Real Estate Market Update

In episode #22 of Industry Insights podcast, Bob Grados joins host Joel Simon to discuss the current real estate market, the types of lenders active in the market and popular transaction types that are thriving in today’s environment.

Joel Simon: There’s been so much published and discussed about real estate in the current market environment, but today I’d like to talk about lenders and, more specifically, different types of lenders. One of the more interesting aspects of your practice, Bob, is that you work on real estate finance transactions that often feature different types of lenders with different stakes in the same asset or group of assets. Can you give us an idea of the number and variety of lenders you come across?

Bob Grados: Sure, Joel. There are typically three types of lenders that are active in real estate financing transactions: banks, life insurance companies, and real estate opportunity or debt funds. On the bank side, there are large players: JP Morgan, Wells Fargo, Goldman Sachs, etc., but you also see regional banks not only active in their local markets, but active throughout the United States. Banks will deal in large commercial loans, but also in volume, and are the large originators for loans circled for securitization. Insurance companies are very active in the real estate finance space, and often are the preferred choice for borrowers who are looking for longer term financing transactions. Insurance companies tend to hold the debt on their books. Real estate opportunity and debt funds operate in both the debt and equity sides of the real estate financing market, and are often the participants looking for mezzanine loan and preferred equity opportunities that bring larger returns as compared to low mortgage loans, although there are real estate debt funds that specialize in first lien mortgage loans as well.

Simon: That sounds like a lot of players to keep track of. Perhaps you can give us an example of a specific transaction (without naming names of course) that illustrates the way different lenders would approach the situation from different perspectives?

Grados: A good example of a transaction is a large commercial mortgage loan that is likely to also have mezzanine debt behind it. In this situation, a bank or a life insurance company may originate both the mortgage and mezzanine loan simultaneously, and the originating lender will then sell off the mezzanine loan to another player, typically a real estate fund. There will be an intercreditor agreement entered into between the holders of the respective debt. To lay off all or a portion of the risk on the transaction, the lender who originated the mortgage loan may sell the loan into a securitization or sell off pieces of the mortgage loan to other banks through a syndication or participation arrangement. In that situation, the lending syndicate will be granted certain consent rights over what the originating lender can do in servicing the loan in the future. The holder of the mortgage loan may also lever its loan in the capital markets by pledging its interest in the mortgage loan as collateral under a repurchase or warehousing facility. In that scenario, the lender under the capital markets credit facility will be granted consent rates over the future servicing of the loan. Additionally, the holder of the mezzanine loan could similarly lever its loan in the capital markets.

Simon: This kind of sounds like a jigsaw puzzle or perhaps a Rubik’s Cube for both business people and the lawyers who have to make all these disparate interests fit together for a successful transaction, not to mention how to take it apart if things go awry. What are some of the pitfalls folks need to be aware of here?

Grados: One of the biggest issues, especially in times of dislocation like we now experience, is the role of third-party servicers in addressing issues with securitized mortgage loans. Initially, of course, a borrower would deal with a primary servicer for day-to-day issues. However, if the securitized loan becomes stressed, requires material modifications, or is in potential or actual default, servicing is transferred to a special servicer and the servicing fees payable by the borrower are increased materially. As you can imagine, after over eight years of a positive real estate financing market, the primary and special servicers were initially not equipped to deal with the onslaught of forbearance and modification requests occasioned by the COVID-19 pandemic. Presently, though, I understand that many of the services have caught up with their workloads, but the ultimate outcome of how special servicers will deal with loans impacted by the pandemic is not yet clear. Another issue that is typically on the table is the dynamic of multiple layers of consent necessary for loan forbearance or modifications. If the borrower has entered into both mortgage and mezzanine loans for a specific property, each of the mortgage and mezzanine lenders typically has an independent right of consent over material modifications and waivers. Depending on the issue presented, lenders of different levels in the capital stack can have different thoughts on a proposed modification. If either the mortgage or the mezzanine lender has pledged its loan under a repo or warehousing credit facility, the repo or warehouse lender will have an additional layer of concern. Therefore, even if the primary relationship lender would be inclined to grant a waiver or permit modification, it may be restricted from doing so under the terms of its own financing arrangement. For any borrower attempting to negotiate a workout of its loan, especially during a market dislocation as we are currently experiencing, it is very important to understand the lender’s business situation as well as the various layers of consent necessary to achieve the goal

Simon: That reminds me of back during the mortgage-backed securities crisis, when a lot of securitization transactions had really complicated intercreditor arrangements, and you often discovered that nobody actually had or thought they had the power to consent because they each pointed the finger at somebody else in the transaction who now had the loan in their portfolio. Sounds like that problem may have been solved and that this time around things are going a little more smoothly?

Grados: Well, I think that of the errors we found in the last downturn from 2008 to 2011, a lot of that has been fixed, but I think that you may still find that there are similar ambiguities as to consent issues up and down the chain.

Simon: Interesting. But it sounds like with the right approach and enough planning, even in these complicated transactions, there are significant opportunities both in robust markets, as well as wobbly ones. What are some of the popular types of transactions you’re seeing now, given the current environment?

Grados: I’m seeing many opportunistic players in the market right now. Obviously, the pandemic has caused market dislocation in value and opportunity, as well as much hardship for owners of commercial real estate, especially retail and hospitality assets. The market dislocations caused hardship as well for the lenders and holders of the loans on various commercial property types. So many opportunistic lenders are coming into the market, either to alleviate the funding gap on the borrower side by providing rescue capital in the form of mezzanine debt or preferred equity investment, or on the other side alleviating the lenders’ stress by potentially purchasing loans at a discount or purchasing portfolios of loans.

Simon: So it sounds like then there continue to be pockets of the real estate market that are active, which I think is really positive news given how depressed the market was at the beginning of the pandemic.