Cashing in on CMBS

Multifamily assets that have gone to special servicing present a growing source of opportunities

Multifamily CMBS loans are defaulting at one of the highest rates of all real estate sectors. This situation presents plenty of opportunities for multifamily companies to acquire these distressed assets or to purchase the property or asset management contracts.

According to numbers from financial research firm Trepp Inc., as of December 2009, the total special servicing balance for multifamily loans was $14.72 billion (962 loans). “Multifamily was the first product to get into trouble with special servicing. It is now surpassed only by retail,” observes Peter Donovan, senior managing director, Multi-Housing Capital Markets, CB Richard Ellis. Donovan estimates that 50 percent of defaulted loans are in monetary defaults, and the other half in maturity defaults.

“The most obvious opportunity for apartment companies lies in acquiring the assets that are being liquidated by the special servicer,” says Stacey Berger, executive vice president of Midland Loan Services, a special servicer and PNC Real Estate company that currently has over $12 billion in its special servicing portfolio.

There are two classes of assets that are for sale: Real Estate Owned (REO) properties, which are properties that have been foreclosed, and—of a much smaller class—the actual defaulted loans.

Apartment players can purchase such properties outright through many of the brokerages. Or, it can purchase the note, which may be at significantly greater discount, but involves a much more complicated process as the new note holder may have to work out the loan or foreclose on it. “[The purchase of the mortgage notes] requires a different set of expertise, says Berger. “Some investors choose to go that route.”

Some observers say that not a lot of multifamily product has been hitting the market from the special servicing portfolios. Indeed, of about the $14 billion in multifamily loans that have gone to special servicing, says Donovan, only about $525 million of that came to the market to be sold or liquidated in 2009.

He adds that special servicers want to hold only to good quality deals that do not require a lot of capital infusion. As a result, what has been put up for sale thus far have been lower quality, smaller deals. “Everyone is waiting for the bigger, better deals to come to the market,” he says.

However, the number of properties coming to market is expected to increase further this year, simply because the special servicing portfolio is so large and still growing by leaps and bounds. Data from Property and Portfolio Research (PPR), a CoStar company, show that the special servicing numbers for the multifamily sector has been increasing steadily in the last few years. “The trend is still for the special servicing balance to be increasing pretty rapidly,” says Mark Fitzgerald, senior debt analyst at PPR.

Katie Schnidman Pelczar, real estate economist and multifamily expert at PPR, says that the increase in loans held in special servicing is driven by the deteriorating fundamentals in the multifamily sector. “Multifamily had the greatest run at the top of the cycle. We are now seeing a major correction in multifamily, and there is a lot of distress because of that correction.”

In order to understand the opportunities in special servicing, it helps to have an idea of the special servicing process. Typically, loans are transferred to special servicing when one of three events are triggered, explains Berger: (1.) The loan is 60 days delinquent or in default, including maturity default; (2.) the borrower is in bankruptcy; or (3.) more subjectively, the loan is in imminent default.

The special servicer, which, unlike the master servicer, has the powers to modify, restructure, workout or dispose of the loan, is paid fees to handle the asset. Berger explains that once the loan goes to special servicing, it is assigned to an asset manager, an employee of the special servicer. The asset manager performs site inspection, meets with the borrower, and prepares an Asset Business Plan and orders an appraisal of the property for the special servicer.

The Asset Business Plan provides resolution and disposition alternatives and a budget for the property. “The special servicer then evaluates those alternative resolutions based on a maximum net recovery present value basis,” says Berger. Alternatives to the special servicer include restructuring, modifying or extending the loan, foreclosing on the collateral property or liquidating the loan. As far as loan workout, the special servicer can, for example, change the interest rate, accrue the interest or extend the maturity.

Besides properties that get placed on the market, there are also opportunities at the loan workout stage. Special servicers are first interested in working out and extending as many loans as they can, and many of them believe they will maximize recovery in a workout, according to Spencer Levy, senior managing director, Recovery and Restructuring Services at CB Richard Ellis. Levy says he is advising his private equity clients to look, in particular, to provide equity in deals that are undergoing workouts. “Servicers are looking for new capital that is subordinate to theirs,” he says.

There are also opportunities for apartment companies in playing the role of receiver. After the special servicer gets the Asset Business Plan, if it determines that it needs to take physical control of the property or take control of the cash flow of the property rather than work out the loan, it will hire a court-appointed receiver. The property need not be in foreclosure for this to happen, and the receiver will either manage the property directly or contract with a property manager.

The receiver acts to “stabilize the property and make sure the cash flows and rents are captured, expenses [are] paid, and finances [are] handled appropriately,” says Brian Hanson, senior managing director at CWCapital Asset Management LLC. CWCapital is the second largest special servicer in the nation with a special servicing portfolio of about 120 CMBS transactions backed by $170 million of commercial mortgage loans.

In some states, special servicers can suggest a receiver or obtain approval to appoint a receiver, says Hanson. In other states, only the court selects the receiver. And in some jurisdictions the receivers need to be approved or licensed, says Hanson.

Conrad Andersen, executive vice president of Financial Services Asset Management at Grubb & Ellis, says that many special servicers want to avoid foreclosure. This is because once a property is foreclosed on, the special servicers cannot provide a “loan to facilitate,” or a new loan. Plus, any third-party financing will be extremely stringent given the lack of liquidity in the capital markets. “So most special servicers are trying to recapitalize the existing debt through receiverships,” he says.

In most cases, he says, the special servicer will bring in a new sponsor who is well-capitalized. The new borrower will bring in capital to lower the loan and make it a performing loan, explains Andersen.

In addition to enlisting the services of a receiver to manage the asset, the special servicer may also request that the receivership order include marketing the property for sale. Indeed, Grubb & Ellis has assisted special servicers with the receivership solution and has been hired by the receiver for brokerage services.

Apartment property management companies can approach special servicers to see if there are receivership opportunities. Hanson says that CWCapital often contracts with companies they already have a relationship with or that are recommended by a close source. And generally, he says, his company looks for skilled property managers who are experienced in the local market.

Multifamily companies interested in purchasing properties can track properties that have defaulted through Realpoint or Trepp, says CBRE’s Donovan. However, there are many properties that default but do not come to the market. “Special servicers are getting flooded with inquiries from everywhere,” Donovan notes. Hanson says potential buyers can also go to special servicers’ Websites. Servicers may maintain a list of properties or links to information about assets that are for sale. Special servicers today include CWCapital, Midland, LNR and Centerline.

Special serviced assets that have come to the market can be found throughout the U.S. and in every major metropolitan area, says Grubb & Ellis’s Andersen. There is a concentration of defaults in the Western U.S., he adds. Such assets are also found in distressed markets such as South Florida and Las Vegas. Andersen says apartment companies can also contact brokerages directly for opportunities with acquiring such properties. “The velocity of multifamily product has not been significant, but that may change this year,” says Andersen.

Is a CMBS Revival in Our Near Future?

The CMBS industry is back from the dead. But whether this will have any effect on financing for the multifamily sector remains to be seen.

After a dry spell of several quarters when the volume of multi-borrower executions was zero, a handful of CMBS issuances (triple-A rated) were made beginning last summer. However, these were single-borrower, rather than multi-borrower, issuances and did not mean the return of broad-based CMBS financing for the commercial real estate market. Individual commercial real estate companies made these issuances, backed by properties in their own portfolios.

Many say that it was the government’s Term Asset-Backed Securities Loan Facility (TALF) financing program that jump-started the CMBS issuances. The program enabled investors to borrow money from the New York Federal Reserve for the purchase of TALF-eligible triple-A-rated CMBS securities.

But TALF may have only revived the securities market. Lenders are generally still not originating CMBS loans at this point, due to the lack of warehousing ability, as well as aggregation risk—lenders being unsure whether there will be a CMBS securities market to sell into.

The exceptions may be some Wall Street companies, who are beginning to originate loans with an eye to CMBS securitization down the road, says Bill Hughes, senior vice president and managing director of Marcus and Millichap Capital Corp. However, these entities tend to want to make larger, $20 million to $50 million, loans, he says.

Additionally, Bridger Commercial Funding announced in December it was resuming originating CMBS loans for income-producing properties, with the intention of eventual securitization. Loans will be in the amounts of $2 million to $20 million.

There is still some uncertainty whether the CMBS revival will endure, especially after TALF expires this year (June for new CMBS issuances and this month for existing CMBS). And if commercial real estate fundamentals continue to deteriorate, exacerbated by the debt and refinancing crisis, then CMBS investors are unlikely to continue to return to the market in good numbers.

It must be remembered, though, that investors may return to top-of-the-line triple-A rated CMBS issuances. For this reason, if CMBS financing dribbles back, it is likely to be limited to top-tier properties, and underwriting will be very conservative, with LTVs of no more than 75 percent and conservative loan covenants. After all, investors can afford to pick and choose.

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