A recent article in the Wall Street Journal* placed a spotlight on the role of “middlemen”, or special servicers as they are known in the CMBS loan marketplace.  It described how high profile investors such as Andrew Farkas and his Island Capital Group recently bought special servicer C-III, and how Fortress Investment Group, which purchased CW Capital, are seeking to profit by purchasing these special servicers, thereby getting a “front row seat,” to distressed commercial real estate assets sold at auction, a scenario that many view as replete with conflict of interest issues.

CMBS loans are securities backed by pools of commercial real estate mortgages and which are administered by master servicers.  When a CMBS loan goes into default, the master servicer passes the loan to a special servicer, which is charged with working out loans on behalf of the investors who bought the bonds.  On the one hand, the special servicers are supposed to represent the interests of the bondholders.  On the other, the same special servicers have the right to buy the distressed asset as long as they pay a fair market value.  Hence, the conflict. While the article goes on to focus on conflicts within the CMBS investment marketplace, the impact will be felt by CMBS borrowers as well.

According to market research firm Trepp LLC, some $87 billion in commercial mortgages are currently being handled by special servicers, compared with $20 billion two years ago and just $6 billion in March 2008.

Conflicts of interest are nothing new in the CMBS industry.  There has been a long-running debate over conflicts that may exist between master servicers, special servicers, and the different levels of tranche investors in a given deal.

A special servicer’s primary responsibility is to work out the loans forwarded by the master servicer and has wide latitude to foreclose or modify a troubled loan, in an effort to maximize cash flows to the CMBS investors.  The ideal solution would be for the special servicer to fix the problems with the loan and return the loan to performing status.

Special servicers are generally compensated by a percentage of the outstanding balance of the loans they serve plus a fixed fee. Unlike the master servicer of a CMBS loan, the special servicer generates more profit if a particular loan goes into default.  This compensation structure could give incentives to the special servicer to prolong the workout or foreclosure process and to liquidate too few loans in order to collect more revenue in fees.**

The servicers may also have conflicts of interest in servicing the loans based upon the possible ownership by the servicer of a tranche of the loan, compensation arrangements for the servicing, duties to make debt service and protective advances when serviced loans go into default and other business relationships with loan borrowers or other stakeholders.

In cases where the originator or sponsor of the CMBS offering is also in the business of being a special servicer, it may hold the most subordinate tranche and also act as the special servicer, so it is not uncommon for such a conflict of interest to exist.  Also, the most subordinate class of certificate holders generally has the right to replace the special servicer, subject to rating agency confirmation, creating another potential source of a conflict of interest for the special servicer.

The takeaways for commercial real estate property owners is that investors who acquire special servicers looking for access to attractively-priced distressed real estate deals will inevitably impact distressed borrowers and that the special servicer may be conflicted with regard to dispassionately working out distressed situations on behalf of those borrowers. As you see from this article, it’s difficult for them to figure out where their loyalties lie even among their owners, master servicers and investors.

The CMBS structure, the motivations of special servicers and these potential conflicts of interest must be clearly understood and dealt with properly to perform a successful commercial modification of a CMBS loan.  Breakwater Equity understands these nuances and has the experience and knowledge to succeed in this complex arena.

*Wall Street Journal Article
Playing the Real-Estate Middleman by Eliot Brown and Anton Troianovski, April 26, 2011 http://www.sfgate.com/cgi-bin/article/article?f=/c/a/2011/04/22/BUIJ1J5IAQ.DTL

**Source:  CMBS Special Servicers and Adverse Selection in Commercial Mortgage Markets: Theory and Evidence submitted to the Real Estate Research Institute