A new rule recently announced by the Internal Revenue Service (IRS) could have a big impact on stemming the tide of CMBS defaults.
The regulation, Revenue Procedure-2009-45, allows servicers to modify and restructure securitized loans before they slip into default, all without incurring severe tax penalties. With the new IRS rule, servicers can now extend and modify loans in much the same way that balance-sheet lenders have been doing throughout the credit crisis.
“Now the CMBS world gets to do what a lot of the banking world is doing, which is extend and amend,” says Charles Krawitz, a senior loan sales asset manager at Cincinnati-based Fifth Third Bank, who previously led the small loan securitization programs at KeyBank. “It’s a good idea for the market as a whole.”
What's more, in the past, modifications of current performing CMBS loans triggered severe tax penalties on real estate mortgage investment conduits and investment trusts. The borrower could only negotiate a modification once the loan went into default and was transferred to a special servicer. But that was a catch-22: By waiting until default, it was already too late to really work anything out. That problem is now addressed.
The issue of CMBS maturities has loomed like a dark cloud over the multifamily finance industry throughout the recession. CMBS defaults across all property types are about 3.04 percent, and the multifamily industry itself is seeing defaults of around 5.4 percent, according to Fitch. In August, that figure grew significantly, thanks to a $195.1 million default on a Babcock and Brown portfolio loan. Most industry observers say the problems at Stuyvesant Town/Peter Cooper Village will likely push the multifamily delinquency rate above 6 percent this year.
While CMBS borrowers will benefit from the new regulation, some in the industry are concerned about the unintended consequences of the new rule. Part of the reason investors are attracted to CMBS is a certainty of returns, but they may be less inclined to invest now if the cash flows and duration of the loans underlying the bonds could be modified at any time.
The new rules are giving investors pause on new issuances, just as some new CMBS deals are prepping to come to market in the winter through the government’s TALF program. “There are a couple of deals out there trying to get off the ground, and this may cause some of the potential bond investors to be leery of putting out their money now,” Krawitz says. “They thought they knew the rules of the game, and suddenly the rules have changed.”
Part of the problem in unwinding CMBS loans is the different interests of all the constituents. The senior class investors (those who hold the “A” notes) would prefer for the collateral underlying the bond to be liquidated so they could get paid off, while junior class investors (those with “B” notes) may not get any proceeds from a liquidation, and therefore would prefer a modification.
There must be a compelling reason for the servicer to modify the loan—they are under a fiduciary obligation to act in the best interests of the bondholders, after all. So the most aggressively underwritten, nonperforming loans won’t find refuge under this new rule. But the good news is, borrowers with low-leverage loans who can’t find refinancing capital due to the lack of liquidity on the market can now pick up the phone and start the process of amending and extending.
The change applies to all modifications made after Jan. 1, 2008.