Charles Ishay planned to hold on to 895,500 square-feet (83,195 square-meters) of office space in suburban Cleveland after the mortgage servicer LNR Property LLC agreed to change terms on $135 million of debt taken on during the 2007 market peak. Orix USA killed that plan.
Orix initiated foreclosure in May against Ishay’s Gotham King portfolio after ousting LNR as servicer on 138 loans in a $2.9 billion commercial mortgage-backed securities deal sold by Lehman Brothers Holdings Inc. that included the Cleveland debt, according to data compiled by Bloomberg.
Conflicts are growing across the country over whether to cut deals with borrowers or seize property to recoup cash for holders of $550 billion in debt tied to everything from mobile home parks to skyscrapers. Special servicers, which earn fees for negotiating with delinquent borrowers on behalf of bondholders, are capitalizing on record defaults by buying distressed CMBS and then appointing themselves to deal with landlords.
“The big pipeline of specially serviced loans has been a cash cow for the special servicers,” said Leo Huang, an investment manager overseeing commercial real-estate debt at Old Greenwich, Connecticut-based Ellington Management Group LLC. “They have a tremendous amount of discretion in CMBS deals and we’re not that far into the resolution process. There’s still a lot to be seen.”
LNR, CWCapital LLC, C-III Capital Partners and Midland Loan Services control 77 percent of servicing rights in the commercial-mortgage backed securities market, which pools property loans and slices them into new securities of varying risk, according to data compiled by Bloomberg.
Landlords that can’t make payments have to plead their case to these firms, who are charged with figuring out the best way to maximize value for bondholders. Special servicers typically collect a monthly fee equal to 0.25 percent of a loan’s balance while working on a problem mortgage and an additional 1 percent when the mortgage is modified or liquidated, according to Deutsche Bank AG.
Their decisions will determine recoveries on deals arranged before the property markets crashed in 2007 when a record $232 billion in commercial-mortgage bonds were sold that year. More than $75 billion of loans backing U.S. CMBS deals were in the hands of special servicers as of the first half of 2012, Standard & Poor’s data show.
“The special servicer oversees every aspect to the loan workout,” said Darrell Wheeler, an analyst at Amherst Securities Group LP in New York. They’re “cautious on information disclosure which can leave market participants many times frustrated to guess the final outcome.”
Ishay, founder of New York-based investor Gotham Realty Holdings, needed to alter loan terms after acquiring eight office buildings for $140.4 million in March 2007, a record for suburban Cleveland, according to Real Capital Analytics Inc. The debt was arranged by Lehman and bundled with other mortgages and sold as bonds, Bloomberg data show.
The value of the properties slumped after the vacancy rate soared as high as 16.1 percent last year from 1.3 percent in March 2007, CoStar Group data show. It’s declined to 10.2 percent at the end of the second quarter. The properties were appraised at $74 million in November.
The Cleveland area has the highest foreclosure rate for office debt among the largest metropolitan areas in the U.S. at 16.3 percent, according to Bloomberg data.
LNR was prepared to modify the loan by cutting the $135 million mortgage into two, according to a person familiar with the deal who declined to be identified because the talks were private. The borrower would make regular payments on the first portion, while the other piece, known as a hope note, would be repaid if the value of the buildings recovered by the end of the mortgage. Ishay would have had to put additional equity into the properties as part of the deal, the person said.
About 170 mortgages have been modified by slicing the original mortgage into two parts since 2009, said Amherst’s Wheeler. The strategy aims to fund investment in properties and avoid legal expenses while buying time for a recovery. While this can work, it may also delay inevitable losses, he said.
Orix took control of the Lehman deal from LNR in December, Bloomberg data show. It foreclosed on Ishay’s Cleveland properties in May, citing the borrower’s failure to make loan payments since July 2011, according to court documents.
Orix also started foreclosure proceedings on three properties known as the Bethany Maryland Portfolio II within the Lehman bond, Bloomberg data show. The multifamily buildings backing the $185 million loan are scheduled to be auctioned today, according to Credit Suisse Group AG.
Ishay and Bud Perrone, a spokesperson for LNR, declined to comment. Elizabeth Daane, general counsel at Orix, couldn’t immediately provide comment.
Holders of the most junior portion of a commercial-mortgage bond have the right to throw out the special servicer and appoint a new one. Five years after property markets crashed, rising losses have wiped out lower-ranking investments, opening the doors for firms to buy bonds and appoint new servicers.
Some special servicers are seeking to buy pieces of commercial-mortgage bonds they oversee to thwart attempts by rival firms to seize control. The targeted bonds may be bought from 15 cents to 40 cents on the dollar, said Amherst’s Wheeler.
Values on a Markit Group Ltd. CMBX index linked to bonds originally rated triple-A that were sold during the boom and have since been cut to junk have risen to 63 cents on the dollar from 61.7 cents on Aug. 30.
Special servicers have ties to real estate brokers, property managers and firms that make direct investments in properties, introducing a host of potential conflicts of interest to the process.
“Special servicing is ripe for conflict and is essentially the unregulated Wild West,” said Ed Shugrue, CEO of Talmage LLC, a CMBS investor and special servicer. “The lack of clarity on a loan’s resolution and the motivation and compensation of those directing traffic impairs an investor’s ability to buy the junior classes of the CMBS capital structure.”
Switching servicers can delay resolving troubled debt, leading to higher losses for bondholders, S&P analysts including Timothy Steward wrote in an August report.
The firms have become a coveted asset as delinquencies surged to 10 percent this year, up from 1.87 percent in 2009. Warren Buffett’s Berkshire Hathaway Inc. (BRK/A) acquired Berkadia Commercial Mortgage LLC in 2009, while real estate investor Andrew Farkas’ Island Capital LLC created C-III after buying the unit from Centerline Holding Co. in 2010.
Starwood Property Trust Inc. (STWD), Cantor Fitzgerald LP, and Lennar Corp. (LEN)’s Rialto Capital Management LLC are preparing bids for LNR, the largest special servicer, according to a person familiar with the negotiations, who declined to be identified because the talks are private.
Details of ongoing loan workouts aren’t typically disclosed as special servicers seek to maintain an upper hand in negotiations with borrowers, said Richard Hill, a debt strategist at Royal Bank of Scotland Group Plc. That leaves bondholders in the dark on the most important decisions determining how losses on their investments may play out.
LNR last month started a web site called “Window Into our Workouts” to address concerns about transparency over how soured debt is resolved. The site gives users “key terms of closed loan modifications,” information on foreclosures and property that are being marketed for sale, Miami-based LNR said in an Aug. 22 statement.
The proper approach varies depending on the situation, said Hill of RBS.
“You’re supposed to foreclose if the property is a dead man walking,” Hill said. “If it looks like more of temporary decline in value, and there is a strong record of having a strong property in a given market,” it might be appropriate to work with the borrower toward raising occupancy and rents, he said.
The business is attracting new entrants and smaller firms as defaults mount, threatening to “overcrowd and complicate an already complex process,” the S&P analysts wrote.
To contact the reporter on this story: Sarah Mulholland in New York at firstname.lastname@example.org