Navigating distress in commercial and multifamily real estate

    glass windows on high rise buildings with a sunset shadow

    After the Great Recession of 2008, the Dodd-Frank Act of 2010, the economic recovery that followed beginning in 2012, and, more importantly, the Commercial Mortgaged-Back Securities (CMBS), regulatory changes which sought to create more transparency for investors (bondholders), investors sought to reduce servicing expenses paid to servicers, and lenders incorporated more covenants and conditions in their loan documents to protect them during default. As a result, today’s CMBS borrower is responsible for all fees and costs associated with the securitization and servicing of the loan. In addition, the borrower’s property level information is disseminated across multiple platforms associated with the securitization in the name of transparency. Furthermore, to open a dialogue with the servicer regarding the loan or the property, a borrower is required to waive all rights and claims against all lender parties, known or unknown.

    In today’s climate following the last recession, to navigate and resolve a defaulted CMBS loan requires that all borrowers and secured lenders work together to create and agree on a feasible business plan and open dialogue to help navigate distressed debt when it comes to commercial and multifamily real estate.

    Below, we’ve laid out a brief overview of debt restructuring conditions impacting CMBS, and tactics for navigating and resolving CMBS debt defaults and workouts.

    The debt restructuring playbook

    First, borrowers should know that loan servicers have policies and procedures detailing how they navigate distressed debt.

    Once the loan has been transferred or assigned to the special situations or the special servicing group, a letter is sent to the borrower identifying the asset manager assigned to the loan. The loan is assigned to an asset manager based on case load, experience, and expertise with the asset class (hospitality, office, retail, multifamily, industrial, etc.). This asset manager is not relationship-focused compared to banking or insurance company credit officers; rather, the asset manager is managing loans with cash flows anticipated to repay others (bondholders).

    The servicer then starts building a new file on the borrower and the collateral. The servicer will generally ask for financial statements since the origination of the loan including copies of all leases and lease amendments (for commercial properties), guarantor financial statements and tax returns, and any other property-related information to assess value and cash flow. The servicer will order broker opinions of value and an appraisal; possibly a Phase I environmental site assessment, a property condition report, and a title update (all at the borrower’s expense) to get familiar with the market, the collateral, and to identify any underlying issues that impact value. The servicer will send the borrower a pre-negotiation agreement requiring a waiver of all claims against the lender and its servicers, employees, etc., and an acknowledgment that the asset manager has no authority to bind the noteholder during communication.

    The borrower must agree to the terms of the pre-negotiation agreement and return the signed agreement before the servicer will engage in any substantive dialogue with the borrower. Once the pre-negotiation agreement has been mutually signed, the servicer will start corresponding (typically via email) with the borrower or borrower’s advisor. The servicer likes to use what they refer to as a dual recovery method – demanding and accelerating the loan while concurrently engaging in discussions (again, via email) with the borrower. Do not be surprised if a default letter arrives within the first 30 to 60 days of initial contact from the servicer. It is part of the dual recovery process.

    The Pooling and Servicing Agreement

    CMBS servicers have a contract to follow known as the Pooling and Servicing Agreement (PSA) or the trust and servicing agreement for single loan transactions. This contract generally guides all parties’ – except the borrower’s – actions. The PSA governs the transfer of the loans to the trustee, the management of the trust (advances, collections, and distributions), servicing of the loans, and the delegated authority and responsibilities of servicers and holders of investments (bonds) in the trust. Under the PSA, the servicer is required to service the loans in a similar manner as it would service loans held on its own book and act in the best interests of all investors (bondholders) and the other parties to the PSA. CMBS is a securitization vehicle with investments sold in slivers or tranches (bonds); revenues flow top to bottom and losses flow bottom to top. Given the risk of loss, the PSA requires the servicer to prepare a business plan and recommended course of action shortly after transfer of the loan to special servicing and submit the plan to the bondholder with the highest risk of loss exposure for consent. In fact, the servicer generally cannot take an action without obtaining the consent of the bottom bondholder, who is required to act in the best interests of all bondholders.

    There are generally two types of CMBS servicers: affiliated and non-affiliated. Affiliated servicers are servicers that have an ownership interest with the bondholder (Rialto, Argentic, LNR/Starwood, for example). Non-affiliated are third-party servicers (often banks such as KeyBank, PNC Midland, Wells Fargo, for example); they only have a contractual relationship under the PSA with the bondholders.

    To navigate this space takes expertise and patience. There are no quick responses, resolutions, or results. Compared to non-CMBS workouts, the CMBS workout moves at a seemingly glacial pace with a heavy focus on policies, procedures, and full recovery. The servicer will look to the borrower or the borrower’s advisor to prepare and submit a feasible restructuring proposal, explain the market, and the collateral. The servicer will expect the borrower to inject new equity and they will ask the borrower to service the loan and/or fund operating without consideration for market conditions, the economy, disease (COVID-19), or natural disasters. While a borrower may see interim relief as was provided during COVID-19 or following a natural disaster, the PSA does not have the ability to easily modify its payment obligations to the bondholders, which are 100% funded from collections from the underlying loans in the securitization, after servicing expenses. Furthermore, it’s important to note that while loans were modified because of COVID-19, interest and fees were generally not forgiven. Rather, the loan balances were increased to include these deferred amounts, or the deferrals were to be collected over a future 12-, 18-, or 24-month period.

    Consequently, both modifications and foreclosures are expensive to the bondholders. They result in real economic losses that, in a declining market, are difficult to recover. Yet, foreclosure is often the easiest method of recovery and requires the least amount of effort. Even so, it does not mean that the negotiations will move promptly; even in a non-judicial state where foreclosure may take two to six months, time is rarely of the essence in workout situations.

    The controlling class decision maker

    CMBS transactions have a controlling class structure with the initial controlling class typically the most subordinate class of certificates (also referred to as a tranche or a b-piece). With losses allocated to the most subordinate class of certificates first, the CMBS structure generally requires all monetary modifications, waivers, lease approvals, and foreclosures be presented to and approved by the controlling class bearing the impact of any financial decisions. The subordinate controlling class also has the opportunity to replace the special servicer. Realized losses and, beginning in 2010, appraisal reductions may also cause control to shift from one certificate holder to another. In pre-2010 CMBS transactions, all classes of certificates were eligible to hold control rights, but, starting in 2010, transactions began to restrict control to only certain classes of subordinate certificates, according to Dechert LLP. Controlling class rights are exercised by a representative selected by a majority of the investors representing the controlling class. Or, if no party is appointed, the controlling class representative is the investor holding the largest outstanding principal balance of the controlling class.

    The special servicer

    The special servicer is charged with maximizing recovery on a net present value basis. The calculation of net present value is an essential point of many special servicer actions. Prior to 2010, PSAs typically did not provide specific guidance regarding how the special servicer should make the net present value calculation or how the special servicer was required to use the interest rate of the loan as the discount rate in the calculation. However, starting in 2010, PSAs have generally adopted a standard that requires the special servicer to use a discount rate for:

    1. Principal and interest payments equal to the higher of (x) the rate that approximates the market rate that would be available by the borrower on similar non-defaulted debt and (y) the interest rate of the loan
    2. All other cash flows, including property cash flow, the discount rate set forth in the most recent appraisal of the property

    Hence, the foreclosure model – assume a 24-month foreclosure, hold and sale cash flow model based on 100% of the net cash flow from the property – often provides a higher net present value than a 48-month loan modification and extension model where the cash flow is equal to a debt service and principal repayment over 48 months.

    Within approximately 60 days of a loan becoming specially serviced, a business plan (known as an asset status report) detailing the special servicer’s recommended course of recovery for the loan – and, if available, alternatives – is due to the controlling class certificate holder. The business plan should discuss the status of the loan; a summary of negotiations with the borrower; a summary of legal, property and environmental concerns; and the recommended action for recovery. The business plan may be amended until consent from the certificate holder is received or upon additional material information impacting the business plan.

    Another interesting fact is the PSA gives the special servicer the ability to reject an offer or proposal. Even if it is the highest cash offer, the servicer can decline the offer or proposal if they determine that rejection of such highest offer and acceptance of a lower offer would be in the best interest of certificate holders. This provision effectively allows the special servicer to determine if a plan is feasible before presenting it to certificate holders for consideration. In CMBS deals closed between about 2004 and 2010, certain parties to the PSA hold an assignable option to purchase any specially serviced loan at a fair price determined by the special servicer or, if certain interested parties are exercising the purchase option, another party (usually the trustee). This option was intended to address certain accounting concerns that are no longer applicable.

    CMBS default rates

    The CMBS Special Servicing Rate reflects a 5.20% default rate as of November 2022, and, by property type, the highest concentration is in retail, lodging, and office, respectively, according to Trepp. Drilling down a bit further, and considering CMBS 1.0 (pre-2010) vs. CMBS 2.0 (post-2010), CMBS 2.0 reflects retail, lodging, and office as the greatest concentration of specially serviced asset classes and a 4.95% special servicing rate. CMBS 1.0 reflects a 52.97% special servicing rate and is primarily comprised of industrial, retail, and lodging, Trepp reported. Combining CMBS 2.0 and CMBS 1.0, retail (11.01%) and lodging (7.06%) continue to be the largest asset classes in special servicing and will continue to show concern with ceased government stimulus and an upcoming recession creating a tightening on consumer spending.

    Servicing compensation

    One other thing to be aware of is the compensation model for servicers. The special servicer earns a special servicing fee of 25 bps on the principal balance of loans under management for typical CMBS issuances. The special servicer also earns a workout or liquidation fee (50 to 100 bps) against the proceeds of a sale or other disposition (including a restructure and modification) of a specially serviced loan or REO property, subject to a few exclusions. The servicer is also entitled to certain other fees, such as default interest, penalty charges, modification fees, assumption fees, transaction fees, net prepayment interest excess, and other fees related to processing borrower requests (like lease reviews). To the extent possible, these fees are charged to the borrower and are highly negotiated. Under certain circumstances the special servicer may be required to share certain fees with the master servicer.  Additionally, it is not unheard of for a servicer to share its ancillary fees with bondholders. Today special servicers are paid less for loan servicing but are expected to adhere to the same servicing standards including increased reporting and communication with bondholders as well as performing ancillary services like underwriting bond investments.

    The U.S. Bankruptcy Code

    Another form of recovery used to be through the Bankruptcy Code. The Code is available to commercial and multifamily borrowers (single asset real estate debtors) as a way to either reorganize their debts under the oversight of the bankruptcy court (Chapter 11) or liquidate and repay creditors through a bankruptcy trustee (Chapter 7). However, the CMBS market has invoked additional remedies against borrowers if the borrower attempts to use the Code to resolve its debt i.e. converting a non-recourse loan to a full recourse loan. The idea is that bankruptcy is a long, expensive process and if the borrower is unable to pay its debts, the lender will exercise its rights and remedies. However, bankruptcy does have its benefits. It is administered by a court, a code, and a set of timelines and governance over the collateral. Creditors with a claim secured by the single asset real estate can seek relief from the automatic stay unless the debtor (borrower) files a feasible plan of reorganization or begins making interest payments to the creditor within 90 days from filing, or 30 days from the court’s determination that it is a single asset real estate case. Bankruptcy filing requires responsiveness and often new equity injection by the borrower/debtor or another party. In today’s rising interest rate market where the past has offered historically low interest rates, there is not much likelihood of having an interest rate crammed down. The debtor has the option of conducting a sale process with a stalking horse (often the lender bidding its debt or the appraised value). While there are outlier cases that last years, with the right management a resolution can be accomplished in a reasonable period and afford many protections not typically available in out-of-court workouts.

    The decrease in CMBS lenders following the Dodd-Frank Act played a role in driving demand to other highly regulated financing sources, such as life insurance companies, banks, and agencies. However, what emerged was an abundance of non-bank or alternative lending sources. Before 2010, CMBS issuers (lenders) were typically the go-to source for deals in secondary and tertiary markets; they typically financed properties in markets that traditional lenders were hesitant to enter or that did not qualify for agency financing in the case of multifamily. With the explosion in non-bank lending facilities, it will be interesting to see how these lenders operate in a distressed loan environment. It’s also important to note where the money comes from for the loan: a line of credit held by a bank or a fund? In addition, if it’s a non-bank lender, do they have the staying power to make it through a recession?


    Borrowers should not expect quick, definitive responses (other than no); the servicer has a multi-step approval process and an in-depth business plan/underwriting analysis that is required for every monetary decision. Servicers have a heavy case-load and monetary changes, waivers, or consents cost the special servicer time and money, which costs the CMBS investor time and money.  With certain debt restructuring conditions impacting CMBS, borrowers in the commercial and multifamily real estate space need to be aware of how their loan will be handled if defaulted in order to maximize the possibility of a productive resolution. 


    Debra Morgan, Managing Director, Restructuring and Dispute Resolution Practice



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    This has been prepared for information purposes and general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.