Commercial real estate (CRE) sectors have not escaped the perma-crisis era in which we live, and the worst appears yet to come. First, hospitality and retail suffered setbacks with pandemic lockdowns. Then, the persistence of work-from-home and employee resistance to returning to the office drastically changed the flow of workers to the office and urban centers. Now, before those issues are resolved, a significant number of CMBS loans are set to mature at a time of rising interest rates and threats of a market-wide credit crunch. With these events conspiring, parties should prepare for foreclosures, losses and resulting litigation.
Hitting the Wall (of Maturities)
As we previously reported, a substantial number of CMBS loans will soon need to be refinanced. Overall, more than 50% of outstanding commercial mortgages will need to be refinanced in the next two years. In the office segment, the Mortgage Bankers Association has predicted that $190 billion of the $750 billion in outstanding office loans are maturing in 2023 and another $117 billion are maturing in 2024.
Up until recently, regional banks could be counted on for a significant amount of new CRE originations. But in the wake of the collapse of Silicon Valley Bank, Signature Bank, and First Republic, regional banks are now straining under the public’s loss of confidence in them. Some, like Valley Bank, are doubling down, and some, like PacWest, are trying to back off. The FDIC has been trying to sell Signature Bank’s loan portfolio, heavy with commercial real estate loans.
Even for financial institutions that survived this first wave of failures, issues with their CRE portfolios could lead to a second crisis.
A Pivotal Moment
The post-pandemic landscape looks cruel for CRE. Overall, the surge in interest rates is depressing commercial real estate values. There are also significantly more variable rate commercial mortgages since the last period of interest rate spikes. Trepp data shows that variable rate loans make up approximately 60% of the CMBS issuances in 2021 and 2022, compared to just 15% back in 2005-2006. Interest rate hedges are more costly.
For office space, the shift to hybrid office usage is expected to inevitably lead to some tenants choosing to downsize, resulting in lower occupancy rates and valuations. These pandemic/post-pandemic circumstances may make it even harder for this sector to bounce back compared to past crises. Retail has already gone through a contraction with the rise of online shopping. Is this the moment offices face a similar behavioral shift?
There is some good news. As J.P. Morgan points out, offices “represent only 14% of total CRE assets in the United States” This segment of commercial real estate is not so large as to bring down the whole economy and not all areas of commercial real estate have the same problems. Office vacancies may be at an extreme high, but industrial construction remains strong.
Still, the effects of recent banking turmoil are an added pressure and CMBS investors are being directed by investment advisors to focus on top-quality CMBS.
Impact on CMBS
Spreads are widening and new issuance is falling. Trepp reported that the Q1 quarterly volume for domestic, private-label CMBS was down 79% year-over-year to only $5.98 billion, a level not seen since 2012.
As S&P has noted, CMBS performance and ratings will depend upon a variety of unique factors that may not apply across the board to all properties (including building, location tenant/industry mix, rollover risk, office utilization and land values.) From their most recent report, retail and lodging have been improving, though regional malls remain at risk. But per S&P office values have decreased by 25% in the past year.
Fitch has been predicting fluctuations in delinquencies this year. Trepp called the May 2023 delinquencies a “tipping point.” The Trepp CMBS delinquency rate reached 3.62% in May which is a 14-month high and is the “largest [basis point increase] since June 2020, driven by office delinquencies.
Valuation and Voting Rights Litigation
A decrease in valuation can be a significant event, greatly impacting investor rights in CMBS deals.
Depending on the terms of the agreements, delinquencies, borrower insolvency events, or modifications of material economic terms could trigger an appraisal reduction event, which leads the servicer to conduct a new appraisal of the property, and potentially, results in an appraisal reduction amount (ARA) that reflects unrealized losses. The appraisal reduction may equal the excess of the outstanding principal balance of the loan minus 90% of the adjusted appraised values of the mortgaged properties securing the loan.
An ARA can impact subordinate certificateholders through reduced distributions of principal and interest and shifting of control rights (generally held by the most junior class that has 25% or more of its initial balance left). With so much at stake, disputes may arise over whether a triggering event has occurred, the appraisal, the ARA, the formula utilized to calculate the ARA and whether control rights have shifted.
- In FCCD Ltd. v. State St. Bank & Trust Co., the parties disputed whether the trigger for a shift in control from the subordinate to the senior interest holder had occurred. Upon an event of default, the contract called for a calculation to essentially determine in the court’s words whether “the subordinate interest holder’s prospect of recovery was so diminished that it could no longer be said to have a sufficient economic stake in the [l]oan.”
It was critical whether the agreement intended the ARA be allocated in part or in total against the subordinate interest. The court found the language in the contract to be unambiguous and that the entire amount of the ARA should be assigned to the subordinate interest, which resulted in control shifting to the plaintiff.
- In In re Trusts Established Under the Pooling & Servicing Agreements, the formula to determine if a party reached the 25% voting rights threshold to bring a cross-claim depended in part on the ARA.
The parties disputed whether both the numerator and the denominator of the voting rights calculation should be decreased by the appraisal reduction. The court held that only the numerator should be so modified pursuant to the plain reading of the contract, resulting in one of the certificateholders not having the required 25% voting rights to bring a cross-claim.
- In LNR Partners, LLC v. C-III Asset Mgmt, a special servicer, LNR Partners, was replaced when the defendant C-III’s affiliate became the trust’s majority controlling class certificateholder and C-III became the special servicer.
In an attempt to regain control, LNR Partners had its affiliate, LNR Securities, obtain ownership in the controlling class and attempted to terminate C-III as the special servicer. C-III argued that although LNR Securities may have had the majority of interests in the controlling class, they did not have the requisite voting rights percentage based on the ARA calculation.
The court denied the motion to dismiss and summary judgment on the grounds that the PSA was ambiguous as to whether the appraisal reduction should be taken into account for the purpose of determining voting rights.
With valuation playing such a significant role in control rights under CMBS deals, big swings in real estate valuations are flashing warning signs of increased litigation. Claims will likely be based on the triggering events and appraisal-related provisions discussed above. Currently pending CRE lawsuits are providing a blueprint for future disputes, just as the sector is about to hit “the wall.”
Nicole Serratore, an attorney in the Insolvency + Finance Group at Davis+Gilbert, contributed to this post.