(Illustration: Miami, Florida. Photo by Antonio Cuellar via Unsplash)
Introduction: Andrew Foster, CRE, Director of CMBS Oversight for KBRA, Dresher, Pa.
According to the Mortgage Bankers Association's Quarterly Commercial & Multifamily Mortgage Lending Survey, commercial and multifamily mortgage lending in the third quarter of 2023 was down 49% from 2018 and down 7% from the second quarter. Outlook for the full year 2023 won't be released for some time, but it was a declining year.
With the stalled commercial real estate transaction market on the minds of many, loan servicing and asset management professionals entered the new year with a new set of opportunities and challenges defined not by a surge in new lending, but by a predicted increase in the supply of troubled loans. While 2023 was marked by a series of interest rate hikes by the Federal Reserve, 2024 is sure to be marked by the continuing impact of the 2023 rate hikes and subsequent actions.
Kroll Bond Rating Agency's (KBRA) 2024 CMBS Sector Outlook outlines the industry trends: Commercial real estate continues to face interest rate headwinds. Borrowing costs remain high as the federal funds rate is at a 22-year high and is expected to remain elevated for the foreseeable future. However, real estate fundamentals across most property types, except office, remain positive to neutral, which will lead to increased origination volumes and CRE securitizations.
To understand trends in commercial/multifamily servicing and asset management, MBA Newslink interviewed executives from Mount Street, Freddie Mac, KBRA and Seyfarth Shaw LLP to discuss the key issues impacting servicing, including asset management challenges, CRE market stress, loan maturities, valuation issues and technology.
MBA Newslink: What asset management challenges is your team focused on?
Pamela Dent
Pamela Dent, vice president, asset management, Freddie Mac Multifamily: Freddie Mac works with partners to advance our mission, including our shared goal of promoting property and tenant safety. This effort has led to updates to several of our standards.
These updates underscore that, for Freddie Mac, a performing loan is not simply one that is not missing payments, but one that is secured by real estate that meets all contractual obligations, including being safe and sound for the tenants who live there.
Freddie Mac is working with stakeholders to ensure properties meet our requirements and has enhanced its property inspection protocols by implementing new standards for timely reporting, quality reporting and replacement reserves.
Specifically, Freddie Mac now requires that the most experienced inspectors be utilized for all properties with affordable mortgages and properties over 40 years old. If a HUD inspection exists, servicers must cross-check it with a Freddie Mac inspection in detail. Freddie Mac staff will randomly select average rated loans to inspect all properties rated below average or poor, as well as average rated loans. If repairs are overdue or if the inspection indicates below average or poor condition, collection of previously deferred replacement reserves will begin. If the quality of the inspection is poor due to under-reporting, incomplete information, or inaccuracies regarding early warning signs, servicers will be heavily penalized, additional requirements will be applied, and Freddie Mac will assess late fees. This is not an exhaustive list, but it represents some notable changes that will be in effect starting in January 2024.
MBA Newslink: Where in Mount Street's portfolio is experiencing CRE market stress?
Steve Luther
Steve Luther, executive director of special services at Mount Street: We are seeing distress across all sectors due to the impact of inflationary pressures. The majority of recent service transfers reflect growing distress linked to the ongoing disruption and disruption in the office sector. Landlords are still struggling with the unique challenges associated with return-to-office patterns, the impact of inflation on capital requirements, and the growing influence of both prospective and existing tenants in negotiating lease terms.
The confluence of these factors has had a very negative impact on values, leading to an increase in borrowers seeking to return collateral to noteholders under the terms of the agreement, particularly when the fact pattern involves older vintage buildings in the secondary market.
Newslink: What are some of the growth areas for your practice and how do you plan to support loan servicers with issues that may arise?
Katie Schwarting, partner, servicing and special services, Seyfarth Shaw LLP: At Seyfarth Shaw LLP, we are focused on growth in two areas of our practice. The first is asset management and special servicing, which is especially important in the commercial mortgage industry as the number of defaulted loans increases.
Katie Schwarting
We help our Special Servicing and Instructions Certificate Holder (B-Piece Investor) clients interpret the obligations and limitations of special servicers when working with borrowers on default matters. We help our Primary and Master Servicer clients identify potential loan defaults, understand the importance of clear communication with borrowers, and help servicers protect lenders' rights under the relevant borrower loan documents.
Second, we assist clients in interpreting and implementing new laws and regulations for their industry. Service providers are affected by anti-corruption laws in multiple jurisdictions, data privacy laws (including cybersecurity threats), a new corporate transparency law that takes effect in January 2024, and other regulations, including the Securities and Exchange Commission's new securitization conflict of interest rules.
We believe service providers are incredibly adaptable and service operations will continue to evolve and grow, and we see this as an area where we can assist our clients with valuable information on what's happening across the market and how service providers can respond.
MBA Newslink: From a ratings agency perspective, what are the hot topics currently impacting master servicers?
Gretel Braverman
Gretel Braverman, Senior Director of CMBS Oversight at KBRA: From KBRA's perspective, as a rating agency, we are particularly interested in servicing decisions that impact CMBS certificate holders and may also impact ratings. In an environment of high non-performing loan levels, our interest is heightened. These decisions include, but are not limited to, servicer prepayments, modification and extension terms, and disposition decisions. For example, a master servicer's decision to continue prepaying P&I payments or to make a decision that they are uncollectible has a direct and immediate impact on the cash flows available to distribute to the securities in the transaction. In an environment of uncertain or declining real estate values, this can be a difficult decision.
As values continue to decline post-pandemic, certain asset classes, particularly Class B office, may be subject to interest shortfalls that move up the capital stack if deemed unrecoverable. Because we consider timely payment of interest in our ratings, we may downgrade ratings on securities affected by shortfalls even if we believe full recovery is more likely than the rating would suggest. According to master servicers reviewed by KBRA, strategies for making loan lending decisions in stressed environments include more frequent communication with special servicers to better understand disposition plans and risks. Other servicers are employing sophisticated modeling to evaluate various recovery outcome scenarios.
Similarly, the terms of any modifications implemented by the special servicer may also affect our ratings. Even if the modifications do not change the expected recovery of the collateral, the terms of the modifications may affect our ratings if the modifications result in delays in timely interest payments or result in a WODRA. An example of this would be the deferral of a portion of the monthly interest payable by the borrower until the maturity of the loan. These deferrals would not be accelerated by the master servicer, resulting in an interest deficiency on the notes. To better understand how these decisions are made, KBRA typically includes discussions of various modifications and workout scenarios in its periodic meetings and reviews of CMBS master servicers and special servicers.
MBA Newslink: How do you view your maturing loan portfolio and do you expect this area to drive relocations this year?
Steve Reuther: We expect maturity defaults to continue to be a fundamental driver of servicing transfers in 2024. Additionally, historically, capital availability is expected to continue to decline in 2024. Borrower refinancing efforts will continue to be hampered by declining real estate values and new loan size will be reduced, requiring significant new capital contributions to repay loans on their scheduled maturities. Maturity defaults are of significant concern, and our loss mitigation efforts include aggressively increasing levels of monitoring across our servicing portfolio.
MBA Newslink: What are your expectations for special services relocation over the next few years?
Katie Schwarting: I believe the number of specially managed loans will continue to rise. While this first wave of loan defaults has been primarily due to maturity defaults, we are already beginning to see the effects of market softening in the office and retail sectors, which could lead to more specially managed loans due to payment defaults. I also believe that variable loans with shorter maturities will remain vulnerable to finding an exit strategy (either through refinancing or loan sales) upon maturity.
Special servicers are exploring modification and workout solutions that are creative but permissible under the relevant servicing agreements. For example, we are working with our servicers to consider proposals from various sponsors to recapitalize troubled assets, such as options for new equity investors, additional preferred stock, or restructuring layered or mezzanine debt on existing loans.
MBA Newslink: Technology is a perennial challenge. Looking ahead, what are some of the key technology initiatives for Freddie Mac Multifamily Asset Management?
Pamela Dent: We strive to adopt innovative technologies to speed up information collection and analysis to improve risk assessment. Key efforts are focused on streamlining data submission and use, as well as enhancing the information review process to enable faster and more efficient risk determination.
From an oversight perspective, our goal is to have faster, more immediate access to data. We are exploring ways to get property information sooner that is essential to quickly identify issues and risks. Indicators of potential issues with property conditions go beyond the property inspection itself. Examples include municipal violations, calls to 311, and other information from the broader environment. We are actively working on technology that will alert us if there are red flags at any of the 30,000+ properties we are involved with. Identifying these issues earlier allows us to more effectively mitigate risk and, more importantly, take steps to stabilize property conditions.
From the perspective of special services and borrower transactions, efficient organization of data allows us to spend less time consolidating information and more time analyzing borrower requests and managing ongoing situations. Our technology initiatives are designed to streamline operations and enhance our ability to manage risk effectively in a timely manner.
(The views expressed in this article do not necessarily reflect the policies of the Mortgage Bankers Association, nor do they imply that MBA endorses any particular company, product or service. MBA NewsLink welcomes your contributions. Please direct inquiries to Editor Michael Tucker or Editorial Manager Anneliese Mahoney.)