Hotel Attorneys and CMBS special servicers look to have a big (and free!) part of the solution to the liquidity crisis, depressed real estate, and hotel values as well as a better way to dispose of toxic assets. Is Geithner listening?
Last week I had a conversation with one of the country's top CMBS special loan servicers, who happens to also be a friend as well as a good client. We were talking about dealing with some of his company's increasing volume of assets under "special servicing" and the difficulties presented by REMIC regulations.
Naturally, as a leader in the industry, he is involved at the highest levels of discussions with executive and legislative branches of government, dealing with The U.S. Treasury Department, the IRS, and Congressional leaders on how to clean up the mess and solve the financial crisis, including the REMIC issues presenting hurdles to commercial loan servicers.
A little bit later, Commercial Mortgage Insight issued two articles publicly indicating significant progress on exactly the issues my friend was talking about. This could be imminent, exciting, and very productive. It truly could represent significant progress toward cleaning up the current financial mess, by mitigating some of the downward pressure on asset valuations, eliminating a lot of all-cash fire sales, and restoring liquidity in the marketplace.
And best of all, this solution will not cost taxpayers a nickel. We just have to remove some artificial restrictions crafted in a bygone era that no longer serve a purpose. In fact, the current applicable regulations create the problem that Jim Butler and Jeff Steiner talked about a number of years ago in their article entitled to "New Rules of Engagement for Workouts: REMICs and Distressed Real Estate Loans."
Hotel Attorneys: Easy fixes for a damaged CMBS model restoring liquidity to the markets and avoiding fire sale liquidations. No cost to taxpayers! By Jim Butler, Jeff Steiner, Guy Maisnik and David Sudeck, Hotel Lawyers
Why is the CMBS market important to any solution to the global financial crisis?
First, one must acknowledge how important the CMBS market was for real estate financing before the "crash." Some of the loans were big. Some of the loans were small. But the so-called CMBS market was the octopus that swallowed New York. It was providing almost $300 billion per year of financing for all classes of commercial real estate including hotels, office buildings, shopping centers, and every other kind of income property.
In certain market segments and after its inception in 1992, CMBS lending dominated as a financing source, where insurance companies, commercial banks, and pension funds had once been the primary source of loans. However, the CMBS market collapsed in the Fall of 2007, and it is now dormant. Unless things change, the lack of CMBS financing will continue to present a huge problem for trillions of dollars of commercial real estate loans that were securitized, with bullet maturities approaching, no replacement financing, and very onerous rules governing the handling of defaulted loans. This parade of horribles is encouraging or forcing real estate owners to engage in fire sale dispositions.
What's the problem with CMBS special servicing of troubled real estate and hotel loans?
What's the problem? The problem is the set of very technical rules buried in the Internal Revenue Code (IRC). These rules, discussed at length in the Butler-Steiner article ("New Rules of Engagement for Workouts: REMICs and Distressed Real Estate Loans"), are restrictive in certain critical areas. The entities holding the loans are typically trusts that qualify as Real Estate Mortgage Investment Conduits (REMICs). The benefit of REMIC status is the pass-through of income for tax purposes. To qualify as a REMIC, an entity must satisfy and remain in compliance with numerous technical rules in the IRC, and a few of these rules create huge problems in the current environment. These restrictions include a prohibition on issuing any new debt, limitations on the types and circumstances in which loan modifications may be made, and a prohibition on engaging in an active trade or business, such that all income must be "passive" in nature.
How can that affect you? These seemingly harmless technical provisions greatly limit a CMBS special servicer's ability to refinance or significantly modify troubled loans, act aggressively to take possession and cleanup troubled assets, hold troubled assets until the markets improve, or issue any new debt to either existing borrowers or potential purchasers of these troubled assets.
How do these technical rules affect lenders and borrowers of troubled commercial real estate loans today?
What does this mean in the real world? These limitations mean a CMBS lender cannot act like your friendly local bank or life insurance company did 10 or 15 years ago. They can't just sit down and renegotiate a loan on terms that makes sense in the current environment. A substantial modification of the existing loan that is in good standing at the time it is revised may constitute a "new" loan, and remember, REMICs are restricted from issuing new loans. A REMIC also cannot provide additional funding to a borrower, even when it makes financial sense to provide such additional funding (e.g., to retain an existing and valuable hotel brand, to jumpstart market demand, or to undertake much-needed life and safety repairs) because that would qualify as a new loan. Finally, a REMIC may not take possession of a property and actively manage or improve it, because that would be an active trade or business.
Translated and oversimplified, this means that REMIC lenders have limited options to work with troubled owners before the problem has become serious.
CMBS solution actually in the works with The Treasury, IRS and Congress?
A roundtable of CMBS lenders and other experts are working with the federal government at the highest levels to solve these problems. All it will take is a change in the tax provisions governing REMICs. Maybe there was a purpose in these arcane restrictions when they were adopted, but it is hard to imagine a valid purpose today.
What can the government do? Just let CMBS lenders act more like your local bank. Let them make workouts and restructurings in any way that makes sense. Let them renegotiate a deal with a borrower when that is the right solution, or foreclose and take possession when it's not. Let them hold assets until the market returns to normalcy without a time restriction and let them actively manage their assets in their existing portfolios. Let them provide new financing to existing borrowers or to facilitate purchases by new borrowers with additional capital. Just apply some reasonable lending guidelines.
Is there hope for a quick and effective solution?
Of course, all of this is a bit of a simplification. The tax rules are inextricably tied to CMBS loans, but there are also the lengthy and complex agreements in place with all the various participants in the loan, such as the borrower, the master servicer, the trustee, the special servicer, and even the bondholders in multiple tranches. Some things can be accomplished more easily. Some will be more complex. But this is truly a rational solution and long overdue, and it won't cost the taxpayers a nickel. It just removes some very technical and unnecessary restrictions that are a huge part of the problem in today's environment.
This is Jim Butler, author of www.HotelLawBlog.com and hotel lawyer, signing off. We've done more than $50 billion of hotel transactions and more than 100 hotel mixed-used deals in the last 5 years alone. Who's your hotel lawyer?
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