Restructuring CMBS Loans Just Got Easier

Story from the Wall Street Journal

The Treasury, responding to the growing pain in the commercial real-estate industry, released new tax rules that make it easier for distressed property owners to restructure loans that were packaged by Wall Street firms and sold as securities.

Most in the real-estate industry, which lobbied intensely for the move, applauded the action. But some warned it has opened a Pandora's box, especially for servicers of the securities who will likely come under new pressure from borrowers and competing classes of investors.

The move is the first round of "additional guidance" the Treasury is weighing to stave off what many fear will be a commercial real-estate crisis, according to people familiar with the matter. A Treasury spokesman declined to comment. A record of more than $150 billion of loans bundled into commercial-mortgage-backed securities, or CMBS, will come due between now and 2012. But as financing remains scarce and values of offices, strip malls, hotels and other types of commercial property continue to drop, more property owners are finding it hard to refinance debt as it matures.

The Fashion Show Mall in Las Vegas.
The mall's owner said a lack of financing flexibility hurt it.

Until now, tax rules have made it difficult for borrowers who are current on their payments to hold restructuring talks with the servicers of these bonds. Developers and investors complain that only those who are delinquent can talk to the servicers. Indeed, many property owners -- notably mall giant General Growth Properties Inc., now in bankruptcy protection -- have cited this lack of flexibility as one of the reasons for having to default on debt and give up properties.

The new guidance from the Treasury makes it clear discussions involving lowering the interest rate or stretching out the loan term "may occur at any time" without triggering tax consequences. In addition, the guidance allows servicers to modify loans regardless of when they mature. The servicer only has to believe there is "a significant risk of default" even if the loan is performing, the guidance states.

"A stalemate now exists on CMBS loans that are not currently in default but need modification," said Jeffrey DeBoer, chief executive of the Real Estate Roundtable, a lobbying body for property owners and investors. "Today's announcement should help break the stalemate."

But some investors holding CMBS bonds are watching nervously because loan modifications, known as "mods," mightn't always be in their best interest. CMBS have junior and senior pieces, and the senior holders may be in a better position, when a borrower defaults, to foreclose and liquidate the property rather than modify the loan. Junior holders, on the other hand, might benefit from a mod because they mightn't get their money back in a forced sale.

"The standards of care for services are to all bondholders," says Patrick Sargent, president of the Commercial Mortgage Securities Association, a trade group.

In general, servicers are required by their contracts to act in the interests of the investors and modify loans only when that can be expected to reduce losses. That puts servicers in the tricky position of trying to figure out which borrowers are basically sound and when it makes more sense to foreclose quickly.

"The biggest concern is that the guidance could open the floodgate for everyone to try to get some sort of loan modifications," said Aaron Bryson, a CMBS analyst at Barclays Capital. "There is a tremendous burden on the servicers to uphold their end of the bargain."

Still, the move by the Treasury reflects the deep concern in government and industry circles over the problems looming in the $6.5 trillion market for commercial real estate. Just as the U.S. economy is struggling to regain its footing, defaults are mounting because of credit-market turmoil, along with declining property cash flows and plunging property values.

In the meantime, the Treasury also is considering "additional guidance" aimed at fending off a potential wave of defaults as more commercial mortgages come due, the people with knowledge of the matter said. The real-estate industry has been pressing for a tax law change that would encourage more foreign investments in commercial property.

Until now, property owners and investors hoping to restructure troubled mortgages were hearing a tough message from most CMBS servicers: We can't talk to you unless you first fall behind on payments. This is because when CMBS offerings are created, the underlying mortgages are legally held by tax-free trusts. The trusts could have been forced to pay taxes if the underlying loans were modified before they became delinquent, according to the old CMBS rules. The new guidance applies to CMBS loans modified on or after Jan. 1, 2008.

In a study for The Wall Street Journal, Trepp, which tracks the commercial real-estate market, found that, year-to-date, 528 CMBS loans valued at $4.7 billion weren't able to refinance when they matured. About 75% of these loans were backed by properties that were throwing off more than enough cash to service their debt.