The Commercial Mortgage-Backed Securities (CMBS) market represents over $600 billion of outstanding bond principal as of the end of the first quarter of 2021 per SIFMA. The performance of this market has been a rollercoaster ride over the last 20 months, with delinquencies during this period peaking at around 10.31% in June of 2020, and with loans in special servicing peaking at 10.48% in September of 2020, according to a CRE Finance Council report. Both metrics have improved, with delinquencies at 6.11% and loans in special servicing at 8.14% as of July, 2021, according to a recent Trepp report. As with most markets, periods of performance stress typically spark heightened scrutiny regarding loan quality and transaction compliance, which, in turn, may give rise to disputes. The following discussion highlights some types of potential CMBS disputes.
Payment and Cashflow Disputes
The payment provisions of CMBS transactions can be complex. As such, disputes often arise as to the classification and distribution of collections. In a recent case involving multiple CMBS trusts, $614 million of proceeds was classified as “Penalty Interest” and was retained by the special servicer. Certificateholders disagreed with this classification, and argued that such proceeds were “Gain-on-Sale Proceeds” and, as such, should have been distributed to the certificateholders (See “Stuy Town” action ).
Additionally, cashflow disputes within a securitization can arise because the servicer and special servicer may retain proceeds from collections to create reserves in lieu of distributing such collections to investors. In a current proceeding, it is being argued that the creation of certain reserve funds allegedly improperly denied payments to certain certificateholders.
Collateral Quality and Disclosure Disputes
Over the last year, market observers have noted concern regarding asset quality underlying certain CMBS transactions. Specifically, two professors from the University of Texas observed in a study that for 28% of loans in a sample of 39,522, the net-operating-income (“NOI”) used to underwrite the loan was overstated by 5% or more as compared to the actual NOI in the first year following origination. An overstated NOI causes an overstated Debt-Service-Coverage-Ratio (“DSCR”), a metric used to ascertain if a property can produce enough cash to cover its debt obligations. This study also observes a high correlation between loans with overstated NOIs and loans that experienced distress during the periods of heightened delinquency resulting from the pandemic.
The University of Texas study also showed that for 12% of the loans in a sample of 6,280 CMBS loans made to purchase the property, the appraised value exceeded the purchase price by 10% or more. In addition, this research showed that these same loans had a 4.7% higher rate of distress during the early months of the pandemic.
The overstatement of the NOI, DSCR, and understatement of LTV, if known to the CMBS issuer, can be construed as misleading statements regarding the quality of the loans underlying the related CMBS. For example, in several cases brought against Wells Fargo it has been claimed, among other things, that Wells Fargo, “misrepresented the credit quality and likelihood of default of the loans it packaged and securitized into CLOs and CMBS, including by artificially inflating the net income and expected cash flows of its commercial clients in loan and securitization documentation” (See Mullen v. Wells Fargo & Company et al). These claims are similar to the allegations made with regard to residential mortgage-backed securities against many RMBS sponsors after the financial crisis.
Issues regarding asset quality and disclosure have also been raised in a whistleblower complaint where it is alleged that originators and CMBS issuers have altered financial data for commercial properties “without justification,” to make the properties look more profitable. According to the whistleblower’s complaint as reported in ProPublica, this is observable when comparing the operating expenses and financial information disclosed on the same property in two separate securitizations.
Most CMBS transactions provide that the most junior class of certificateholders, or “directing holders”, maintain control rights regarding the special servicer. More recent CMBS transactions generally provide that these control rights can shift from one tranche of certificateholders to another pursuant to an appraisal-based reduction in certificate balances. In this context, disputes can occur because the appraisal reductions are controlled by the current special servicer, who may have strong economic incentives (e.g. servicing fees) to assure such control is retained by one tranche of holders vs. another.
Control disputes may be more prevalent now than in the past because of the increase in delinquent and special serviced loans that will be the subject of appraisal reduction reviews. The increased performance volatility within the commercial real estate market facilitated by the pandemic may result in a greater likelihood of disputes regarding appraised values and appraisal reductions.
The foregoing discussion highlights only some of the types of disputes that are expected to affect the CMBS market. There already has been an increase in the number of cases involving borrowers and special servicers, senior and mezzanine lenders, and other CMBS market participants. For example, earlier this year the SEC filed a complaint against Morningstar Credit Ratings for allegedly failing to adhere to their own CMBS credit underwriting standards.
ConclusionIn the current environment, prudent CMBS market participants should commence a careful review of all CMBS disclosures and governing documents, be vigilant in assessing loan quality and due diligence results, address red flags, and review their CMBS policies and procedures.
Subject matter expertise
Managing Director, Restructuring and Dispute Resolution Practice
Director, Restructuring and Dispute Resolution Practice
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