It's 2006. A well-located, quality property is on the market andattracts a plethora of qualified bidders. It ultimately trades fora very high price, thanks to the abundance of debt capital in themarket. The buyer takes control, hoping to up the property's valueeven further by increasing rental rates over the next fewyears.

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But three years later, the economy has taken a nosedive and therent roll hasn't increased as much as anticipated. What's more, thefinancial markets have done a complete ISO, and it's impossible tofind new financing or to sell the asset. Backed into a corner, thebuyer ultimately defaults on the loan and gives up control of theproperty.

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The story could be that of any number of deals that closedduring the market peak of2006 to 2007. It just so happens that thisis the story of the largest property acquisition in history. It mayalso be a harbinger of what we can expect to see in the coming fewyears.

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How We Got Here

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By now the tale of the failed Stuyvesant Town/Peter CooperVillage deal is well known: Bought at the height of the market in2006 by a JV of Tishman Speyer and BlackRock Realty, the1l0-building, 11,200-plus-unit residential property is one ofManhattan's premier residential complexes. Tishman paid $5.4billion for the SO-acre asset, thanks to $3 billion in CMBSfinancing and $1.4 billion in mezzanine debt, with the balance madeup of equity from the JV and other investors.

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Upon taking control of the property, the new owners embarked ontheir plan to increase its cash flow by bringing somerent-stabilized units-comprising about 73% of the complex'sunits-to market rate through rollovers and the eviction of illegaltenants. The JV intended to spend about $125 million, or $11,300per unit, for capital improvements over the next three years. Butthe rollover and renovation process went slower than had beenexpected, due in part to legal snags as well as general economicconditions. As of the third quarter of2009, average monthly rentsper unit at Stuy- Town were $2,021, by comparison, average marketrents for New York City apartment units were significantly higher,at $3,491 per month in Q3.

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As a result, the property's cash flow remained lower than whatthe buyers had hoped-at least, too low to cover debt serviceobligations. By year-end 2009, the Tishman- BlackRock JV had notonly gone through its $400-million debt-service reserve but also anearly $200-million general reserve.

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What was to be the final blow came when the New York Stateappeals court ruled that the JV and its predecessors had improperlyderegulated and raised rents on thousands of units at the complex.Not only was the further conversion of more units halted, but thecourt also found that the tenants were due some $215 million inrent rebates.

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At this point, the $3-billion first mortgage on the property wasseverely underwater. The property, based on current rent rolls, wasnow widely valued at around $1.8 billion-a 67% decline from its2006 purchase price.

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In January, the Tishman-BlackRock JV said it would be handingthe keys to the complex back to the lenders after being unable tonegotiate a restructuring of its debt that would maintain itsownership. The ownership stake was also why Tishman bowed out ofmanaging the property, special servicer CWCapital has since hiredlocal firm Rose Associates.

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Calls made to CWCapital were not returned. BlackRock deferredcomments to Tishman, which would not comment beyond its Jan. 25joint statement announcing its intention to transfer control of thecomplex to its creditors.

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Observers generally concur that the Stuyvesant Town/Peter CooperVillage predicament is a result of market conditions at the peak ofthe cycle and a "perfect storm" of assumptions going awry. Andwhile its sheer size and the players involved give it a degree ofnotoriety, this transaction really isn't any different thanhundreds of others that took place during that period.

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The hyper-liquid credit market was much of what fueled investorappetite for the deal, asserts Woody Heller, executive managingdirector and head of the capital transactions group at Studley. Henotes that the players involved shouldn't be vilified for whattranspired. "If there was one group that bid $5.4 billion andeveryone else bid $3 billion-yes, then they'd be at fault. But youhad about 20 groups clamoring for this asset and were furious whenthey weren't the ones that were selected," he says. "Everyone wasprepared to make the same mistake, and desperate to make the samemistake."

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In the Jan. 25 statement, the partnership indicated thattransferring control was the "only viable alternative tobankruptcy" A property transfer also tends to be a lot easier andcost-effective than a time-intensive foreclosure for all partiesinvolved.

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Only that didn't happen. On Feb. 16, the lenders on the$3-billion first mortgage sought court approval to foreclose on theproperty and have it sold.

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According to sources, the property transfer hit a snag when thequestion arose over who would be responsible for nearly $100million in real estate transfer taxes. A foreclosure would avoidthe transfer tax and from the filing, it seems that the plaintiffsare hoping the proceeds of the sale would cover the legal costsinvolved with the proceeding, along with the other expenses.

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The tax issues that have emerged in the Stuy- Town transactionare not unique to this deal, in fact, it's among the first of manymore we will likely see, and will lead to changes in the way weapproach this business for years to come.

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"The tax implications in these situations are definitelyproblematic, as opposed to doing a quick, unopposed foreclosure,"says Edward A. Mermelstein, co-founder of Edward A. Mermelstein& Associates. "These are issues that no one has necessarilydealt with in the past 15 to 20 years. We're seeing a lot ofproposed legislation to address this because it's going to becomeincreasingly prevalent. With all of these underwater assets, we'regoing to have debt forgiveness issues popping up on a regularbasis."

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A Complicated Pie

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The Stuy-Town deal could serve as a poster child to the hundredsoflarge, complicated structured financings that were put togetherin the past several years. The deal includes a huge first mortgagethat was then securitized and mezzanine financing from severalsources, as well as equity stakes by a variety of investors. Withthe property valued at a fraction of its purchase price, it'sobvious that quite a few players will have lost money. The questionis, who will have taken the greatest hit when this all shakesout?

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Tishman and BlackRock, with their investors, each kicked about$112 million in equity into the deal. Other equity investors arethe California Public Employees' Retirement System (with a$500-million stake), the Florida State Board of Administration($250 million), the California State Teachers' Retirement System($100 million), and the Church of England ($70 million). Most ofthe investors have accepted their losses and written their stakesdown to zero.

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Meanwhile, the $3 billion in mortgage debt was split into fivenotes and pooled into larger transactions. CWCapital services theCMBS deals with the three largest pieces: a $250-million note inthe COBALT 2007-C2 deal, an $800-million piece of the ML-CFC 2007-5offering and a $1.5-billion note in the Wachovia 2007 -C30 deal (towhich the four other CMBS deals defer). LNR Partners services theother two deals- Wachovia 2007-C31 (a $247.7-million note) andML-CFC 2007-6 ($202.3 million).

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When the loan was transferred into special servicing inNovember, Fitch calculated the losses at about 40%, and theloan-to-value at 189.2%. When the debt was originated in 2006, theLTV on the first mortgage was 76.2%. Yet the ratings agency "doesnot anticipate any immediate rating actions following CWCapital'sforeclosure filing," according to Fitch senior director AdamFox.

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And then there are the mezzanine lenders, which provided a totalof $1.4 billion. In the $300-million senior tranche are HartfordLife Insurance Co. ($100 million), Deutsche Genossenschafts-Hypothekenbank ($100 million), Allied Irish Bank ($50 million) andWachovia ($50 million). The $1.1- billion junior tranche housesstill control issues within the CMBS stack. "With these CMBS deals,it's becoming increasingly difficult to determine who's gotcontrol, even if you go beyond the mezz and you get into the firstmortgage," says Bram. "If the CMBS first takes control, questionsare going to be raised as to who runs the first."

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At the same time, there have been reports that some real estateinvestors are looking into buying certain investment-grade tranchesof the Wachovia 2007-C30, the controlling piece of the debt stack.The one holding the controlling piece usually has a say in thespecial servicers actions and gets priority in bidding on the assetwhen it goes on the block.

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But for this strategy to work, "would be buyers will have topick accurately which of the multiple classes in the massive$7.9-billion deal will become the fulcrum," according to a reportfrom Debtwire. "Historically, controlling classes have always beenunrated junior tranches at the bottom of the structure but themassive losses caused by the collapse of the Stuyvesant deal pushedthe fulcrum up in the Wachovia 2007 -C30 deal."

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Before the walls came tumbling down, the controlling class inthe CMBS deal was an affiliate of CWCapital, which also serves asspecial servicer. The new controlling class, if any, will bedetermined once the property-and, subsequently, the loan-isreappraised, and it's likely it will be at some point thisyear.

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The most senior CMBS tranche, meanwhile, would get paid aboveall others. In the case of the Stuy Town transaction, that trancheincludes Fannie Mae and Freddie Mac, which together hold more than$2 billion in Stuy-Town securities. Their senior debt positiongives them little to no say in what's done to the asset. But anultimate sale may increase the GSEs' stake in the property, sinceit's likely that the buyer in the deal will obtain agencyfinancing. (The GSEs held $359 billion, or 39% of all outstandingmultifamily debt, at the end of 2009, according to the MortgageBankers Association. )

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That aside, a number of entities, most of them major names inthe industry, have been circling the Stuy- Town deal since signs oftrouble started emerging several months ago. Even after theforeclosure filing, the most visible parties- Wilbur Ross of theRelated Cos. and the Lefrak Organization's Richard Lefrak-told theNew York Post that they are still interested in buying the complex.A group comprised of Stuy-Town tenants-which placed a losing bid inthe 2006 sale-also indicated their interest in acquiring theproperty.

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One in a Line of Many

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There are observers who believe what happens in the Stuy-Towndeal is a large-scale illustration of what's occurring on deals allover the country, since this obviously isn't the only bigtransaction that was split up and put into several CMBS pools. Itwas, after all, the CMBS market that fueled the frenzied credit andinvestment conditions of the investment arena.

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A simple look at CMBS volume will tell the story of thecommercial property financing market, relates Jeffrey Rogers,president and COO of Integra Realty Resources Inc. When thingsstarted to heat up in 2005, there was $169 billion in CMBS deals,up from $93 billion in 2004. In 2006, it jumped to $203 billion,and in 2007, it jumped to a record $230 billion. "Any deals doneduring that period are probably underwater at this point," hestates.

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Meanwhile, CMBS investors will likely look at the fallout fromthe Stuy- Town situation as an indication of what could happen inupcoming securitized deals. The result could have severeconsequences for the future of the securities market. Sam Chandan,global chief economist and executive vice president of Real CapitalAnalytics, says that a default the magnitude of Stuy- Town "hasimplications for a broader class of investors' perceptions of riskin holding CMBS exposure. As a result, it has a potentiallychilling effect on current efforts to reignite securitizationactivity and liquidity in secondary markets."

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Some investors will view the default as "a result of systemicissues in the CMBS market that have yet to be properly addressedand not an asset-specific issue," he relates, adding that whileanother huge default may not be looming, "there is a very largepool of securitized mortgages outstanding that has been subjectedto far less scrutiny."

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Securitized or not, a whopping $14.4 billion in properties fellinto default in December alone, and just a few weeks into January,another $4.6 billion in assets defaulted, reports RCA. As of Feb.3, the level of distressed commercial real estate reached $184.1billion.

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Many of those deals took place during the height of the market,from 2005 to 2007. Some of the biggest trades that took placeduring that period are now considered "in trouble" by RCAanalysts:

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The Four Seasons Resort in Irving, TX was put up for auction inFebruary after the owner, Bentley Forbes Group, missed a payment onthe $ 183-million CMBS loan and the servicer didn't agree with itsplan to pump more money into the resort.

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The Renaissance Mayflower, a 660-unit hotel in Washington, DC,entered special servicing in January after the owner, RockwoodCapital, asked servicer Midland Loan Services to rework the termsof the $200- million CMBS first mortgage.

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Trilogy, a 1,095-unit multifamily property in Wyncote, PA, waspicked up by Fairfield Residential in 2007 for $154 million. The$137.5-million CMBS first mortgage matures this July, but theborrower is currently delinquent or in default on the loan.

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The former Robinsons- May Department Store, a329,749-square-foot vacant mall in Beverly Hills, CA, is to go onthe auction block after United Kingdom based CPC Group defaulted onits loan. Lender Credit Suisse had sold the $356.5-million loan tomany banks, and Banco Inbursa holds the highest stake. It refusedto foreclose on the property, demanding that CPC pay $22.6 millionas well as legal fees for breaching its "carrying costs agreement."Now in foreclosure and to be sold in auction, the asset is now inthe hands of Chicago Title Co.

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Algonquin Commons in Algonquin, IL was transferred to specialservicing last year. The owners, a JV of Inland Real Estate Corp.,Morgan Stanley and the NY State Teachers Retirement fund, paid $154million for the 565,000-square-foot power center, which iscurrently in receivership with a $72.6-million outstandingbalance.

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And that's just a few of the largest deals, the distressed poolis filled with hundreds of smaller ones, and that pool is growingas the default/delinquency rate rises. As of the third quarter,4.06% of CMBS loans and 3.43% of debt held by banks and thrifts wasdelinquent or worse, according to the Mortgage BankersAssociation.

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Of the $1.45 trillion in outstanding commercial and multifamilydebt tracked by the MBA, $183.9 billion will reach maturity thisyear and $99.8 billion will mature in 2011. Those, along withbillions more in 2012 through 2017, will need to be refinanced.Given the tighter conditions of the debt market, there's a goodpossibility that many borrowers won't find new sources ofcapital.

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On top of that, there are billions of dollars worth of dealsthat have been extended or worked out, that is, transactions thatwould likely have defaulted or gone delinquent if the lender hadn'tworked out a short-term solution with the borrower. RCA notes that$27.5 billion of the total current distress in the market has beenrestructured or modified. There's still a chance those loans willturn sour in another few years.

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Until recently, many lenders have been open to restructuring orextending loans because they were wary of taking the losses. Thiswhole extend-and-pretend trend kept many defaults at bay and keptdistressed transactions to near-nil levels until late last year.Indeed, just 10.8% of all the sales that closed last year involveddistressed situations, says RCA.

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"There are some large, looming defaults out there, and theproperties under special service watch are mushrooming at a levelthat most people don't understand because it's been happening soquickly over the past year," notes Mermelstein.

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But now that banks are somewhat healthier and they have a betterunderstanding of the market, it's likely we'll see more distressedofferings. "There's a tidal wave of debt that's coming due, and noone knows how these owners are going to dig themselves out," saysAnton. "The assumptions that were used to finance real estate twoto four years ago are now proving to be all wrong. Those chickensare coming home to roost." While all of that may spell bad news forproperty owners, it's certainly good news to all those distressedinvestors who have patiently been waiting on the sidelines for dealflow to increase. That, in a nutshell, "is the creative destructionof capitalism," says Anton.


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