One of the big selling points of CMBS loans—their non-recourse structure—may come back to haunt investors in the COVID-19 recession.
A growing number of borrowers are throwing in the towels and walking away from distressed CMBS loans in cases where equity has been completely washed away. That distress is particularly acute in lodging and retail with the volume of loans that have moved to special servicing for August at 25.0 percent and 17.3 percent respectively, according to Trepp. Examples include some of the biggest names in real estate and major assets within CMBS conduits. Bloomberg recently reported that some of the entities controlled by Blackstone Group Inc., Brookfield Property Partners L.P., Starwood Capital Group and Colony Capital Inc. are among those handing back keys on some struggling assets—even as they continue to rake in millions in new fundraising.
CBL & Associates Properties was one of the first mall operators to announce in May that it would cooperate with lenders on foreclosure proceedings on some of its struggling properties that included the Park Plaza Mall in Little Rock, the Eastgate Mall in Cincinnati, and Hickory Point in Forsyth, Ill., among others. According to Fitch, CMBS conduit exposure to CBL-operated malls back in May included 16 loans totaling $1.06 billion. Hickory Point Mall has since been liquidated with a 68 percent loss on the loan’s original $33 million balance. Of the 15 remaining loans, six are currently with their special servicer, according to Fitch. (CBL appears to be prepping for a bankruptcy restructuring.)
There were a number of class-B malls that were clearly struggling prior to COVID-19 but were still managing to generate positive cash flow to cover debt service. The impact of the pandemic on brick-and-mortar retail has resulted in owners who are now in a cash flow negative situation. “I think that is causing a lot of them to consider whether or not they want to keep reaching into their pocket to subsidize the property for another 12 months, when they know it’s going to be impossible to refinance,” says Manus Clancy, senior managing director and the leader of applied data, research, and pricing departments at Trepp.
CMBS borrowers or sponsors that have little or no equity left in a property can walk away relatively unscathed. “It is very easy for the borrower to stick the keys in the mail and be done. They can shed their liabilities within 30 to 60 days if they are going through a cooperative foreclosure,” says Clancy.
Investors know the risks
Ultimately, it will be CMBS investors and lenders that were required to keep skin in the game as part of risk retention rules who are going to end up taking a financial hit on the bad debt. “Inevitably, there will be losses running through the waterfall of the CMBS trust,” says Brian Olasov, executive director, financial services consulting at Carlton Fields and an adjunct professor, real estate capital markets at the NYU Schack Institute of Real Estate.
In the Great Recession, the government created the Term Asset-Backed Securities Loan Facility (TALF), which added liquidity to the CMBS market. That was partially revived earlier this year. However, in the current recession, both bond holders and borrowers are being hurt by the impact caused by COVID-19, adds Bryan Shaffer, a principal and managing director at George Smith Partners, a real estate capital advisory firm based in Los Angeles. In rare cases, the borrower is playing the system in being able to walk away from their non-recourse loan, but at the same time many borrowers are being punished by the lack of flexibility of CMBS lenders, he says. “In my view, this is not a business cycle change , but a once in a lifetime national emergency caused by a global pandemic. So, the federal government should play a role in providing liquidity to lenders to allow borrowers to stay in their current loans,” he adds.
Although investors certainly seem to be getting the short end of the stick, most were well aware of the going in risks. “Everyone goes into this eyes wide open. If you’re in the CMBS market, you know these loans are non-recourse. You know that the borrower can give them back, and you’re relying on the 20- to 25-year history of the market to understand what that risk is,” notes Clancy. It creates a more difficult situation for special servicers when a borrower contests a foreclosure, because it drags out the process and ends up costing the lender more time and money to get control of a property.
Borrowers cut their losses
Non-recourse is nothing new in the CMBS world, but the feature certainly moves to the forefront in the times of crisis. During good times, non-recourse is not generally an issue. “A borrower has equity to protect and is going to continue doing the right thing in servicing the debt and following all of the covenants required of them under their loan agreement,” says Olasov. In situations where a borrower doesn’t have equity in the property and the immediate outlook for the property are grim, they are more likely to cut their losses. “CMBS allows borrowers to do exactly that,” he says.
The fact that CMBS loans rely on separate special purpose entities to structure individual loans provides added protections for borrowers that have other holdings. The separate structures weren’t intended as a loophole, but rather a means to help ratings agencies better understand the underlying credit risk. For example, if a borrower owns 12 different shopping centers and files bankruptcy on one, it could potentially create a ripple effect that might take down the whole portfolio.
“The notion on the part of ratings agencies was to be able to separate out individual assets to stand on their own,” says Olasov. Part of that gets to the non-recourse nature of CMBS. As long as the borrower hasn’t committed what is referred to as a “bad-boy” act under most carve-out guarantees, the borrower gets to walk away from the property. The lender through the special servicer would not pursue the borrower or sponsor for any deficiency judgement. “All of that is a feature and not a bug of CMBS,” he says.
Although it can be easy to walk away from a CMBS loan, there are some potential pitfalls that can trip up some borrowers. For example, a non-recourse loan can quickly become recourse if a borrower violates any of the covenants or non-recourse carve-outs or acts in bad faith, notes Shaffer. In the last cycle, filing for bankruptcy became a violation of some non-recourse carve-outs. Wells Fargo and other lenders won legal cases that allowed for them to make the loans full-recourse for any borrower who put their properties into bankruptcy, he adds.
More reforms ahead for CMBS?
Following the Great Recession, CMBS issuance virtually ground to a halt and was slow to rebound to modest levels. Although there could be additional reforms ahead post-pandemic, the industry could be better positioned to handle the near-term headwinds.
“CMBS is really a core source of financing, and it is particularly attractive for new loans in times when rates are low and credits spreads are low, which is right now,” says Olasov. Although there is going to be some short-term pain in losses to investors, Olasov believes that the sector will be resilient and remain an important capital source for commercial real estate over the longer term horizon.
Yet there will likely be some lessons learned in the current crisis that could result in more reforms ahead for CMBS. One change that may materialize in loan documents and borrower terms is very clear language regarding pandemics. Just as properties after 9/11 were required to have terrorism insurance, a lot of people have business interruption insurance, but it may not be clear as to whether or not pandemic shutdowns are included in that business interruption coverage, notes Clancy.
There also be more reforms that speak to some of the friction points that emerged over the past six months, such as requirements for higher loan reserve levels, how those reserves can be used and how forbearance is conducted. “I think all of those things will be subjects of conversation going forward,” says Clancy. In addition, the industry may want to reopen the REMIC rules so that if another event similar to COVID-19 happens, it doesn’t require an act from Congress to give a time out to the real estate mortgage investment conduit (REMIC) rule to offer forbearances, which is what is happening now, he says.
During the Great Recession, the problems that resulted in distress were somewhat self-inflicted by lenders and overly aggressive underwriting and lack of discipline. In the current climate, the problems that have resulted in distress were result of an unforeseen situation that was thrust upon the industry, notes Clancy. However, the way a borrower behaves remains fairly consistent. “In 2008, if borrowers thought prospects were limited for a property and equity was negative, they would throw in the towel. And that is true now,” he says. “Until the market punishes people for giving back properties, that behavior will always be the same.”
