Archive for September 20th, 2009

REMIC Modifications and Their Impact

One year ago, one of the most intriguing questions on the minds of commercial real estate investors was what was going to happen to large, performing CMBS loan that matured and the owner was not able to refinance. Since then, 528 CMBS loans valued at nearly $5 billion matured and were unable to be refinance even though 75% of these loans were throwing off more than enough cash to service their debt. The evaporation of the CMBS market and the entire shadow banking industry has created an extremely challenging financing market for all large loans, even for properties which have the cash flow to cover debt service payments. This lack of liquidity has continued to be a tangible concern for the industry. 

A potential solution to this problem was announced by the IRS last week when they issued guidance (Revenue Procedure 2009-45) that provides significantly greater flexibility to modify the terms of commercial mortgage loans that have been securitized into commercial morgage backed securities. RP 2009-45 makes it clear that negotiations involving modifications to the terms of these loans can occur at any time (the servicer only has to believe there is a “significant risk of default” even if the loan is performing) without triggering tax consequences. It applies to all modifications made after January 1, 2008.

Until now, a borrower with a CMBS loan had no one to speak to at the master servicer. The master servicer serviced the securitized loan and the borrower would have to essentially go into default to have the loan transfered from the master servicer to a special servicer. The borrower could then have a dialogue with the special servicer to discuss reworking the terms of the loan.

Administrative tax rules applicable to Real Estate Mortgage Investment Conduits (REMICs) and investment trusts imposed severe penalties for changes made to commercial morgages or investment interests after the startup date of the securitization vehicle. The trusts could have been forced to pay taxes if the underlying loans were modified before they became delinquent, according to the old CMBS rules. Therefore, borrowers were unable to even begin discussions with their loan servicers until they had already defaulted of default was imminent. Often, however, by the time a loan reaches this status, options are generally limited and it is too late to work anything out. Foreclosure would be a likely result, further depressing valuations.

This new IRS guidance puts CMBS borrowers on almost a level playing field with borrowers who have loans with traditional banks. Those bank borrowers have always been able to call their banker at any time to discuss any potential problems that the loan might face. Now borrowers with CMBS loans can do the same thing thereby enhancing the possiblity that the loan can be salvaged and the property can be maintained.

While this modification is applauded by many in the industry, there are some concerns.

First, this program will really only help those borrowers who are conservatively leveraged and simply cannot refinance because of the extraordinary condition of the credit markets today. Any borrowers who have negative equity and are highly leveraged are out of luck (whether they can arrange a modification or not) and may only be delaying the inevitable if they are able to convince the servicer to modify.

Second, it is feared by many that the guidance could open the floodgates for everyone to try to get some sort of loan modification whether it is justified or not.  Some borrowers may take a shot just for the heck of it. It will be interesting to see what criteria servicers use to determine who gets help and who doesn’t.

Third, servicers will come under tremendous new pressures from several participants with different objectives such as competing classes of investors. Some investors holding CMBS bonds are watching nervously because the modifications might not always be in their best interest. CMBS have senior and junior pieces (known as the “A-note” and the “B-note”). The senior piece is in a better position and has incentive, in most cases, when a borrower defaults, to foreclose and liquidate the property. Junior holders, on the other hand, might benefit from a modification because they may not get any proceeds back in a forced sale.

Fourth, the fiduciary responsibility of the servicer is to all bondholders and they should modify loans only when that can be expected to reduce losses. That puts servicers in the challenging position of trying to figure out which borrowers are essentially sound versus knowing when it makes sense to foreclose quickly. My guess is that, based upon the relentless pile of files mounting on servicer’s desks, modifications will be the path of least resistance.

Fifth, from the brokerage perspective, this modification will only further constipate the pipeline of distressed assets which is already moving like molasses. Many of the properties which would be considered “distressed” are financed with CMBS loans and, to the extent that brokers were looking forward to selling these assets, we will have to wait even longer for these opportunities to present themselves.

Importantly, the guidance only applies to outstanding loans and only to servicers who believe a loan modification is in the best interest of all of the bondholders. The servicers are still bound by the terms of the pooling and servicing agreements and the servicing standards (which are not affected by the guidance) but at least the tax rules will not prevent dialogue among the parties.

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,000 properties in his career.

Advertisements