Special servicers: The back-office power brokers of commercial real estate

They are based far from Wall Street — Overland Park, Kan., Irving, Tex., Horsham, Pa. — and despite their expertise in commercial real estate, they drew little attention during the industry’s boom years.

They are special service firms, experts in managing troubled commercial real estate loans. And like pawnbrokers, shoe repair shops and bankruptcy lawyers, they saw their fortunes rise during the recession. Thousands of loans for office parks, shopping malls and apartment complexes across the country have fallen into default and piled onto the servicers’ desks, and they are now determining the fate of billions of dollars of bad real estate bets made before the crash.

How the servicers handle these loans will help steer the fate of the real estate industry and the national economy, not to mention the investors and borrowers who are still unwinding from the sticky situations they found themselves in after borrowing big during the boom years.

Take Beacon Capital, a private Boston firm that by spring 2010 was in trouble.

Beacon had bought 20 premium office properties in the Seattle and D.C. areas in 2007 for $6.35 billion. But like many firms during the boom, Beacon borrowed heavily to buy the portfolio, and after the crash, ratings agencies declared that a $2.7 billion loan Beacon took out on the properties was underwater and distressed.

Beacon’s lenders transferred the loan to a servicer to determine whether it should be salvaged or sent to foreclosure — much like thousands of other loans. About $90 billion in U.S. commercial real estate loans are now in the hands of a dozen or so special servicers. And with buyers still falling behind on loan payments, many of the top servicers have become the darlings of some of the country’s savviest investors.

With so many billions of dollars in loans under their management, however, there is growing scrutiny of servicers, including speculation about whether they are really doing what is best for the lenders they represent. Regulators including the Internal Revenue Service, the Treasury Department and Congress have paid increased attention to servicers’ operations. Some top firms are now owned by companies that also are buyers and owners of real estate, raising the prospect of a conflict of interest. And thousands of loans remain in a sort of purgatory, stalled between foreclosure and repayment.

A glut of debt

The delinquency rate for securitized commercial real estate loans — or the portion of loans for which payments are at least 30 days overdue — reached 9.7 percent in April, the highest level on record, according to the research firm Trepp. Many borrowers have slowed or stopped their payments. They hold on in the hope — given the long and ongoing period of low interest rates — that lenders will agree to more favorable terms or that property values will improve.

The Federal Deposit Insurance Corp. began advocating for “prudent commercial real estate loan workouts” more than a year ago, in effect suggesting that bankers accept the fact that many of their real estate loans would never be fully repaid and agree to more lenient terms with their borrowers.

It’s somewhat like what the government encouraged banks to offer homeowners who were underwater: enough of a break to prevent foreclosures, allow transactions to continue and minimize losses for banks — and allowing the economy to start churning again.

Enter the special servicers. While many construction, development and real estate investment firms began shedding jobs en masse after the crash, servicers found themselves woefully understaffed for the volume of bad loans that flooded in. One top-grossing firm, C-III Capital Partners, manages more than $14 billion in outstanding loan balances, up from about $1 billion a few years ago.

“We’re really busy. We’re very active. We’re just generating lots of business right now,” said Brian Hanson, managing director at CW Financial Services, which had the country’s second-largest special-servicing business as of the beginning of the year.

Hanson said CW is actively servicing more than 1,200 loans worth more than $23 billion.

When they are assigned to manage a loan that is delinquent or potentially in trouble, servicers typically start down two paths simultaneously: one toward foreclosure and another toward a loan modification that would allow the borrower to remain the owner.

Hanson said the company has been considering more loan modifications — or “workouts” — in recent months as property values in some markets have stabilized and more borrowers come up with cash to shore up their positions.

“It seems like there’s a little bit better opportunity to do workouts in this market,” Hanson said. “Property owners may be seeing more light at the end of the tunnel, perhaps, or there is more of a chance of them contributing more capital.”

But nearly three years after Lehman Brothers went into bankruptcy, the majority of distressed real estate loans remain in limbo. Of almost $350 billion of the commercial real estate debt that has become distressed since the recession, only about half has reached a resolution, according to Real Capital Analytics, a research firm.

David Kahn, a partner in the Washington office and the real estate practice of Holland & Knight, is among those who wonder why a resilient market such as Washington’s hasn’t seen more workouts.

“Despite all the hearsay talk about the workouts that are going on,” Kahn said, “we have not seen many of them that have reached the finish line.”

A niche field takes off

So why haven’t there been more workouts?

First, there’s a reason servicing is such a niche field — it isn’t as simple as just getting a lender and a borrower to sit down and agree on a new deal. Major purchases during the go-go years of real estate were bundled and securitized as bonds. Investors of all kinds bought different slices of the same loans, and a workout that might make sense for one could wipe others out of the deal completely.

“The most senior bondholders have a certain investment strategy in mind, and the same thing with the junior bondholders,” Hanson said. “And they may be the same and they may not. But if there is a change in strategy that would affect all of the bondholders, it is easy to see how there could be a dispute between bondholders.”

Second, the servicers required some time to identify and hire staff capable of negotiating these complex deals, often between major financial institutions.

“It took a while for special servicers to sort of get the machine going,” said Manus Clancy, senior managing director of Trepp. “A lot of them weren’t adequately staffed for this level of business until last summer.”

The third possible reason is a blockbuster: Servicers might not be actingin good faith to facilitate workouts, according to industry sources, so the servicers themselves — armed with information about the properties and the loans — can scoop up real estate on the cheap, according to industry sources. Although they are bound by the contracts governing each loan they service, in most cases servicers also have an option to buy properties they help liquidate.

This theory is given ammunition by the entrance of high-profile investors into the special-servicing field since the recession. Four of the top five largest servicers in the country have been acquired since late 2009, when Warren Buffett’s Berkshire Hathaway formed a partnership that bought Capmark Financial Group.

Not six months later, another big-name investor, Andrew Farkas, made his own splash when his Island Capital Group bought Centerline, one of the country’s leading servicers and the company that was handling Beacon Capital’s Seattle and D.C. portfolios. Centerline was renamed C-III Capital Partners, and Farkas moved to strengthen C-III by agreeing to purchase another services firm, NAI Global, last month.

Two more deals came in the second half of last year. A combination of firms led by New York’s Vornado Realty Trust, a firm with major holdings in the Washington area, acquired a major stake in LNR Property of Miami, and Fortress Investment Group, a New York private-equity firm, bought CW Financial Services.

Some of the deals stoked speculation that these new owners might be interested in a lot more than fees from service work.

“I think there’s absolutely incentive on the part of some of the buyers of these pieces to be in a position to get a hold of some of these properties,” said Steve Miller, director of U.S. debt and risk research for CoStar Group, a real estate data firm.

But Miller cautioned that the servicers’ position is valuable only if the properties can be had at an attractive price.

“They bought an option to acquire properties,” he said. “If the market clearing level is pretty low, that’s worth something. If the market clearing level is rich for their blood, their option is useless.”

Said Trepp’s Clancy: “It’s very interesting. We haven’t really reconciled how they could do that easily. These special servicers have a fiduciary responsibility to maximize the recovery to bondholders, [so] you would be hard pressed to do that under the responsibilities that the servicers have. I certainly wouldn’t expect a press release if it were happening.”

Indeed when two titans of commercial real estate, Sam Zell and Steve Roth, chairman of Vornado, took the stage at the Warner Theater in March as guests of a local Realtors group, Zell suggested that Roth had bought into LNR to acquire that option to buy properties the company was servicing.

Roth replied that, no, he had made the purchase for “insight” into the securitized mortgage market. Then he chuckled and asked, “Is the press in the room?”

Vornado declined further comment.

Strict legal guidelines

As it happened, Beacon and its borrowers, working with special servicer C-III, did come to terms on a loan modification that required the company to put up $200 million initially but gave it a five-year extension. Beacon then turned around and sold Market Square, at 701 and 801 Pennsylvania Ave. NW, for $615 million, or $904 per square foot, a record for Washington real estate.

Beacon’s president, Fred Seigel, said his experience was better than he had expected.

“The general perception was they’re overwhelmed in terms of the volume of loans flowing into special servicing, you won’t be able to get their attention, they’re difficult to deal with,” he said. “I think if you have any experience with them, that perception has really been dispelled.”

Servicing executives say their business operates under strict legal guidelines and couldn’t easily be manipulated.

“The role of the special servicer is defined in the underlying documents,” said Bob Lieber, executive managing director of Farkas’s Island Capital Group, owner of C-III. “Our job is to maximize the recovery to bondholders as a whole in the trusts we service. There are many different parties and perspectives represented in this equation, often with different or competing economic interests, but our job as special servicer is clear, and that’s what we will do.”

Hanson, of CW Financial Services, said servicers were obligated to meet their contractual responsibilities.

“I think the contracts are pretty clear in what the special servicers are required to do,” he said. “You have to follow the rules and follow what’s best for the bondholders.”

Another special servicer, Stacey Berger, executive vice president at Midland Loan Services, a division of PNC Bank, said he believed the proper controls were in place. But he didn’t doubt that the motivation exists for some who have moved into the servicing business to go after a piece of the properties in their portfolios.

“I would think that it would be a very dangerous business strategy to try to act in your best interests to the detriment of very interested and assertive senior investors,” he said. “That’s not to say that people couldn’t do it.”

Jonathan O'Connell has covered land use and development in the Washington area for more than five years.
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