Borrowers play chicken with lenders

<span style="font-style: italic;">Increasingly, commercial property owners skip payments to force loan modifications</span>

With dwindling cash reserves, some commercial real estate borrowers in New York have resorted to aggressive tactics, like withholding payments or paying late, to get their lenders to agree to modify loans.

It’s a game of chicken borrowers sometimes play with lenders, sources say, because as long as borrowers stay current, lenders are reluctant to modify their loans.

In addition, unless the loan is in imminent risk of default, loan officers and servicers of securitized loan pools often cannot change the terms of a mortgage.

“I see it happening in New York, and I see it happening nationally,” said Constantine Korologos, managing director at advisory firm Deloitte Financial Advisory Services. “A borrower says, ‘I have a train wreck approaching,’ and the [loan] servicer says, ‘Sorry, you are still current.'”

The property owner is therefore “forced to become a bad borrower to get the attention” of the loan servicer, he said.

The risk to the borrower, of course, is that once the loan is declared in default, the lender can step in to foreclose.

Despite early signs of a stabilization in the Manhattan office-leasing market, commercial property owners are faced with the prospect of further declines in value and depressed rents for several more years, analysts say. Many owners are therefore seeking to modify their loans now instead of losing the property after watching their bank accounts hit zero. The catch is that their lenders will not pay attention while payments are current.

Steven Holm, a real estate partner with the law firm of Levy Holm Pellegrino & Drath, said he knew of a borrower in New York City who had stopped payments to get the lender on notice. He declined to identify the company.

“They knew they were running into trouble,” Holm said. “These are people who are trying to be responsible, and who see where the market is heading.”

Most borrowers and lenders are reluctant to discuss the loan modification process, but Manhattan-based Millennium Properties says it defaulted on $90 million in loans in California to force the lender to negotiate a loan modification.

“In order to commence discussions with the debt holders of the Four Seasons Hotel in San Francisco, Millennium Partners has strategically withheld payment of debt service,” the company said in a statement. “Conversations on restructuring the debt have begun and Millennium Partners is hopeful that they will result in a positive outcome.”

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And as reported by The Real Deal, in Midtown Manhattan, private equity firm Five Mile Capital alleged in a lawsuit filed in July in New York State Supreme Court that the borrower on the former New York Times Building at 229 West 43rd Street created a situation that would lead to default, to trigger a restructuring of the loan.

The property owner, AFI USA, headed by embattled billionaire developer Lev Leviev, denied there was a manufactured default related to the valuation of the property, and won a recent interim ruling supporting its claim.

Meanwhile, real estate attorney Edward Mermelstein said that while he was not aware of owners paying late or withholding payments deliberately to trigger a default event, he said borrowers are sending letters to lenders announcing they are in distress as a way to spur negotiations with lenders. And banks are responding with loan modifications.

“You are seeing lenders be extremely creative, reducing principal, waiving interest, pushing the interest forward,” he said.

Creating a “default event,” an event that can prompt a default, is imperative for securitized loans under the rules governing real estate mortgage investment conduits, known as REMICs, which are used to create CMBS loans. In such loans, a default event must occur, or appear imminent, before the loan can legally be modified.

“I think this topic is another example of what people see as the structural deficiencies in how CMBS deals were set up,” said Jeff Temple, partner with law firm Morrison & Foerster.

In fact, the Washington-based trade association Real Estate Roundtable is lobbying Congress and the Obama administration for a loosening of restrictions, in order to facilitate negotiations between the borrowers and the CMBS servicers.

The danger of triggering a default event, said Alan Hoffman, a partner at Long Island-based accounting firm Janover Rubinroit, is that the borrower could lose the building.

“If they are in default, the loan can be called” and foreclosed on, he said.

Another concern for borrowers is an interest rate penalty hike, which can be as much as 5 percentage points higher for defaulted loans, said Dax Scharfstein, managing director and general counsel with the financial firm the Carlton Group.

Nonpayment as a negotiating tactic can also backfire, because special servicers do not want to be threatened, said Joseph Forte, past president of the Commercial Mortgage Securities Association, and a partner in the real estate and finance group at law firm Alston & Bird.

“Right away, the special servicer says, ‘We don’t trust you.’ It is not a [good] way to start the discussion,” Forte said.