately, taken on behalf of the trust before any decision is made and executed. One potential solution for CMBS 2.0 deals was set forth in the recent Dodd-Frank legislation: the designation of a CMBS operating advisor. Originally a market reaction to investor concerns, the role of the operating advisor has evolved from a regulatory perspective into a proposal under the new Regulation AB II rules, which would generally require a deal with an affiliated special servicer and subordinate investor to include a “credit risk manager. ”An independent advisor can provide an objective review of the actions of the special servicer in full view of a transaction’s stakeholders and can identify potential abuses within the servicing process.
Investors responded favorably when the role of operating advisor was initially introduced to the CMBS market in the $400 million DDR 2009-DDR 1 transaction, and this feature is now present in almost all new issue CMBS 2.0 deals. This role provides increased transparency for all bondholders, although the special servicer has no duty to follow the operating advisor’s directives. Nevertheless, an operating advisor can provide confidence that the actions of the special servicer are consistent with the servicing standard and are free from real or perceived conflicts.
Another specific area of investor concern arises from the fair value purchase option contained within CMBS 1.0 transactions, which allows special servicers and controlling class holders to buy a distressed asset for a recently appraised value. This option was originally developed to satisfy certain accounting requirements (that are no longer applicable) and to provide a safeguard that an asset would not be sold at an artificially low price; however, with the new ownership of certain special servicers, there are concerns that some are now positioned and incented to use this mechanism to purchase assets for principal investment affiliates.
Achieving an Open and Competitive Bid Process
In order to ensure true market pricing, the exercise of a fair value option should not culminate in an immediate sale, but should instead establish a fair, transparent and open competitive bid process. This may include stalking horse, open auction or other methods to achieve an open and competitive process. In most CMBS 2.0 deals, for example, the special servicer is required to solicit offers from third parties and to sell a defaulted asset for no less than a “fair price,” subject in some deals to the directing bondholder’s right to purchase the asset at par if the third-party fair price is not at least equal to par. For CMBS 1.0 transactions, the inclusion of a transparent bidding process would mitigate the ability of special servicers and / or control class holders to acquire trust property assets hidden from the view of other bondholders. Additionally, this process may in some instances increase the absolute value of the bids received, leading to a better result for all trust certificate holders.
Unlike recent and prospective CMBS 2.0 transactions, legacy CMBS 1.0 deals have no clear mechanism to designate an operating advisor, transparent bid or other potential solution. However, there are still ways in which solutions may be brought to legacy deals. For one, market participants can reach consensus and agree to modify existing transactions and incorporate new solutions. Although a consensual change is unlikely because all certificate holders must agree to such change, market participants can agree retroactively to designate an operating advisor or to institute a transparent bid process. These and other solutions can also be influenced and implemented through the legislative process, although any such changes that abridge existing contracts would be considered a taking of rights (including economics) from certain parties. As a last resort, litigation, arbitration and mediation are always available as methods for resolving these disputes in the absence of either consensual agreement or legislative enactment. For example, the nebulous “servicing standard” of CMBS deals is fertile ground for litigation aimed at addressing possible conflicts of interest in legacy and new issue deals.2
Conclusion
The overarching objective for the special servicing of CMBS assets is the equitable resolution of real estate workouts and restructurings. Due to conflicts of interest in the special servicing field, investors struggle to access, analyze and manage the risk associated with their CMBS investments. As a result, the flow of capital into the CMBS market will likely be inhibited unless the industry continually refines its special servicing model by mitigating real and perceived conflicts of interest, by making the process more transparent and by promoting full value recoveries from non-performing assets. Modifications to the structure of CMBS deals, such as providing a neutral third-party operating advisor and / or a transparent bid process, can serve to provide greater comfort and transparency to CMBS stakeholders, as well as a path toward more effective special servicing.
1 Commercial Real Estate Direct – CMBS Special Servicers See Sharp Drop in Volume of Loans. Commercial Real Estate Direct.com; FM Financial Publishing, 7 Oct. 2011.
2 Special servicing concerns are certainly not limited to the three special servicers referenced previously. In Cedarwoods CRE CDO II Ltd. v. Galante Holdings Inc. (11-653624, NYS Supreme Court in Manhattan), four investors in the CSMC 2007-TFLA transaction (including Angelo Gordon & Co.) are seeking to preclude Galante from purchasing the J.W. Marriott Las Vegas Resort & Spa at a loss of approximately $65 million or 43 percent of the original first mortgage loan, and this litigation does not involve LNR, C-III or CW Capital as special servicer.