What You Need To Know About Special Servicers, The ‘Problem Loan’ Problem-Solvers
The term “special servicing” can send a shiver down the spine of some commercial real estate owners, but many don't have a clear picture of what occurs when a loan goes through that process.
Special servicing is a frequent subject of headlines during times of distress like the Great Recession or at the height of the pandemic. Another one of those periods has begun in recent months, as disruptions to the office market and lending environment have left many owners unable to pay back the billions in loans coming due.
The percentage of CMBS loans behind on payments last month reached the highest level since June 2020, according to Trepp. The delinquency rate for office loans saw a 128-basis-point jump and surpassed 4% for the first time since 2018 — the highest month-to-month increase in Trepp’s history tracking office debt.
Over just the last two months, examples of office loans going to special servicers have included a $39M loan backed by an office property in the Dallas suburbs, a $485M loan on a Park Avenue office building in Manhattan, an $841M loan backed by a seven-building portfolio in the D.C. suburbs, and a $1.3B loan backed by a 146-building nationwide portfolio.
Although a loan that goes into special servicing is an indication that it is heading for trouble, that might not always be the case. Special servicers can pursue a range of strategies to resolve a loan with a positive outcome for the borrower and the lender.
To peel back the curtain on how the special servicing sector works, Bisnow spoke to two special servicers and two firms that track the industry to break down the steps of the process and the possible outcomes for a loan.
“It’s not as complicated as people like to make it out to be,” Killick said. “There’s this desire to make it more arcane than maybe it is. There are certainly people out there that try to tell all the borrowers that it’s deep and terribly mysterious, and it really isn’t.”
What Are Special Servicers, And What Types Of Loans Do They Handle?
In short, a special servicer is an intermediary between the master servicer, which oversees the CMBS loan, and a borrower. The special servicer will help negotiate terms of the loan between the borrower and the master servicer to help find the best course of action that will maximize returns for the trust that owns the loan.
Special servicers don’t service run-of-the-mill bank loans. A special servicer isn’t looking at single-family mortgage loans or even construction loans. These firms focus on commercial mortgage-backed securities: fixed-income investments that are rated and backed by commercial real estate mortgages. At least $50B in CMBS loans were issued each year since 2013, with $109B issued in 2021 and $70B issued last year, according to Trepp.
It is rare to see a loan under $2M enter special servicing. Usually, smaller loans are sold off to avoid the process due to its costly nature.
Special servicers are typically paid in monthly installments and receive other fees when a resolution is made. These other fees are usually negotiated with the borrower beforehand.
A special servicer is only called on when something happens to the loan that is out of the norm.
What Are The Typical Reasons A Loan Gets Transferred To A Special Servicer?
The most common scenario is when a borrower misses payments on a loan and it enters default. If a borrower is delinquent on payments for more than 60 days, the loan automatically enters special servicing.
The second-most-common reason a loan enters special servicing is when a property is heading toward an imminent default. This could be because the loan is approaching its maturity date and the asset’s revenue has declined or it has a major tenant vacating.
“We have loans that come to special servicing that ultimately never miss a payment because something gets worked out or the borrower reconsiders, or maybe it was an insurance issue that got resolved,” Killick said.
Instead of waiting for a missed payment, Tishman brought the loan in for special servicing ahead of its maturity date. The main reason was the building’s assessed value dropped by $12M during a temporary loss of tenancy.
What Types Of Companies Act As Special Servicers, And How Are They Selected?
There are a large number of special servicing companies in the market. Some companies act solely as intermediaries between the borrower and master servicer, while others act as both bondholders and special servicers.
Some special servicers are attached to national financial institutions, like Wells Fargo Bank, KeyBank, PNC Bank subsidiary Midland Loan Services, and government-backed agencies Fannie Mae and Freddie Mac, according to a list of servicers provided by Fitch Ratings. Other large special servicers include LNR Partners, which is owned by Starwood, CWCapital, Greystone and Rialto Capital Management.
A special servicer is selected by the lowest-class bondholder in the CMBS trust that owns at least 5% of the security. These bondholders are the first ones to suffer a loss when a loan goes into default.
The large firms that have their own special servicing arms sometimes hold these bonds and then service the loans themselves. When a bondholder goes to a third-party special servicer, it has the discretion to choose which company to use based on the firm’s reputation and relationships within the industry.
“There are people who buy these bonds and appoint a third-party special servicer, and that’s the space we are in,” CWCapital’s Killick said. “The other business model is to have a bond management arm and a special servicer. Some of the big players in the industry, Rialto and KKR, will buy the bonds and will appoint themselves as the servicer. It’s a way to control their own destiny.”
Why Have More Loans Gone Into Special Servicing Recently, Especially In The Office Sector?
Higher interest rates combined with a pullback in lending have made it hard to refinance loans, especially those tied to office buildings, and there is a big wave of CMBS loans maturing in 2023 and 2024 that need to be refinanced.
Coming out of the Global Financial Crisis, CMBS loans saw a bump in originations, hitting $84B in 2013 as the economy saw a major boost. This rise has come to the forefront as most of these 10-year loans are now beginning to face maturity in a tumultuous lending environment.
“The maturity question presents a problem in the market,” said Jack LaForge, associate research manager at Trepp. “In 2013, 2014 and 2015, interest rates were lower than they are currently, so the rates you’d have to pay on the loan if you were a borrower, let’s say 3% in 2013, now that property has to be refinanced with another loan, but the interest rates are higher.”
A total of $7.8B in fixed-rate office CMBS loans are expected to mature this year, and 84% of them are predicted to run into refinancing challenges, according to Moody’s Analytics. With the rise in vacancy and hybrid work schedules, lenders have been more hesitant to give extensions as office valuations continue to drop.
The inability of borrowers, especially office owners, to secure a refinancing deal ahead of their maturity date is leading to more loans going to special servicing, and experts predict this trend will continue throughout the next year.
“The market is very focused on office properties,” Fitch Ratings Senior Director Adam Fox said. “There are definitely some assets that will be challenged through the end of the year.”
What Types Of Actions Does The Special Servicer Take?
When a loan enters special servicing, the basic duty of the special servicer is to help negotiate terms between the borrower and the master servicer to come to a resolution.
The special servicer aims to come up with a plan that will recover the most possible money for the trust that holds the CMBS loan. These plans often start with negotiations with borrowers to reach a payout or modify the loan and bring the borrower current on a payment schedule, but if that is unsuccessful, they move toward foreclosure scenarios.
Special servicing firms typically have multiple teams of specialists who handle duties like assets management, investor reporting and appraisals. For events like the pandemic, when hospitality and retail loans were seeing special servicing rates of 26% and 18% at their peaks, respectively, the firms brought on specialists in those sectors to help navigate the storm.
Jenna Unell, senior managing director of special servicing for Greystone, said most special servicing firms follow a servicing standard, which requires them to maximize the recovery of the principal and interest on a loan for the trust.
“If the borrower can come to the table and we can get a better resolution from the modification of that debt, then we would typically go that route,” Unell said. “These aren’t unilateral decisions. We work in the best interest of all certificate holders.”
Special servicers also receive appraisals of assets attached to the loans they’re servicing. For assets that may be harder to assess due to market circumstances, such as a lack of comparable sales in the office sector, servicers might look for broker opinions of value.
“Because of the volatility in the commercial real estate market, there are not a lot of commercial property trades going on, so it’s very difficult for appraisers to point to market comps to get a valuation,” Fitch’s Fox said.
If a loan is still performing, which means that it hit its maturity date but payments are still being made, a borrower has to get permission from the special servicer to sign any new leases, make renovations and undertake any other big changes to the asset. This is to make sure that the borrower’s actions are in the best interest of the trust.
What Are The Best- And Worst-Case Outcomes For A Borrower Once A Loan Is Transferred To Special Servicing?
When a loan goes to special servicing, it doesn’t always end with the borrower losing the asset.
Some loans enter special servicing and can come out with a full payoff, with the borrower coming to the table and paying a loan in full. Borrowers can also have positive outcomes by reaching agreements for loan modifications and payment plans, or they can secure a refinancing deal.
If the borrower can’t reach one of those outcomes, the special servicer will try to liquidate the asset or sell the note, and in some cases, these sales can result in a full recovery of value for the trust.
The worst-case scenario is when an asset is foreclosed on and pushed into an REO, or real estate-owned, sale. The special servicer must take on management of the asset or appoint a receiver.
This usually happens when negotiations between the borrower and lender fall through and a refinancing deal can’t be reached. If the asset is significantly underperforming, the distressed sale can result in a big loss for the investors in the trust.
Roughly 25% of the 611 loan resolutions totaling $15.5B in 2021 resulted in losses, according to a Fitch Ratings study. The loss severity averaged 11.3%, and the majority of loans that suffered losses were in the retail and hotel sectors.
How Long Does A Loan Typically Stay In Special Servicing?
There is no set time frame for how long a loan can stay in special servicing, and it depends on the depth of the issues servicers are trying to fix. Some loans can be so complicated that they take years to modify or negotiate.
A majority of loans take between 20 and 25 months to resolve. Greystone’s historical resolution period is around 17 months, Unell said, adding that special servicers are trying to get the best outcome for the trust, and the longer it stays in special servicing, the more money the trust will pay.
“You’re paying more fees, so usually it’s not in anybody’s interest,” Unell said. “We’ve had a few examples where we've had loans in special servicing for many years and have had good resolutions, but generally when they’re in that long, it’s for litigation.”
However, most loans serviced don’t make it past two years. For the loans that go REO, a trust is required to sell the asset within three years, but it can exercise one three-year extension.
“The largest loss severity historically is the REO sale,” Unell said. “If the loan is completely underwater and we don’t have the value there, plus you’ve got the cost and time of going through the foreclosure process, then you have to market the property to get it sold.”