Tax Changes Should Give Many Borrowers More Flexibility in Working With Lenders, But Those Already Drowning In Debt May Be Out of Luck
The Internal Revenue Service last week issued eagerly awaited new guidelines that allow certain commercial mortgage borrowers to modify and restructure their securitized loans without triggering massive tax penalties. The new rules allow servicers to intervene before it's too late and the borrower is facing loan default and foreclosure.
Previously, property owners holding performing loans who were up to date on paying their mortgage -- but still needed to refinance in the face of declining rents and rising vacancies -- couldn't initiate loan restructuring or modification talks with lenders. Only those owners entering default or imminent threat of default could negotiate with servicers. Under the new rules in Revenue Procedure 2009-45 issued by the IRS and the Treasury last week, special servicers can at any time reduce the interest rate or extend the term of securitized loans held in real estate mortgage investment conduits (REMICs) and investment trusts. That flexibility allows borrowers with at-risk or distressed assets and onerous loan terms to ask for help earlier in the game. Download the IRS's Revenue Procedure 2009-45 (PDF)
REMICs are special-purpose investment vehicles used to pool mortgage loans and mortgage-backed securities. Securities or debt financings structured as REMIC trusts can be accounted for as a sale of assets and removed from an originating lender's balance sheet, exempting the trust from federal taxes. Under the old rules, modifying commercial loans after they were placed in a REMIC pool triggered a 100% tax penalty and potential loss of tax-exempt status. Fearing the worst, servicers would either not return borrowers' phone calls or advise them to call back after entering default.
The move drew applause from many in the industry, including Real Estate Roundtable President and CEO Jeffrey D. DeBoer, who lobbied Congress over the summer for the changes. DeBoer said that the IRS has taken "a very positive step toward easing today’s crushing liquidity crisis in commercial real estate."
"Amidst a massive wave of maturing commercial real estate debt, and still virtually no credit available for refinancing, borrowers need to be able to talk with their loan servicers about restructurings in a timely manner, before the point of default," DeBoer said.
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Govt: Trying To Unfreeze Credit Markets
The new REMIC rules are the latest moves in a larger federal effort to cope with a wave of commercial real estate mortgage defaults and foreclosures that analysts predict will cause additional bank failures and could hamper the economic recovery. According to Fed data, CMBS loans make up more than 25%, or $900 billion, of the $3.5 trillion in commercial real estate debt outstanding.
Moody's reported that the average delinquency rate in CMBS conduit and fusion loans was 3.23% in August, up more than 300 basis points from July 2007's 0.5%, and is likely to continue rising in coming months.
Another part of the government's emergency plan involves offering loans to investors to buy new and existing securities under the Term Asset-Backed Securities Loan Facility (TALF). The Federal Reserve Bank of New York reported that investors requested $1.4 billion in legacy CMBS loans last week, but no loans for new CMBS issuance.
The availability of cheap government loans in part fueled investor perceptions that troubled CMBS debt and other securities backed by real estate are undervalued. A number of investment firms, hedge funds and private-equity players have stepped forward with plans to launch initial public offerings for REITs buying distressed mortgage debt. Vulture appetite peaked in August when Starwood Property Trust, Inc., managed by investment star Barry Sternlicht, saw its IPO price jump 38%.
But analysts warned that the field was quickly getting too crowded and subsequent REIT IPOs haven't fared as well. This week, two major IPO pricings were delayed, and then slashed. The offerings by Colony Financial Inc. and Apollo Commercial Real Estate Finance, expected to raise a combined $900 million, priced at only about half that amount on Wednesday. Two other mortgage REITs, Foursquare Capital Corp. and Ladder Capital Realty Finance Inc., are scheduled to price within the next few days.
The IRS rule changes widen the definition of imminent default and extend the time frame that borrowers and servicers can negotiate loan modifications, said Eric Gunderson of Highland Advisor Partners, speaking at a client webcast by Marcus & Millichap on "Solutions for Maturing Loans and Underperforming Properties" last week.
"It's going to greatly increase the odds that the master [servicer] can transfer loans to the special servicer and modify the loans," Gunderson said.
Overleveraged Borrowers: Too Far Underwater
Some observers, however, argue that many distressed borrowers are too far gone to help. Property values continue to decline and analysts wonder if the REMIC changes are just another mechanism for lenders to postpone action on troubled loans. Banc of America Securities Merrill Lynch said in a commentary last week that the new guidelines won't help "loans that are deep underwater, and there are many of these."
Tino Korologos, distressed debt leader for Deloitte, argues that the changes are "potentially only a variation of the 'pretend and extend' position the industry has taken so far because values still have a long way to go."
"It doesn't address the problem of who will provide liquidity. It also could anger a lot of the senior investors, the AAA buyers, who will be the liquidity providers of CMBS 2.0 in the future," Korologos said.
Michael J. Rufkahr, an attorney in the Washington, D.C. office of Dechert LLP, wrote in a report to clients that "the rose from the IRS may have thorns."
The new regulations impose a requirement that the collateral value for a mortgage loan be retested. Thus, a modification that alters a substantial amount of the collateral or that changes the nature of the loan between recourse and nonrecourse can only go forward if the loan-to-value ratio holds up, Rufkahr wrote. All collateral supporting a loan, therefore, will have to be revalued and must remain sufficient to support the modified value of the loan.
CoStar Senior News Editor Mark Heschmeyer contributed to this report