How Special Servicers Handle Troubled CRE Loans This Cycle Will Be Different Than Past Downturns

With roughly $50B in CMBS loans tied to office buildings maturing in the next 18 months, special servicers — the firms hired by CMBS trusts to resolve issues as they arise — are about to be very busy.

The number of properties that have been transferred to special servicing is on the rise, but unlike the last two times special servicing rates shot up — in 2020 at the onset of the pandemic and during the Global Financial Crisis — interest rates are already high and expected to keep rising.

That means the playbook special servicers expect to follow this time around when tasked with working out solutions with borrowers in distress will be different than before. 

Special servicing executives and commercial mortgage-backed securities experts told Bisnow they expect resolutions to come a lot sooner than they did in the aftermath of the GFC, when some loans languished in special servicing for years. 

A need for speed would be largely driven by the localized nature of the issue. Office loans are where distress is expected to be concentrated, and the business case for an office building is fundamentally different than it was when many of these maturing loans were underwritten.

“We have a situation where the reality that we live in is completely upside down,” said Amy Hatch, vice chair of the financial services litigation department of Polsinelli. “When you look at an asset like an office, that may never recover. I mean, who knew that half of America wasn’t going to be going to the office?”

The rate of borrowers falling behind on their office loan payments is rising sharply.

Just 2.4% of the CMBS conduit office loans that matured in the fourth quarter of 2022 are delinquent, according to Moody’s Investors Service. For loans that matured in the first quarter of this year, the delinquency rate is 7.9%.

Office loans that matured in April and May have a 37.5% delinquency rate, per Moody’s. Of the 10 largest newly delinquent loans in the country, four were secured by office properties.

In the GFC, values were impacted across all commercial real estate asset classes, while residential mortgages were the weak link that kicked off the chain reaction that started the recession. 

After 2009, special servicers were inclined to keep loans in their purview for longer. Special servicers didn’t want to force lenders to sell their assets in a depressed market, Fitch Ratings Senior Director Adam Fox told Bisnow.

The pandemic made it impossible for retail and hotel borrowers to stay current, sending a wave of CMBS loans to special servicing. More than $12B in fixed-rate conduit CMBS loans defaulted in the first half of 2020, 10 times more than the defaulted loans from the same period a year earlier, according to Fitch Ratings. 

“There was a lot of volatility in the market at that point, limited capital for buyers to purchase assets,” Fox said. “A very tumultuous time.”

In both crises, special servicers tended to keep troubled loans in special servicing for years until the asset values recovered enough that loan investors could recoup more of their costs. In 2009 and 2020, the Federal Reserve cut interest rates to historic lows, allowing borrowers a chance to refinance and new buyers to finance their purchases. 

“When a loan was going to mature when rates were low, it was easy for someone to go out and refinance at the same rate,” Hatch said. “So you could easily just get out, and the values were continuing to stay steady and go up.”

In 2023, the economy is still growing, inflation is persistent and the Federal Reserve has raised its benchmark interest rate by 5% since last year. Fed watchers predict it isn’t quite done raising rates either. Those factors could cut into the patience special servicers grant office borrowers.

“From what we’ve been seeing, [special servicers] may be faster,” said Darrell Wheeler, vice president and head of CMBS research for Moody’s Investors Service. “They seem to be more efficient with what is viable and what is not viable.”

Of the office loans that matured in the first quarter of 2022, 1.5% were liquidated at a loss to investors, according to Moody’s. That rate more than doubled a year later to 3.2%, which Wheeler said was evidence that special servicers are more willing to resolve loans faster.

Aside from interest rates, office landlords face perniciously elevated vacancy rates across the country as remote work schedules solidify and layoffs, particularly among tech companies, mount. The average U.S. vacancy rate rose to 18.6% in the first quarter of 2023, a sharp rise from 12.7% at the end of 2019, according to Cushman & Wakefield. 

Concerns over tenant demand because of remote work are already impacting office values. The national average sales price of an office building dropped to $195 per SF at the end of May from $250 per SF in 2022, according to CommercialEdge.

Greystone Vice President Jenna Unell told Bisnow that what real estate is worth today will drive how quickly special servicers will liquidate delinquent loans. 

“If there’s some scenario we can maximize that recovery with a resolution that's going to take 18 months as opposed to 12, we’d do that, but we have to take that time into consideration,” Unell said. “Because of the time value of money, we’re not incentivized to just sit on an asset. We’re trying to move things towards a resolution but want to move it towards the best resolution for holders.”

Wheeler said the office vacancy rate is setting the stage for a “long, drawn-out process” for office buildings to recover value, and it is scaring away banks and other potential lenders that fear the impacts remote work will have on corporate office demand could reverberate for years.

“I don’t know what hybrid is going to be, but if I’m an underwriter, I’m avoiding anything with rollover,” he said. 

Higher interest rates also make it less likely that a buyer will be able to acquire a property and pay off its mortgage that way. A lack of sale and refinancing options means a wave of foreclosures is likely inbound, Hatch said. 

“Your other option is just to walk away and tell your lender, ‘I’m just going to turn in the keys,’” she said.

Technology is helping special servicers get through the process of loan workouts faster than during the Great Recession, said Alex Killick, managing director with CWCapital, one of the world's largest special servicers.

“The tech is a lot better now, a lot more data at your fingertips [and] not sending requests that take three days to come back,” Killick said. “We were on the very tail end of the fax era last time, and now information flows a lot more quickly.”

Jon Banister and Taylor Driscoll contributed reporting for this story.