CMBS Bondholders Left In The Dark As Valuations Tumble

When a 145K SF suburban Maryland office building sold for just $5.7M at an auction this spring, it brought a resolution to a three-year-long spiral that began when its sole tenant, the Montgomery County government, terminated its lease in 2021.

The CMBS loan tied to 255 Rockville Pike in Rockville, Maryland, once valued at $56M, still had a $33.6M unpaid balance. The years it spent in special servicing and the pennies it ultimately sold for meant the investors in the loan suffered $33.7M in realized losses, according to a report by Trepp.

It's one of a growing number of examples of CMBS loans that are resolving for increasingly greater losses, sometimes larger than the total balance of the debt.

Behind the scenes, bondholders are growing skittish as they watch real estate investments flounder while special servicers continue to kick the can down the road.

“The underlying valuations implied by the prices of the CMBS are just completely not in accord with the underlying prices at which actual real estate is traded, therefore you have these kinds of securities in suspended animation,” said Dan Zwirn, CEO of troubled debt specialist Arena Investors.

“With a huge number of owners of those securities not really wanting to crystallize the losses, that gives an all-clear sign to a special servicer that's delighted to eat away at the value for as long as possible because the actual value is not showing through on the price anyway.”

Last year, the volume of CMBS loans in special servicing increased by 29% to $41B, roughly 7% of the larger $600B CMBS universe, driven by distress in the office sector, according to Trepp.

At the same time, total CMBS loan resolutions without losses more than doubled last year, from $2.5B in 2022 to $5.2B. Average time to resolution also dropped to 38 months from 47 months, according to a Fitch report. 

But that doesn’t necessarily mean that these resolutions are ideal solutions for the borrower, the special servicer or the bondholders. In the report, Fitch Director Arshia Chatterjee attributes the seemingly positive figures to there being fewer standard resolutions in 2023 and an increasing number of landlords handing the keys back to their lenders. 

In many cases, loans are being extended to be revisited on a later day, experts said. 

“Everybody's happy, as long as they can stick their head in the sand and hope it happens tomorrow,” Zwirn said.

Commercial property prices have already tumbled by 21% since the Federal Reserve started raising interest rates in March 2022, according to Green Street. Meanwhile, an estimated $1.2T of commercial real estate debt is maturing in the next two years, a quarter of which are tied to office and retail segments of the market. Most of that debt is held by banks and packaged into CMBS, according to the International Monetary Fund. 

“Special servicers have been very, very aggressive about not giving into the reality of the situation,” Terra Strategies Managing Partner Shlomo Chopp said. 

And that can make CMBS investors nervous. While special servicers and borrowers negotiate behind closed doors, bondholders eavesdrop, attempting to see how much they can recover. If a loan is extended only for property values to further fall, the investors in the CMBS bonds could take a bigger hit. 

However, bondholders aren't given all of the details about ongoing loan workouts, meaning they don’t know if, when and by how much they will lose.

“If you're a huge bondholder with multiple trusts, you can imply power. If you're a controlling class of a trust, you can actually say, ‘No, I want this, that and the other,’” Chopp said. “If you're just another guy that owns a $500K piece in a $500M trust, you really don't have any power whatsoever. The guy may not even take your call.”

Lisa Pendergast, executive director of the Commercial Real Estate Finance Council, compared the loan workout process between a borrower and special servicer to a game of chess. Neither side can reveal details to avoid the risk of a negotiation falling through. That can leave bondholders in the dark. 

“There's a fine art to it. I do think that there are times where as an investor, you're saying to yourself ‘Gee, I really wish I knew more,’” Pendergast said. “But there's no way to transmit some of that without giving that strategy away in many cases.”

She added that convincing a borrower to pay off some of the loan in the short term or invest in the property can give bondholders a cushion if the value does deteriorate. Having the property reappraised can also provide investors with more insight.

Regardless, special servicers can still get pinged if they aren't communicating enough to a loan's investors.

In May, Fitch Ratings flagged transparency concerns about Mount Street’s U.S. special servicing arm. The concern revolved around UK-based Mount Street’s reporting of valuations on a delinquent loan backed by Shorenstein Properties’ 1407 Broadway.

In a meeting with Bisnow, Mount Street co-founder and CEO Paul Lloyd said that there has been a “transition to mastery” in the market given all the pressures surrounding loan workouts. He said that though the firm has a team that has long worked in the field and has tools for transparency, it is among the less familiar special servicers since it only began its U.S. expansion in 2017. 

“We don't have that legacy book that these other services have. But are they scrutinized as much as we are?” Lloyd said. “Obviously we're the new kids on the block over here, so we do get people who can ask more, which means we have to make sure that everything we do is to the letter of the law, done in the best interests of the entire stack, that we are doing the right job for what we were appointed to do.”

Other special servicers have also had to navigate complaints from the other side.

Office landlord 601W Cos. sued Rialto Capital this month, claiming the special servicer pressured the developer to pay more than $195M in debt and interest that accumulated on a $164M loan backed by Chicago’s Civic Opera House or risk foreclosure. The lawsuit alleges that Rialto negotiated “in bad faith” and is actually a bondholder in the package of CMBS loans tied to the property, The Real Deal reported. 

Rialto didn't respond to Bisnow’s request for an interview. It and other servicers are often criticized for the time it takes for them to reach a resolution as they rack up fees.

"The reality is, the more work that you do as a special servicer, chances are the higher those fees are. It's that simple,” Pendergast said. “Certainly, as a borrower and as an investor, those fees can potentially cause monies not to be available that could be available to put into the transaction potential."

In a high-profile recent case, holders of even the AAA-rated class of bonds in the $308M CMBS loan backing Blackstone's 1740 Broadway took a loss after the building sold last month for nearly $200M. Only $117M was left to pay back investors after the loan racked up $62.3M in liquidation expenses, according to Trepp.

But servicing fees are just a routine part of the CMBS universe, Chopp said, adding that any potential conflicts of interest are routinely outlined in loan prospectuses.

“It’s not news,” Chopp said. “Anyone that complains about it is basically saying, ‘Oh, I don't like socialism, but I like socialism when it helps me. I like capitalism, but I don't like it when it hurts me.’”