It’s complicated: Commercial mortgage-backed securities

This article was first published in the Journal of Corporate Renewal

Commercial mortgage-backed securities (CMBS) issuance peaked in 2007, at $230 billion, and was a source of high-proceeds, competitive rate financing for commercial real estate and multifamily. Following the Great Recession, the Dodd-Frank Act of 2010, and the 2012 economic recovery, the CMBS lending market recovered over the next nine years. In 2021, the CMBS market originated a whopping $109.1 billion, and another $70.1 billion in 2022. Today, estimates for all outstanding commercial and multifamily mortgage debt range from $5 trillion, according to the Federal Reserve, to $4.5 trillion, using the Mortgage Bankers Association’s data, which excludes loans backed by owner-occupied commercial properties.

To better understand the influence securitized debt and the banking industry have on lending, it’s important to appreciate the amount of debt held between the two. CMBS, collateralized loan obligations (CLO), and other asset-backed securities (ABS) represent 13.1% (or $597 billion), while banks and thrifts represent 38.3% (or $1.71 trillion). Combined, these two groups encompass 51.4% of all outstanding commercial and multifamily debt. The rest is held by life companies (14.9%), agency and government-sponsored enterprises (GSE) and mortgage-backed securities (21%), and others (12.6%).

This article discusses the CMBS structure and servicing while providing strategic guidance on how to navigate challenges in structured finance. Regardless of the asset class or lender, navigating and resolving a defaulted loan require borrowers, borrower advisors, and lenders to work together, have an open dialogue, and mutually agree on a feasible business plan.

The debt restructuring playbook

First, a borrower who needs to navigate distressed debt should know that lenders and servicers have policies and procedures detailing how they address distressed debt. Some, such as agency servicers, may go as far as detailing response times, setting critical dates for ordering third-party reports, and describing how to respond to emails. Even insured financial institutions have workout guidance. For example, on June 29, the Federal Reserve Board–Agencies issued a policy statement on commercial real estate loan accommodations and workouts (which updated the 2009 version).

Once a loan has been transferred or assigned to a CMBS special servicing group (often based on case load, experience, or geography), a letter is sent to the borrower introducing the asset manager. This asset manager is not relationship-focused and instead concentrates on maximizing recovery on a net present value basis through collection of cash flows from the collateral.

The servicer builds its file on the borrower and the collateral, and initially may have little knowledge of the collateral or its market. The servicer will ask for financial statements, 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. Over an initial period of 90 to 120 days, the servicer may order broker opinions of value, an appraisal, 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 and the collateral while identifying underlying issues that may impact recoverability.

The servicer will also send the borrower and its advisor 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 lender during the communications. The agreement will also state that the loan terms remain in full force and effect until a written modification agreement is entered into between the lender and the borrower. The borrower and its advisor must agree to the terms of the pre-negotiation agreement and return the signed agreement before the servicer will engage in substantive dialogue. Once this agreement has been fully executed, the servicer will start corresponding with the borrower or borrower’s advisor to pursue what is known as a dual recovery method, demanding and accelerating a defaulted loan while concurrently exploring loan negotiations. A default letter within the first 30 to 60 days of initial contact from the servicer is common.

The pooling and servicing agreement

CMBS servicers are engaged and operate under a contract known as the pooling and servicing agreement (PSA) or the trust and servicing agreement for single loan transactions. This lengthy and complex contract governs the actions of all parties – except the borrower and guarantor – in the decision-making and loan recovery process. The PSA guides the initial transfer of the loan from the loan originator to the trustee, the management of the trust (including advances, collections, and distributions), servicing of the loan, and the delegated authority and responsibilities of servicers and holders of the investments in the trust. The servicer is required to service the loan and any real estate owned (REO) properties in the best interests of all certificate holders, in accordance with the PSA, the applicable loan documents, and applicable law. The servicing standard also requires the servicer to service loans (and REO properties) in the same manner as it would service a loan (or REO property) held on its own account or for other third parties. If the servicing standard is followed by the servicer, the servicer is indemnified by the trust.

CMBS is a securitization vehicle with investments sold in slices or tranches. Interest and principal payments, sales proceeds, and collections flow top to bottom (rated to non-rated bonds). Losses flow bottom to top (non-rated to rated bonds). 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 controlling certificate holder for consent. The servicer cannot take any material action without obtaining the consent of this certificate holder.

In general, there are two types of CMBS servicers: affiliated and nonaffiliated. Affiliated servicers and bondholders have a common parent company (e.g., Rialto, LNR, Argentic), while non-affiliated servicers are often banks/third-party servicers (e.g., PNC Midland, KeyBank, Wells Fargo) with only a contractual relationship under the PSA with the certificate holders. Certificate holders with the first loss bond (the controlling class) may select their servicer. The servicing market is accustomed to changes in control and changes in servicing, but it still adds time to the loan negotiation and recovery process. In the end, a servicer’s focus is maximizing recovery and loan performance for the benefit of the certificate holders.

Navigating this universe takes expertise and patience; there are no quick solutions. Compared to other workouts, a CMBS workout moves at a glacial pace, with a heavy focus on policies, procedures, and maximum recovery. The servicer will ask the borrower or the borrower’s advisor to prepare and submit a practical restructuring proposal, supported by the market, and the collateral. The servicer may expect the borrower to inject new equity and fund operating shortfalls. While a borrower may obtain interim relief from the servicer, the PSA does not provide a mechanism to modify the payment obligations to the certificate holders. Such obligations are 100% funded by the net loan (or REO) collections. Furthermore, while loans may have been modified during COVID-19, interest and fees were often deferred rather than forgiven and may show up in a payoff quote or subsequent demand letter.

Modifications, foreclosures, and discounted payoffs/loan sales are expensive to the certificate holders. These changes result in immediate losses that are difficult to recover in a challenging market. They could create changes in certificate holder control and servicing. Foreclosure is often the easiest method of recovery that requires the least amount of effort, but that doesn’t mean the foreclosure process will move swiftly. Even in a non-judicial state where foreclosure may take two to six months, time is rarely of the essence.

The controlling class decision-maker

CMBS transactions have a controlling class structure with the initial controlling class held by the most subordinate class of certificates (known as the non-rated tranche or B-piece). With losses first allocated to the most subordinate class of certificates, the CMBS structure requires all monetary modifications, waivers, lease approvals, and foreclosures be presented to and approved by the controlling class certificate holder bearing the impact of any financial decisions. The subordinate controlling class certificate holder can also replace the special servicer. Control can shift from one certificate holder to another through realized losses or appraisal reductions. Controlling class rights are exercised by a representative appointed by a majority of the investors representing the controlling class. If no party is appointed, the controlling class representative is the investor holding the largest outstanding principal balance of the controlling class of certificates. Newer issue CMBS may or may not identify the controlling class certificate holder in the monthly remittance reports.

The special servicer

The special servicer is charged with maximizing recovery to the certificate holders on a net present value basis. The calculation of that net present value is an essential point of special servicer actions. Since 2010, PSAs have typically adopted a standard that requires the special servicer to use a discount rate for:

  1. Principal and interest payments equal to the higher of either the rate that approximates the market rate that would be available by the borrower on similar non-defaulted debt or 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.

Within approximately 60 days of a loan becoming specially serviced, a business plan detailing the special servicer’s recommended course of recovery – and, if available, alternatives – is due to the controlling class certificate holder. The business plan includes the status of the loan; a summary of negotiations with the borrower; legal, property, and environmental concerns; and the recommended recovery action. This plan can be amended until consent from the certificate holder is received or upon receipt of additional material information.

Interestingly, the PSA gives the special servicer the ability to reject offers or proposals. The special servicer may decline what may appear to be the highest cash offer if the acceptance of a lower offer would be in the best interest of all 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 securitizations closed between 2004 to 2010, certain parties to the PSA hold an assignable option to purchase a specially serviced loan at a fair price determined by the special servicer or, if interested parties are exercising the purchase option, another party. This option was intended to address certain accounting concerns that are no longer applicable, but it created quite an opportunistic purchasing market from 2010 through 2018.

Hospitality defaults and gateway cities

According to Trepp, the CMBS special servicing rate as of June 2023 was 6.42%, topped by retail (11.06%), office (7.24%), and hospitality (6.4%). Industrial (0.39%) and multifamily (3.28%) were the lowest. To further distinguish between loans originated before and after the Great Recession, the special servicing rate for loans originated before the Great Recession was 33.73%, compared to just 6.19% for loans after the Great Recession. There are virtually no multifamily specially serviced loans in pre-Great Recession securitizations, with only 0.23% of specially serviced industrial loans in post-Great Recession special servicing securitizations. Think about that for a moment: Multifamily is a small concern for loans originated after 2010, while industrial is not a concern for loans originated before 2010. In addition to office delinquencies that we see today, especially in the Class B and Class C categories, hospitality is showing signs of concern in certain MSAs and the business-traveler product.

Servicing compensation

The compensation model for servicers is an important consideration. The special servicer earns a fee of 25 basis points 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 basis points) against the proceeds of a sale or other disposition (including a restructure and modification) of a specially serviced loan or sale of an REO property, subject to few exclusions. The servicer is also entitled to other fees, such as modification, assumption, and transaction fees; default interest and penalty charges; net prepayment interest excess; and other fees related to borrower requests (like lease reviews). When possible, these fees are the borrower’s responsibility and are highly negotiated. Today’s special servicers are paid less for loan servicing and are expected to adhere to the same servicing standard while providing increased reporting and communication as well as performing ancillary services like underwriting bond investments.


The decrease in CMBS lenders following the Dodd-Frank Act played a role in driving demand to other regulated financing sources, including life insurance companies, banks, and agencies that produced an abundance of non-bank or alternative lending sources. Previously, CMBS issuers (lenders) were considered the go-to source for deals in secondary and tertiary markets, which were markets that traditional lenders were hesitant to enter or multifamily that did not qualify for agency financing. With the reduction in bank lending, rightsizing bank balance sheets, and more conservative lending metrics, the non-regulated, non-bank lending facilities will gain substantial market share over the next few years and may face regulatory oversight. Alternative lenders are already stepping in to provide rescue financing to plug the gap between what more traditional lenders are willing to lend and the amount of equity the sponsor is willing or able to fund. And they are not always lending to own – most are lending for yield. When considering alternative financing sources, it is important to understand where these lenders obtain their capital and what drives their investment decisions. Is it a warehouse line from a bank (that it can terminate) or a fund with a pre-determined life? Do the alternative lender’s founders have the experience to weather a recession? Is the alternative lender large enough to warrant the attention of regulators in the future?

CMBS loan workouts involve an intricate dance among borrowers, lenders, and servicers in the commercial real estate arena. As defaults continue to rise and recovery becomes a focal point, the glacial pace of negotiations tests the patience and expertise of all involved. In this complex web between borrowers and lenders, the controlling class holds the reins, while special servicers navigate the delicate balance to maximize recovery. But amid the process, borrowers face challenges in a market driven by policies, procedures, and financial interests. Working with professionals that align their interests with those of the borrower and understand loan documents and PSAs, special servicing, real estate, and financial instruments will make all the difference, allowing borrowers to focus on the real estate, their investors and partners, and their company.


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debra kennedy

Debra Henderson 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.