CMBS Loan Modification and Refinance
Many Commercial Mortgage Backed Securities (CMBS) loans are set to mature over the next year. Although the underlying properties are generating more than enough cash flow to meet all loan, tax and reserve payments, these loans are still in imminent danger of default.
We have seen many borrowers surprised when their loan is put into special servicing even though they have never missed a payment. This article discusses the special servicer process and offers suggestions as to how borrowers should work with servicers.
Although this may appear basic to many borrowers, some discussion is helpful on the roles of master and special servicers.
Special Servicer vs. Master Servicer – The Difference
The master servicer collects payments and disburses monies to the bondholders, taxing jurisdictions and others. Their primary authority is to oversee the administration of the loan. Because of IRS REMIC and contractual limitations, they typically have no authority to make or approve loan modifications.
Pooling and Servicing Agreements (PSA)
The contractual limitations can be found in the pooling and servicing agreement. Often called a PSA, these agreements are frequently in excess of 1000 pages. Every CMBS loan has a PSA that dictates the responsibilities and authority of the master and special servicers. Few real estate lawyers have experience with CMBS servicing and PSA agreements.
CMBS Loan Modifications – Caution Approaching Servicer
Many borrowers approach the master servicer directly and seek a modification. That is some what understandable because until that point, all their dealings have been with the master servicer. Borrowers frequently don’t even know who the special servicer is.
Caution! By approaching the master servicer directly, the borrowers may be placing themselves in a technical default. Lay people think of defaults in terms of missing a payment but that isn’t the case in the CMBS world.
Often the loan documents say that loss of a key tenant or a request for a hardship modification are enough to trigger a technical default. Sometimes the master servicer will tell the borrower that it must miss or be late on a payment so that the loan can get transferred to a special servicer.
Be very careful! Some of the largest special servicers in the industry are notoriously difficult. In our opinion, that includes some of the largest servicers including LNR Partners, CWCapital and C-III Asset Management. If your loan is coming due or you need to modify your loan, speak with us first.
Loan modifications for CMBS funded properties are rare. The special servicer may have the authority to modify a loan but rarely exercises that power. That means borrowers need to prepare long before the loan matures. Although property values have increased in many areas of the country, the cash flows on many properties are not sufficient causing traditional bank lenders to pass on refinancing requests. Hard money lenders and equity investors may step in but these deals take time and many borrowers are reluctant to give up part of their ownership interest or lack funds to make principal reductions on the loan.
There are options but borrowers will need plenty of time and should not wait until the note matures before approaching the special servicer.
We have seen at least one deal where the borrower assumed the special servicer would allow it to use accumulated reserves to buy time for refinancing and / or use that money to make a principal reduction. While those requests may make economic sense, remember that many special servicers are notorious for the way they deal with borrowers.
Whether the fault falls completely on the special servicer depends on the terms of the pooling and servicing agreements. The PSA often gives special rights to holders of particular tranches of the trust. [CMBS loans have a “trust” as the noteholder. The trust often has several layers or tranches. Those noteholders with higher level tranches receive a smaller piece of the revenue stream but they are first to be paid.]
Special Servicer Conflicts of Interest
The PSA agreements often give special servicers the right to acquire the property at a fair value price. Not the best price. That’s right, the person servicing your loan may have the right to buy it without your approval in the event of default.
If you are thinking this creates a huge conflict of interest, we agree. Servicers have a duty to the bondholders; the owners of the trust. Obviously, if a property is in default, the noteholders want to get the best price possible and minimize their losses. Assuming the special servicer decides to acquire the property, however, they will obviously want to obtain it at the lowest possible price. CWCapital is currently in litigation over this issue. Special servicers may also have a duty to be fair in their dealings with the borrowers.
The conflicts in these arrangements are so many that they could be the subject of a book. Unfortunately, the borrower is often the one with the least clout, especially when they attempt to negotiate on their own.
Often a borrower will miss a payment in order to transfer the loan from the master servicer to the special servicer. Remember the master servicer has no authority to change or extend the terms of the loan.
Borrowers need to know that the minute a loan goes into substantial special servicing, fees and charges begin to mount. Of course, this comes at the worst time for borrowers.
Pre-Negotiation Letter (PNA)
The loan terms typically say that the special servicer can initiate foreclosure on behalf of the trust. Sometimes, special servicers will offer to hold off on the foreclosure. Unfortunately, that typically means signing a pre-negotiation letter (PNA).
We say “unfortunately” because the terms of most PNA agreements include a waiver of all defenses the borrower may have. Those agreements typically have a confidentiality clause too. You can’t sue and you can’t talk to others.
Even if no PNA is signed, forbearance is often not in the borrower’s best interest. Default interest, late fees, appraisal fees, receivers and the like can make it impossible for the borrower to ever dig out. At that point the borrower is at the complete mercy of the special servicer and the special servicer often wants to acquire the property for its own portfolio.
Sometimes the special servicer won’t foreclose but will instead sell the note. This is common in states where foreclosures can drag on for years or where the borrower intends to fight. By selling the note, the borrower may lose some of its claims when the note is transferred.
Another dynamic to be considered in most CMBS loans are the powers the special servicer has to allocate payments. Borrowers are shocked to learn that even though the property was generating sufficient cash flow to pay down the note, the special servicer reallocated the payments to everything but principal. Again, the special servicer appears to have many conflicts of interest with the bondholders and borrowers but that rarely stops them from acting in their own best interests.
Although loan modifications are rare, the modifications with the best chance of success are short term extensions of the maturity date. Even then, special servicers will often demand a principal reduction payment.
We hope that you walk away with several lessons from this article. First, make sure you have a good lawyer before you approach the servicer or special servicer. Even if your loan is current, a modification request could trigger a technical default. Local real estate lawyers are great for knowing local customs and laws but very few have experience with CMBS loans, REMIC rules and New York trust law. [Many trusts are established in New York.]
Second, special servicers – especially the larger servicers including LNR Partners, CW Capital and C-III Asset Management – can be very difficult. (We are presently pursuing claims against LNR Partners and CWCapital.)
Finally, don’t wait. Simply because rents are servicing the debt and your loan is current does not mean a lender will quickly refinance the loan. Worse, special servicers may have an economic interest averse to yours.
There are many, many CMBS loans that mature over the next year. Many borrowers are in for a rude awakening when they try to refinance their loans. Call us before you are in a technical default or have your loan transferred to special servicing. The earlier we can get involved, the more options you have.
Need more information? Contact Attorney Chris Katers at [hidden email] or call 877.858.8018. The author of this post, attorney Brian Mahany, can be reached at [hidden email].
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