Rising UCC foreclosures are “the tip of the iceberg”

Churchill Real Estate’s Justin Ehrlich has seen a lot during his time as a developer and lender in New York. He witnessed the collapse of the real estate market during the 2008 financial crisis, followed by the mad rush to build luxury condo towers in some of Manhattan’s swankiest neighborhoods.

But nothing compares to the past nine months, he said. “It’s not normal,”  Ehrlich noted. “It’s the worst I’ve ever seen.”

He pointed to an unusual rise in Uniform Commercial Code foreclosures by mezzanine lenders, which he sees as a canary in the coal mine for a mound of distress expected to hit the market in the next year. While judicial foreclosures are still banned under an emergency order by New York Gov. Andrew Cuomo, UCC foreclosures on some high-stakes projects have been moving ahead in recent months since they can bypass state courts.

With one of the roughest years on record coming to a close, many have been waiting for their moment to jump on distressed properties. Now, mezz lenders — which provide junior debt on real estate projects — are increasingly initiating UCC foreclosures on some major developments in need of “rescue funding.”

In August, for example, SL Green Realty filed a UCC foreclosure tied to a high-end retail property on Fifth Avenue owned by Joe Sitt’s Thor Equities. And most recently, CIM Group has been battling it out in court with Ziel Feldman’s HFZ Capital Group to auction off loans tied to several of the developer’s Manhattan condo projects.

Matthew Mannion, who specializes in UCC foreclosures, has conducted at least eight auctions tied to mezz loans or so-called membership interests since March, according to an affidavit filed last month. And Mannion told The Real Deal that more are on the way.

“This is the tip of the iceberg,” he noted.

The uptick in cases presents an opportunity for deep-pocketed lenders like SL Green and CIM that may soon be able to expand their portfolios by taking over projects on the cheap.

Representatives for SL Green and CIM declined to comment.

“Many of the players in the mezz space are not afraid to own the asset,” said Janice Mac Avoy, co-head of Fried Frank’s real estate litigation practice.

Mezzing around

After the last recession, banks pumped the brakes on highly leveraged real estate deals, forcing many developers to look elsewhere for funding. Mezz debt became one of the go-to financing sources to help fill the gaps.

It also has its drawbacks.

Mezz lenders are often among the last to get paid back on a project. So when things go south, their positions can easily get wiped out.

But mezz lenders have a trump card in UCC foreclosures. They are often processed within two to three months, much quicker than traditional foreclosures, which can carry on for years.

By initiating a UCC foreclosure, a mezz lender has a chance to take over a struggling project or sell its stake in the property. In such cases, the junior lender has a huge advantage. It can place a “credit bid” on the property using the existing debt it is owed from the borrower. This allows mezz lenders to acquire assets at a lower cost than if they bought the property outright.

“Mezz lenders are much more aggressive because they are in a riskier position,” said Neil Shapiro, a partner at the law firm Herrick, Feinstein.

Yet UCC mezzanine foreclosures can be trickier than traditional mortgage foreclosures. Rather than being secured by the property, a mezz loan is converted to an equity interest in the business. So if the junior lender succeeds in a foreclose, it becomes the property’s primary owner and must make payments on the senior debt.

But Mac Avoy said banks and other senior lenders are often more apt to work with subordinate lenders — which usually have no prior history of default — than troubled borrowers. “Lenders aren’t thrilled doing business with someone who isn’t able to pay them back,” she noted.

When considering a foreclosure, mezz lenders have to decide if the project is worth more than its debt. If not, the mezz lender can try to sell its loan or work with the borrower on restructuring the loan terms.

“I am seeing the beginning of a lot of lenders saying, ‘We can’t do nothing,’” said Jay Neveloff, a commercial real estate lawyer and partner at New York-based Kramer Levin Naftalis & Frankel.

Lenders are getting especially antsy with borrowers who have been behind on payments for some time.

Such is the case with Mack Real Estate Group, which is seeking to foreclose on the second phase of the Denizen — All Year Management’s luxury apartment complex in Bushwick. Yoel Goldman’s Brooklyn-based firm was unable to close on a $652 million refinancing for the 900-unit rental complex and has halted payments to its bond investors in Israel.

Representatives for All Year and Mack did not respond to requests for comment.

Courtroom drama

In New York’s high-flying real estate market, nothing comes easy.

So as more lenders seek to foreclose on assets, more borrowers are filing lawsuits to stop them.

In one of the most high-profile cases so far, Los Angeles-based developer and lender CIM sought to foreclose on mezz positions on four of HFZ’s Manhattan condo projects.

The day before the planned auction last month, HFZ filed a lawsuit seeking to stop the sale, arguing that it was “commercially unreasonable.” The developer claimed that CIM’s two-month auction notice was indefensible and called the foreclosure effort a “predatory attempt to capitalize on the Covid-19 pandemic.” The judge ruled in HFZ’s favor and halted the auction for the time being.

Wonder Works Construction made similar claims in a lawsuit against New York-based mezz lender Nahla Capital. The lender sought to foreclose Wonder Works’ Upper East Side condo development Vitre, noted for its shiny glass façade. Nahla hired a team of JLL brokers to market the loan back in October.

But a judge denied Wonder Works’ lawsuit, noting that the firm had been in default on its loan payments since January. The auction went ahead this month, and Nahla won a credit bid on the property to essentially become the owner.

Representatives for Wonder Works did not respond to a  request for comment.

Generally speaking, Neveloff said, borrowers usually file lawsuits to “buy time” to negotiate on payments. In at least one case, this has proved to be a successful strategy.

In May, Beverly Hills-based Ohana Real Estate Investors sought to foreclose on the five-star Mark Hotel on the Upper East Side and sell the hotel through auction. Alexico Group, the hotel’s owner, filed a lawsuit, which led to a judge delaying the sale for 30 days. That bought Alexico time, and the two parties were eventually able to reach a settlement, which increased the principal and interest rate on the mezz debt, Bloomberg reported.

Ohana and Alexico declined to comment.

The lawsuits can delay a sale, but ultimately a developer has to find money to pay its lenders. If not, Mac Avoy said, it will be similar to what occurred in the last crisis. 

“It’s the musical chairs … of different ownership,” she noted