Thomas F. Nealon III is Group General Counsel for the Real Estate Financing and Servicing Group of LNR Partners, Inc., the largest special servicer in the CMBS industry with a portfolio of more than 17,500 commercial real estate mortgage loans with an aggregate principal balance in excess of $220 billion. In his role as General Counsel, Mr. Nealon oversees all legal issues relating to workouts, creditor’s rights litigation, and bankruptcy matters. Mr. Nealon recently co-authored a book on the current credit crisis, Mortgage and Asset Backed Securities Litigation Handbook (Thomson West 2008). Mr. Nealon is also an active fundraiser for the American Liver Foundation, having raised over $420,000 for the Biliary Atresia Fund for the Cure by participating in the last seven Boston Marathons.
At the beginning of the “credit crisis,” many people were predicting that it would be over by the end of 2007, then by the first half of 2008. As we sit here at the end of the third quarter of 2008, obviously that has not happened and things appear to be getting even worse. Why do you think the credit crisis is lasting longer than what was initially predicted?
I think that in large part, initially everyone saw the credit crisis as being synonymous with the subprime lending crisis that started back in 2007. However, the subprime lending crisis was really just a leading indicator of the breadth and depth of the larger credit crisis. What has actually become clear is that while subprime played a significant role in accelerating the credit crisis, it was more of a symptom rather than the sole basis of the credit crisis. In fact, there were much deeper issues going on in the credit and lending world that were tied to the euphoria of continuing ascending property values and cap rates and the willingness of people to believe that any property bought at virtually any price was going to increase in value. So even if there might have been a questionable credit decision that was being made, the rising property values would basically rescue anybody from some questionable credit transaction. What we clearly have now come to realize is that the credit crisis is (as the name would suggest) a vivid demonstration that there were serious issues in the credit and underwriting associated with many of the loans that were being made (whether we’re talking about residential or commercial properties). This included the amounts of the loan proceeds that were being advanced for many properties. The level of debt became so high for so many properties, and the rate of appreciation stopped so suddenly, that it will take a considerable amount of time for debt levels and property values to come back into balance (especially “balance” as defined by traditional underwriting).
What differences have you observed between the real estate downturn in the 1990’s and the current downturn?
Probably the most significant and certainly the most fundamental difference is that the 1990’s downturn was substantially driven by over supply. There simply was too much inventory of numerous property types for the economy to absorb fast enough. In the current credit crisis, there is significant overleverage within the market as a result of a series of events. During the last few years, lenders were competing to see who would advance the most proceeds, which certainly drove up the leverage levels and brought down cap rates. During this period, properties were trading or being refinanced with amazing frequency and each time a property was traded or refinanced it would be at a substantial increase in value over a relatively recent trade or refinance when essentially the underlying real estate fundamentals of the property had not changed. As a result, at the end of the credit cycle in the second half of 2007, the level of debt on many properties exceeded the reasonable revenues that one might normally expect using traditional underwriting. In addition, many loans (certainly well over 50%, if not 75%, of the commercial real estate loans made towards the end of the credit cycle) were interest only loans. In certain cases, the properties at origination could not even service the interest payments, so interest reserves were built into the loan in order to carry that loan until the property stabilized. Unfortunately, the optimism that stabilization would be the cure in some finite period of time (two or three years) clearly has not turned out to be the case. So the debt levels on many properties will not reduce over the term of the loan while, at the same time, many properties are actually decreasing in market value due to buyers and sellers adjusting their cap rates and expectations regarding loan proceeds. So, when compared to the downturn in the 1990’s, it should be relatively easier for the real estate market to correct itself in the sense that you don’t have to wait for the economy to absorb oversupply over an extended period of time. But certainly the correction will be painful (and in some cases very painful) as we go through a process of resizing the debt on properties to accurately reflect the underlying economics and cash flow associated with that particular property.
What has been the biggest challenge for you with respect to the current real estate downturn?
There are two big challenges for special servicers in the current real estate market. The first challenge is that this represents the first real wave of significant CMBS loan maturities that are confronted with a difficult credit market. For loans that were maturing a year and a half ago, borrowers basically had their choice of potential lenders and loan options when they were looking to refinance because the number of lenders who were active and competing for business was pretty plentiful. However, the options are very limited in 2008. This is coupled with the fact that 2008 is ten years after one of the first really big years of commercial real estate loans being securitized into pools. So, even though a significant number of the loans originated in 1998 were refinanced or defeased during the credit boom, there are still many loans maturing in 2008. Unfortunately for these borrowers, they are finding themselves faced with limited lending options and, in many cases, the options that are available are not particularly palatable to these borrowers, many of whom had become accustomed to non-recourse, interest only loans with low fixed interest rates and high loan to value ratios. Now, those borrowers may be looking at either full or partial recourse loans (many of which have floating interest rates) with much lower loan to value ratios than were commonplace in early 2007. So part of our job is to help borrowers understand the reality of the current credit market and that they are going to have to do what they need to do if they want to pay off their loan, which may mean accepting loan terms that they do not necessarily like in order to refinance their properties.
The second challenge is loans that were promised on rather optimistic property level projections which have not or will not materialize (at least not in a reasonable time frame). As I alluded to in the last question, there were many loans with interest only reserves or with very optimistic projections as to the growth and lease-up of the underlying properties. A certain number of those loans are not living up to those expectations, so the cash flow has not increased to a level adequate to service the interest only debt or, more importantly, pay back principal. So it requires some conversations with borrowers to say that we understand what everybody hoped, wished, believed was going to be the case, but obviously that is not the case. These are very difficult situations that have to be addressed on a case by case basis.
For the commercial loans that have defaulted, have you noticed any common themes?
Yes, I would separate most of the loan defaults that we are currently seeing into three categories. First, there are the maturity defaults that we discussed above where loans are maturing at a time when the credit options and opportunities for borrowers to pay off or refinance are not particularly great. The second category is loans where the underwriting was particularly aggressive. So, as a result of the aggressive underwriting, the degree of leverage on a property may be significantly in excess of the revenue generating capabilities of that property. Some of these types of problems may have been camouflaged for a period of time by making the loan interest only or by having an interest reserve put in place at origination. But, as these loans age and the aggressive assumptions on which the underwriting was based don’t materialize, it becomes readily apparent these loans are in trouble. So it’s not so much that adverse things have happened with a property or that even the underlying fundamentals of a property have changed from loan origination, just that the loan was made based on overly optimistic (and in some cases unrealistic) expectations that the property’s revenue or value would increase in a very finite period of time. The third category of default has been more directly related to the economy at large where properties have actually encountered adverse changes. A recent phenomenon is that there have been an increasing number of bankruptcies in the system with both national and regional retail chains and restaurant chains. Clearly those kinds of bankruptcies cause default issues at properties because in certain cases these are not insubstantial tenants and may actually be major tenants for the properties that are not easily replaced. That clearly is putting additional stress on some retail properties, particularly those that were financed in recent years where the margin for error is significantly less due to low debt service coverage ratios and high loan to value ratios at origination. But it is worth noting that despite all of the negative news that is currently coming out regarding real estate in general and the securitized lending market in particular, the default rate for every type of commercial loan (e.g., CMBS, life companies, etc.), is near historical lows. In fact, the current delinquency rate on CMBS loans is around 0.5%, which is very close to its all-time low of approximately 0.25% (which low was set about a year ago). That being said, delinquency rates have been trending upwards for CMBS loans (from about 0.25% a year ago to about 0.5% today) and one would anticipate that if the credit markets continue to contract and the general economy continues to suffer that this trend will intensify.
Many of the loan structures that were being utilized for larger loans became increasingly complicated over the last few years. What problems have you encountered in workouts involving these types of loans?
A common feature of some of the very large loans (i.e., typically loans in excess of $100,000,000) that were originated over the last few years is very complicated capital stacks. There was a general belief with many of these large loans that given the nature of the underlying properties (which tended to be “trophy” type properties or properties with significant credit support built into the underlying tenant base) that the likelihood of there ever being any kind of issue regarding payment or repayment was virtually non-existent. However, the credit crisis has adversely affected all property types and this has put stress on these structures as well. For example, a large loan may have an “A note” (which is typically placed in a pool of securitized loans) that is so large that it may actually been broken up into two, three, or four pieces and it will be in a number of different securitizations. There is a also a “B Note” representing a portion of that same loan, which may not actually be held in a securitized pool, that is pari passu with the “A note” (meaning it is supposed to get paid along with the A portion for only so long as there aren’t defaults or other situations that arise that would cause the B note to get cut off under the co-lender agreement). Often the co-lender agreement gives the B note holder the right to cure the default or even purchase the senior loan. So if the loan goes into default and the B note is cut off, the holder of the B note has some tough decisions on whether exercising these remedies is a smart economic decision (the proverbial throwing good money after bad money). Another complication that has arisen in workout scenarios for larger loans is mezzanine debt (or “mezz debt”), which is essentially a second junior loan on the property where the collateral for the loan is not the underlying real property, but is an interest in the ownership structure of the borrowing entity, either directly or indirectly. In those cases, there will be fairly complicated inter-creditor agreements that will determine who has consent rights or cure rights under certain circumstances. One of the features may be elaborate appraisal control provisions which basically entail an appraisal of the property and if the appraisal indicates property value at a certain level, then control may shift to another party in that capital stack who will have the ability to dictate what kind of actions will be taken in the event of a default or in response to a borrower request for relief. What happens in these times of economic stress is that these structures are actually being tested and implemented, and obviously the junior lender getting squeezed out of the decision-making process is usually not very happy about their new position. So, once again, it becomes a question for that junior lender of what steps they should take (basically, how much additional money should they commit to the transaction) to maintain or improve their position in the capital stack or even take over the project.