CMBS Special Servicing Volume Dips in August

The volume of loans in the hands of the CMBS industry’s 17 special servicers declined last month, after increasing for two straight months, and now stands at $40.6 billion, according to Morningstar Credit Ratings.

The decline was driven by the $994 million of liquidations that took place during the month. According to the Horsham, Pa., rating agency, 2,246 loans are now in special servicing. That compares with 2,288 loans, with a balance of $41.1 billion, that were in special servicing in July.

Because the universe of CMBS tracked by Morningstar declined to $621.5 billion from $627.8 billion, the percentage of loans in special servicing remained flat in August, at 6.54 percent.

CWCapital Asset Management, the most-active special servicer, saw the volume of loans it handles shrink by some $340 million, while LNR Partners saw its volume shrink by $230 million. And C-III Asset Management saw a $90 million increase. Most other servicers saw much smaller changes in the volume of loans they handle.

While loans continued to get pushed to special servicing, most had balances of less than $75 million. The biggest to transfer last month was the $69.7 million mortgage against the Indian River Mall & Commons, a 434,577-square-foot retail property in Vero Beach, Fla., that’s owned by an affiliate of Simon Property Group. The loan is securitized through Banc of America Commercial Mortgage Trust, 2005-1, and was transferred to C-III because it’s expected to default upon its November maturity.

C-III also is handling the biggest large-balance loan to be transferred to special servicing in recent weeks: a $122.6 million mortgage against a portfolio of 936,320 sf of office space owned by Investors Real Estate Trust. The Minot, N.D., REIT said it was considering surrendering the portfolio in a deed-inlieu of foreclosure because it’s not likely to be able to refinance the loan when it matures in 2016. The loan, commonly referred to as the IRET Portfolio, was transferred to C-III in late July.

First Deal of Conduit Flurry Prices

The first of six scheduled CMBS conduit transactions priced late last week at levels that were substantially tighter than the last conduit, which priced three weeks earlier.

The benchmark AAA class of the latest deal, WFRBS Commercial Mortgage Trust, 2014-C22, priced at 84 basis points more than swaps, 6 bp tighter than the 90-bp spread for the last conduit, COMM, 2014-CCRE19, which priced on Aug. 13. And the BBB- class of the WFRBS 2014-C22 deal priced at 345 bp more than swaps, in 25 bp from the COMM deal.

What’s more, the latest conduit deal’s A-S class, which typically carries the highest ratings, was rated Aa1 by Moody’s Investors Service. That is the equivalent of a rating of AA+ from Fitch Ratings and Kroll Bond Ratings, the other two agencies that rated the WFRBS deal. It marks the first time that a conduit deal’s junior class has received split ratings. But the class still priced tighter than the previous conduit, at 115 bp more than swaps versus 118 bp. Said one investor: “There’s money out there that needs to be put to work.”

The A-S class of the WFRBS deal has 23 percent of credit support, meaning that 23 percent of the transaction would have to be wiped out before it would be impacted. For it to have won Moody’s Aaa rating, the thinking is that the bond class would need to have 25 percent of subordination.

WFRBS deal were somewhat of a surprise to some investors, given that five other conduit deals are in the wings and expected to price before the month is out. That volume ought to give investors the ability to be extremely selective, so they would demand greater yields from certain deals.

Indeed, the benchmark AAA class of COMM, 2014-UBS5, priced on Tuesday at a spread of 88 bp more than swaps. Its A-S class, which has a balance of $100.9 million and carries an Aa1 rating from Moody’s, but AAA ratings from Kroll and Morningstar, priced at 123 bp more than swaps and its BBBclass priced at 370 bp more than swaps.

The deal’s underwritten leverage level is 66.8 percent and it lacks the multifamily concentration of the WFRBS deal. Only 6.7 percent of its $1.4 billion collateral pool is backed by loans against apartment properties, which are considered less volatile than other property types. But the benchmark class of GS Mortgage Securities Trust, 2014-GC24, was being shopped at a level of roughly 87 bp more than swaps. The deal’s A-S class was being shopped in the area of 110 bp more than swaps.

Meanwhile, some investors still require a Moody’s rating, so the split rating could have excluded them, or forced them to price the class wide of where it printed.

The WFRBS deal benefited from its 16.8 percent concentration of loans against apartment properties, which included $65.5 million of residential cooperative properties, which have relatively low leverage. While the transaction’s underwritten loan-to-value ratio was 64.6 percent, Moody’s stressed LTV was 110.1 percent. That increases to 114.3 percent if the co-op loans are excluded.

Also helping was the fact that Moody’s rated bond classes down to the deal’s class C, which it rated A3. It hasn’t been asked to give its ratings for classes below the most senior in a number of previous deals. The rating agency often requires greater levels of credit support than other agencies for certain bond classes before it gives comparable ratings.

Meanwhile, the CMBS market was bound to see an improvement in spreads.Other fixed-income securities had tightened, so the expectation was that CMBS would as well. Spreads on the secondary market had tightened by a couple of basis points last week.

Investors expect at least two other conduits to price when all is said and done. Those would be led by Deutsche Bank and JPMorgan Securities, respectively.

Bank Lending Through August: Commercial Real Estate Lending At Smaller Banks Continues To Thrive

Summary

• Commercial real estate lending continues to grow rapidly and the smaller banks further underwrite the construction industry.
• Business loans at the largest banks in US continue to rise but support M&A activity, stock buy backs, and hedge fund and private equity transactions.
• Foreign-related institutions are reducing the US cash being taken off shore.

Three areas I would like to focus on today: commercial real estate lending at the smaller banks; business lending at the largest banks; and the reduction in cash assets at foreign-related institutions in the United States.

First, let's look at commercial real estate lending. Over all, commercial real estate loans at all commercial banks in the United States rose at a 7.2 percent, year-over-year rate in July 2014. This amounted to an increase of about $105.0 billion. In the four weeks ending on August 27, 2014, they increased another $7.9 billion.

The largest portion of this increase came at the smaller, domestically chartered banks. Almost two-thirds of the commercial real estate loans in the domestically chartered banks come from the smaller commercial banks, a total of almost $1.0 trillion.

Over the past 52-week period, the smaller banks increased their loan portfolio by 11.0 percent, or about $95.0 billion.

The smaller banks have almost 37.0 percent of their loan portfolios in commercial real estate loans - 24.0 percent of their total assets.

One of the major concerns of the Great Recession was the fear that commercial real estate loans were going to result in a lot more bank failures than actually occurred. The commercial real estate loans were five- to seven-year loans and were to be paid off at maturity. The loans did not turn up on the bad loan lists of the banks because in 2010 or 2011 or 2012 they had not matured yet and hence there was no pressure on the banks to write them down…or off. The hope was that the recovery would allow them to be paid off…or refinanced.

The recovery did its job. The banks were able to refinance the loans…with the consent of the regulators - and, because of the delays in finishing the projects, construction firm's required additional funds to pick up on where they left off during the recession - and these new funds were approved.

One of the major reasons for the increase in the loan balances at these banks is not because of new loans coming on the balance sheets of the banks, but because of the new money given to the borrowers so that they could complete their projects.

The health of these smaller banks is becoming more and more dependent on the ultimate payoff of these commercial real estate loans. My concerns are with the concentration of bank assets in these loans; the shakiness of the economic recovery so dependent on these commercial real estate developments; and the continued shrinkage of the banking system, especially in the number of small banks in existence.

The second area is the growth of business lending, commercial and industrial loans, at the largest banks in the United States. From July 2013 through July 2014, C&I loans in the whole banking system rose by about 11.0 percent, a good healthy number. In the past four weeks, ending August 27, C&I loans rose by another $15.5 billion.

Of this increase, 44.0 percent of the increase came at the 25 largest domestically chartered banks in the United States and another 27.0 percent came from foreign-related institutions.

These organizations primarily lend to larger corporate organizations.

It seems as if the largest proportion of these loans have been going to large corporations - to help them pay dividends, to buy back stock, and to engage in mergers and acquisitions - and to hedge funds and private equity funds to help them finance their current transactions.

Note, that almost all of these uses of funds are not for current productive purposes, either the production of consumption goods or for producing investment in plant or equipment. The money is being used in the financial circuit of the economy to support financial transactions.

This is, of course, evidence of why the efforts of the Federal Reserve are flooding into areas of the economy that do not result in more robust economic growth.

Finally, I would like to call attention to the fact that foreign-related institutions, in the past four weeks or so, have actually been reducing the amount of funds they are taking off shore. I have focused on the behavior of these foreign-related institutions almost every month in my review of the banking system for the past four or five years.

Over the last four weeks, the foreign-related institutions have reduced their "Net deposits to related foreign offices" by almost $80.0 billion. Over the past several years as the financial situation in Europe grew, these deposits grew from a negative amount of around $150.0 billion to a positive amount of about $650.0 billion, a swing of about $800 billion dollars. Not an insignificant amount of the Fed's money to be taken off shore.

We will have to watch this further to really understand what is taking place. The decline could be the result of the actions of the European Central Bank and the efforts of the ECB to lower the value of the euro. We will see.

 

Overall, the commercial banking system seems to be doing all right and surviving. It is just not contributing much towards further economic expansion.

Carve-outs: Bad-boy Guarantees Have Borrowers Getting Spanked

So-called bad-boy guarantees have recently created headaches for borrowers when CMBS loans go bad, industry experts told Mortgage Observer. A number of recent cases across the nation have interpreted the guarantees, which prohibit certain borrower activity, like “indebtedness,” and “insolvency,” to mean that the principals of a borrowing entity are personally liable for losses in the event of default—a shocking development for CMBS borrowers and lenders alike.

It began with a 2011 case, Wells Fargo vs. Cherryland Mall, which rose to the highest court in Michigan. A provision that the borrower would “not become insolvent” was found to constitute a personal guarantee by the principal of the development company, which had defaulted on a CMBS loan, said Sam Lee of Duval & Stachenfeld. “It created a ripple effect,” in the industry, he said, because that “innocuous phrase,” one type of bad-boy clause, was boilerplate in many CMBS loan documents at the time. (The ruling by the Michigan court was actually later overturned by the state legislature, in an unprecedented move).

The Michigan ruling “meant, in effect, that a non-recourse loan—a loan that is asset-based, where you’re only looking at the property—all of the sudden became a recourse loan,” said Jonathan Mechanic, head of real estate at Fried, Frank, Harris, Shriver & Jacobson LLP. Cherryland was followed by a similar case in Georgia, in 2012, where the court followed the Cherryland court’s precedent (and Wells Fargo was also the plaintiff ), and later by CP III Rincon Towers vs. Richard Cohen, filed this year in New York’s Southern District.

Many in the industry agree that the Cherryland case was not in line with industry expectations, or with the intentions of borrowers when they signed. In fact, the court did not look at intention in Cherryland, said Janice Mac Avoy, a partner in Fried, Frank’s real estate group.

Even lenders do not universally want the guarantees interpreted this way, a source told MO, because they could discourage borrowers from from taking out CMBS loans in the future. (Bad-boy guarantees have largely been removed from loan documents now, that attorney said, though legacy CMBS could continue to spur suits for the next couple of years).

In the Rincon case, a fund named Carmel Partners bought the debt after Bear Stearns went belly up, said Ms. Mac Avoy, who represented borrower Mr. Cohen. Carmel argued that clauses prohibiting “unpermitted” indebtedness and transfers triggered full recourse when the borrower was slapped with a mechanic’s lien. Carmel sought to take control of the property, a San Francisco condominium conversion, by way of a non-judicial foreclosure. But the fact that in draft documents with the original lender the borrower deleted a clause that would have triggered loss recourse in the event of a mechanic’s lien supported Mr. Cohen’s argument this instance should not trigger full recourse, and the court found in favor of Mr. Cohen.

Carmel is appealing, however, and, if successful, the outcome would alarm many CMBS borrowers, sources said. It would also potentially open the door for a bevy of litigation, since so many CMBS loans would fall under the same New York jurisdiction.

The industry is keeping a watchful eye on the case. The appeal should be decided early next year, Ms. Mac Avoy said.

“Some people are outraged that [bad boy clauses] are getting enforced,” said Chris Delson, a partner in the real estate group at Morrison & Foerster LLP.

And the Georgia and Cherryland rulings run contrary to industry understanding of CMBS loans and their risks, Ms. Mac Avoy asserted. “The issuer is saying ‘we are not making individual credit decisions,’” when originating a CMBS loan, she said. Rather, they are lending based on property fundamentals.

Still, many believe the courts in New York will take the side of CMBS borrowers. Such a ruling would be in line with the sentiment of past, similar cases brought and decided here, sources said.

“We had a case at 610 Lexington Avenue about a year and a half ago where a lender tried to take the position that it was recourse,” said Mr. Mechanic. “The court sided with us and said, ‘no, that doesn’t make sense.’”

Private Equity: When Lenders Question Funds on Their Guarantees

Concerns over the net worth and liquidity of private equity funds are increasingly causing disputes and delays in commercial real estate transactions, Schulte, Roth & Zabel’s Jeffrey Lenobel told Mortgage Observer.

“I represent a lot of private equity and disputes and extensive negotiations happen on virtually every deal where a guarantee from a private equity fund is involved,” said Mr. Lenobel, head of the of the New York-based law firm’s real estate group.

With private equity investors now playing such a pivotal role in commercial real estate deals, those investors are now asked to sign guarantees ranging from non-recourse carve-out guarantees to environmental indemnity agreements to completion guarantees in construction deals. A leading cause of friction is unmanaged expectations, wherein lenders expect a consistent and concrete proof of income and liquidity, according to Mr. Lenobel.

“The first and threshold issue is that just because a private equity firm has a series of funds doesn’t mean that fund II can guarantee the obligations of fund I,” he said. “These funds, for the purposes of guarantees, are separate entities and I don’t think the investors in one fund would have any interest in guaranteeing the real estate held by investors in a different fund,” he added.

The concerns are multilayered. During the investment period of a given fund, there is little if any liquidity, Mr. Lenobel said. Instead, the value of that fund comes from uncalled capital commitments made by various investors and is, essentially, theoretical.

“At the point, if a lender says, ‘O.K. private equity fund, you need to guarantee the obligations, what’s your net worth?’, you are going to look at the fund’s financial statement during this investment period and see that it virtually has no assets and virtually no equity,” he explained. In those situations, disputes often arise between lenders and private equity investors over whether uncalled capital commitments count as assets.

After the investment period, when all of the capital has been called and a private equity fund owns several assets, a different issue arises. Since the average lifespan of a private equity fund is relatively short compared to most real estate companies, REITs and pension funds—in many cases between seven and 10 years after the investment period—the sale of a private equity fund’s assets may raise new concerns about its net worth. As a fund sells off its assets, the liquidity and net worth tests often imposed by lenders can yield unsatisfying results, making it more difficult for that fund to prove its solvency.

“Everybody has to look at the timing of the tests imposed by lenders on private equity funds,” the real estate attorney said. “This will avoid unexpected problems.”

In order to comply with customary net worth and liquidity covenants, private equity funds can mitigate guarantee concerns by holding onto a percentage of their assets to establish reserves and also by establishing third party lines of credit, among other measures, he said.

In most cases, lenders just need to manage their expectations, he added.

“Lenders are starting to understand how funds work and that is paramount to these issues, since private equity funds are among thebiggest players in the real estate industry today,” Mr. Lenobel told MO.