With defaults in commercial mortgage-backed securities expected to hit 11 % by year's end, CMBS special servicers are inundated with requests for modifications, extensions and discounted payoffs. Whether loans are in distress due to the market downturn or the reduced refinancing options caused by new underwriting guidelines, the maze of special servicing directives is difficult to maneuver because all special servicers have their own particular procedures and objectives for handling distressed loans. In many instances, in fact, the special servicer may actually not be the directing certificate holder.

But we have come to find one consistent trend: generally, the special servicer needs to do what's in the best interest of the trust or bondholders within the REMIC. It's important, therefore, that borrowers understand this when they begin the modification process.

We're actively involved with CMBS modifications, discounted payoffs and extensions, and we have come to understand two significant requirements: borrowers need to operate in good faith, and special servicers need to look for short-term solutions that have long-term benefits.

For example, we assisted a borrower with a modification request to a CMBS loan against a class B-plus office building in a submarket with more than 30% vacancy. With 50% vacancy in the property, the asset was operating at a negative $45,000 monthly cash flow after debt service. While the borrower never missed a payment, he helplessly watched rents fall $11 per foot in less than two years. This borrower paid $24 million

for the property in late 2005 and was looking to refill the many small suites. Based on supporting market data, the asset's value had deteriorated to roughly $8 million. With no sign of improvement in the office market, the borrower's investors couldn't afford

to feed the asset indefinitely without defaulting. Therefore, they requested the property be transferred to special servicing. After 30 days and their own internal analysis, the master servicer agreed and approved the transfer to the special servicer.

After the appraisal and broker opinion of value came back, the special servicer decided that it was in the best interest of the trust to get a pay down by the borrower and have additional escrows ($1 million total) put up by the borrower versus having the loan default. In return for the $1 million from the borrower, the servicer reduced the loan by $3 million to $10.5 million (still $2.5 million above liquidation value, leaving the trust in a better position versus foreclosing).

For borrowers, a few tips:

Have cash and be willing to leave the lender in better shape than it would be if it foreclosed. The servicer as well as the certificate holder must agree that a modification is their best option to do what's best for the trust.
Understand the loan covenants and documents to ensure there have been no violations. Any violations create an adverse relationship with the special servicer. For example, some consider strategic defaults a means of getting the lender to work with borrowers. I do not recommend that approach since failing to send in your net cash flow each month is a carve-out violation. You can expect that special servicers in some cases will immediately move toward putting in a court-appointed receiver and begin foreclosure proceedings if a borrower does this. CMBS loan modifications take months to accomplish, are not always successful, involve fees and expenses and must leave the lender in better shape than the alternatives. Success as an intermediary between the special servicer and the borrower is not much different than the role we fill in originating new loans, it just takes longer and requires more parties. And if that is not enough, due to these factors, the eventual outcome is often less predictable.

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CMBS Modifications, From Start to Finish

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