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CRE Finance World, Autumn 2013

A publication of Autumn issue 2013 sponsored by CRE Finance World Autumn 2013 29 #5 — Unintended Consequences Adverse loan resolutions can have unintended consequences for CMBS trusts. Not only do the realized losses invade the credit enhancement for senior bondholders, but loss severities in excess of 100%, as noted herein, divert cash flow from bondholders (through interest shortfalls) to recoup non-recoverable servicer advances. In particular, larger loan assets can have materially harmful impacts on senior CMBS bondholders when things go wrong. In the case of the Tri-County Mall Portfolio ($135 million — CSFB 2005-C2 – 91% loss severity), that represented 9.3% of the CMBS trust, the related losses extinguished the classes “B” through “G” of its trust. Similarly, in the Macon & Burlington Mall Portfolio ($131 million – WBCMT 2005-C20 – 97% loss severity), that represented nearly 4% of its CMBS trust, the related losses extinguished seven classes (“J” through “P”) and impacted the “H” class of its trust. Likewise, reimbursement of non-recoverable advances can create interest shortfalls, cutting off “money good” securities until the underlying loans amortize and the interest shortfalls are reimbursed out of principal cash flows (converting interest shortfalls into principal realized losses). Conclusion Despite a generally improving economy, CMBS delinquencies remain stubbornly high and loss severities are on the rise. Additionally, the most aggressively underwritten CMBS vintages of 2005–2007 are entering their maturity windows and more than $400 billion of CMBS loans contractually mature over the next four years. CMBS investors will need to carefully consider the characteristics of the underlying collateral for these vintage transactions to determine if extreme loss conditions exist that can invade trust classes previously thought impenetrable. Specifically, we note the following themes from our analysis of CMBS losses: • Cash Flow is King. Assets with cash flow dramatically outperform those without it. More important than in-place or underwritten cash flow, is the quality and volatility of the asset’s cash flow. As demonstrated by actual realized losses, assets with higher cash flow volatility experience greater loss severity. • Underwrite the Collateral and Conditions vs. Character. Since the majority of CMBS loans are non-recourse, ultimately, the trust’s recovery is limited to the asset quality of the collateral and the conditions of its marketplace. The expectation that a borrower, even a high-quality and highly-capitalized borrower, will throw good money after bad to support a non-performing loan, has proven to be false. Not surprisingly, among liquidated loans, higher quality assets in desirable markets suffered the lowest loss severities. • Not All Advances are Recoverable. Servicers need to be more vigilant in advancing funds to determine that such advances are not just recoverable but accretive to the asset recovery. As noted herein, extreme loss severities (beyond 100% of the loan amount), create unintended consequences for bondholders who become subject to interest shortfalls, or losses, to recoup otherwise non-recoverable servicer advances. In certain instances, like a borrower, it may be better for the trust to “walk away” from the asset rather than to support it. • Time Is Not Always an Ally. When loans go bad, they can go bad very quickly. Swift action, in hindsight, could have generated materially greater recoveries for the respective CMBS trusts, particularly for those assets that were not self-supporting, in the above examples. “Waiting and seeing” or “extending and pretending” can work, but often just preserves hope for a junior controlling holder who may no longer retain an economic interest on a spot basis. • The “Trickle Down” Effect. Extreme CMBS losses do not just impact “B-piece” buyers and junior certificate holders. As discussed, extreme losses, particularly for larger trust assets, can quickly and significantly impact even AAA holders through interest shortfalls and/or principal losses. The damaging effects of the financial crisis on the economy and on CMBS in particular, have opened up investors’ eyes to the breadth and width of what can go wrong in CMBS from an asset, servicing and structural perspective. Applying lessons learned from extreme CMBS losses will help eliminate unpleasant surprises when underwriting legacy transactions and also mitigate potential losses in future CMBS “3.0” transactions. As always, caveat emptor. Edward L. Shugrue III is the CEO of Talmage, LLC (“Talmage”). Talmage is an independently owned and operated commercial real estate investor, Special Servicer and advisor created in 2003. Since its formation, Talmage has made in excess of $10 billion of real estate debt investments and acted as the Special Servicer or advisor on over $40 billion of successful CMBS resolutions. Talmage is headquartered in New York City. www.talmagellc.com Losing More than Your Loan


CRE Finance World, Autumn 2013
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