In theory, commercial real estate loan servicing is a simple task – managing a loan’s interest and principal payments throughout the term of the financing. But in practice, the task is exponentially more complex, particularly for commercial mortgage-backed securities loans.
Borrowers have long expressed discontent with CMBS loan servicing, which inherently has more friction than traditional bank loan servicing. Once a loan is securitized and part of a REMIC trust, it is no longer owned or serviced by the lender which originated it and a third-party master servicer keeps on top of interest and principal payments. In the event of a problem, a loan can be transferred – with a fee – to a special servicer for modifications or workouts.
There have been winds of change for CMBS loan servicing since the end of the global financial crisis, much of which was tested during the covid-19 pandemic, says Roy Chun, a senior managing director at KBRA, a New York-based rating agency.
“There have been many changes and enhancements implemented post-GFC that came from servicers who learned what worked and what could be done better,” Chun tells Real Estate Capital USA. “A lot of this was put into practice during the pandemic, when more borrowers were asking for relief. One of the things everyone learned from the GFC was that communication, not just technology, was one of the best ways to approach servicing.”
“There are a still a lot of natural pain points, but I also think a lot of goodwill was created during the pandemic as servicers were able to be very responsive”
Chun cites a greater amount of communication between master servicers, which oversee loans throughout their term, and special servicers, which come online in situations where a loan is in default.
“This communication is one of the most important things servicers are doing, both before anything happens and throughout the process of transferring a loan from a master servicer to a special servicer,” Chun says. “You’d hear stories of what happened during the GFC that made it sound like the master servicer would throw a loan over the wall and leave the special servicer to figure it out. But now, the special servicer knows what is going on by the time a loan is transferred.”
This greater communication likely helped reduce the number of CMBS loans being transferred to special servicing during the pandemic. Still, about 12.5 percent of all loans ended up being transferred.
According to data from New York-based analytics provider Trepp, the CMBS special servicing rate dropped to 4.79 percent basis points in July, a 12bps decline. The number of loans transferred into special servicing has fallen steeply over the past year, declining from 8.14 percent in July 2021.
But Toby Cobb, co-founder and managing partner of 3650 REIT, a national mortgage lender which originates short- and long-term loans, sees the potential for a world in which loan defaults and delinquencies are minimal.
3650 REIT believes there are some basic problems with incentives and alignment of interests in CMBS, including the idea of fee-based special servicing and a lack of skin in the game for a loan’s originator. The firm originates loans for its own balance sheet and uses the traditional REMIC structure to securitize long-term, fixed-rate loans.
“We have a loan servicing strip on every loan we originate and, if the loan goes into special servicing, it is a bad day for our team,” Cobb says. “Our team aims to fix these problems before a loan goes into special servicing. We all make loans which sometimes need forbearance – we all made hotel loans prior to the pandemic – and we have learned there doesn’t need to be a special servicing fee paid for modifications.”
“I learned acutely about what outcomes could be like in workout situations”
Cobb came to this conclusion after his tenure as co-CEO of Miami manager LNR Property Corp, where he and his colleagues completed about $40 billion of workouts on more than 1,800 loans.
“I learned acutely about what outcomes could be like in workout situations,” Cobb says. “Just the activity of trying to take an asset from a borrower cost somewhere around 15 percent when you factored in lawyers, appraisals, accounting and engineering, plus the friction. We learned the best outcome could only be about 85 cents on the dollar.”
This, Cobb believes, is the real challenge for the industry. “More behavior like what is happening in the alternative lender and CLO space, where there are constructive relationships with borrowers through the life of the loan. Unless the 10-year, fixed-rate CMBS can modify itself to behave more like a constructive relationship, it will continue to dwindle and only be an option because of the rate and proceeds it provides.”
Under greater surveillance
Prior to the pandemic, servicers spent considerable time beefing up their surveillance groups, including adding more triggers to monitor potential problems, says Gretel Braverman, a senior director at KBRA. “Servicers were always monitoring loans, but this became much more collaborative during the pandemic because they were doing their own in-depth surveillance and were aware of issues and discussing solutions for problem loans earlier in the process.”
The speed with which information is flowing has also increased. “Everyone in the industry wants to see information in real time and that’s been a big driver for better data and communication,” Braverman says. “The industry is really working to get that information out to interested parties quickly. Servicers are also being alerted to news reports on problem tenants or borrowers – they are getting that pulled right into their systems; the asset managers are getting alerts in real time.”
The pandemic was a time that stretched servicers’ ability to respond to borrower requests and better servicer loans. But Daniel Berman, a partner at New York law firm Kramer Levin, notes government support and stimulus may have artificially kept potential problems at bay.
“We didn’t really get to see the impact [of the pandemic on commercial real estate] because there was a tremendous amount of governmental support in a way that mitigated the distress. All excess remedies were held off,” Berman says.
“Even with more lenders out there, the problem will arise now because between 2008 and today, rates have been kept artificially low and it was always possible for a borrower to refinance as new lenders came into the game and were competing. But now rates are coming up.”
This is no longer the case, with Berman observing a change over the past six months. “I think we are at the beginning of a period in which there are problems with loans that were put into place a few years ago,” he says. “The question becomes if those loans could be refinanced, given today’s rates.”
The old and the new
Greystone, a New York-based real estate financial services company, has been an active player in the commercial mortgage-backed securities b-piece market and believes it is possible to combine data and technology with traditional loan servicing.
The firm, which acquired seven CMBS b-pieces in the secondary market, recently purchased its first new issue b-piece with the acquisition of the non-investment grade tranche of August’s roughly $1 billion BANK 2022-BNK43 conduit. As the b-piece buyer, Greystone will also be the special servicer on the deal and Greystone is planning to further build its CMBS b-piece portfolio, says Jenna Unell, a senior managing director.
“Technology has been a major focus of ours over the past two years, including enhancing our surveillance and portfolio management systems,” Unell says. “Our portfolio management system is distinct from our surveillance systems and lets us look at bonds from a cashflow perspective.”
Maturity defaults are a specific area of concern, and one Greystone sees as a primary risk.
“We are expecting to see more maturity default issues as opposed to real problems with the underlying real estate,” Unell adds. “In terms of losses or the complexity of the workout, it could be just as bad as having some distress in the real estate because if the borrower can’t refi out of a loan, the borrower is most likely they are not going to come out of pocket. As the special servicer, we’re going to have to make some other kind of concession with the borrower or take a loss.”
Still, Unell believes there is substantial capital available in the market and, moreover, there haven’t been a substantial number of losses in CMBS.
“During the pandemic, we did have a lot of loans coming into special servicing for covid relief but that was for the most part a short-term impairment and borrowers and lenders worked together to come up with short-term solutions,” Unell says. “For the most part, those are resolved, and those loans are now back to performing. And that is an example of a different kind of default – we had a lot of assets that were defaulted but we could come up with solutions that work.”
While these loans could still experience maturity default issues, there is some bridge financing available. Preferred equity also is becoming increasingly capable of bridging that gap, Unell adds.
The new servicing standard
Fundamentally, the function of a servicer has not changed since the start of the global financial crisis.
“The servicing standard has not changed,” Unell says. “It is the role of the special servicer to maximize the recovery of principal and interest to the certificate holders on a net present value basis and that has not changed.”
As a servicer, Greystone’s goal is always trying to figure out how to maximize recovery and use historical data to do this.
“Our group has resolved about 5,900 assets historically, or about $59 billion of loan balance, and we have a lot of historical data around resolution strategies and loss severities,” Unell says. “We certainly can use that information to make the right decisions. I don’t think the servicing standard has changed but do think we are better able to use the tools we have to make the best decision.”
The industry continues work toward being more borrower-friendly, KBRA’s Chun adds. This includes having portals through which borrowers can more easily contact master servicers and special servicers, which makes it easier for borrowers to submit financials, rent rolls and make requests.
“A lot of effort has been put into making a better borrower experience,” Chun says. “Part of this is about communication, to make the borrower more comfortable within the CMBS framework. “There are a still a lot of natural pain points, but I also think a lot of goodwill was created during the pandemic as servicers were able to be very responsive. A lot got done without loans necessarily being transferred to special servicing, with forbearances being provided at minimal costs. The servicers are cognizant during covid and created a lot of goodwill. Now borrowers are coming back with credit issues and it’s a balancing act.”