Over the past several months, we have seen a herd of new firms and new divisions appear in response to increasing distress among commercial properties and their associated mortgages. These companies promise everything from loan-sale advisory services to legal counsel to distressed-asset disposal assistance, and so far, all of them at least appear to be legitimate.
But as the infinitely intricate financing structures involved with many commercial mortgages begin to come unraveled, it seems that even the most capable advisory firms will be ill-equipped to manage the complications expected to ensue – especially when trophy properties and the aftermath of aggressive dealmaking are involved.
For instance, you may have read in numerous recent reports about the confusion and controversy surrounding the recent default on $700 million of the mortgage tied to the John Hancock Tower in Boston. (If not, take note, because similar tales may very well unfold at other big-name properties this year.)
Private-equity firm Broadway Real Estate Partners bought the Hancock Tower, a 60-story office building and city landmark, for $1.3 billion in late 2006. Like so many others at the time, the company obtained its financing based on bets that office demand would continue to grow and rents would continue to rise, according to a December 2008 Boston Globe article – which calls the deal ‘eye-popping.’
Instead, two major tenants have since left the building, bringing its vacancy rate to an unsettling 15% and leading to the tower's current troubles.
So, with the loan in default and the markets fresh out of capital infusions to offer, now the lender forecloses on the property, right? Maybe someone calls one of those advisory firms to help sort everything out, the building is passed to new hands, investors take their losses, and we return to our regularly scheduled programming. Right?
Not so fast. Consider the composition of the Hancock Tower's financing: A total of $700 billion of debt was divided up into CMBS and sold to investors, the Wall Street Journal reports. Between $50 billion and $75 billion in loans were sold as mezzanine debt and split into numerous risk-differentiated pieces as well.
The defaulted slice of the mortgage involves $700 million in mezz – a one-year bridge loan – divided among nine investors with varying levels of risk exposure and correspondingly varying levels of enthusiasm for seeing an immediate foreclosure.
BlackRock Inc., which owns the riskiest tranche, and others likely to take the hit are – not unexpectedly – in favor of giving the borrower an extension, according to the Wall Street Journal article. Five Mile Capital Partners and others at the other end of the risk spectrum want to see Broadway mail its keys soon. But whose interests take priority?
‘In the most extreme outcome, an inability by Broadway Partners to negotiate new terms or find fresh capital could result in a messy foreclosure at New England's largest and best-known office building,’ the December Globe piece explains. ‘But real estate professionals said a foreclosure on the Hancock seems unlikely, because that could lead to lawsuits and because many lenders involved in the transaction are not equipped to manage the 1.7 million square-foot building.’
Moreover, even the courts do not seem prepared – yet – to sort through the tangles of tranches and competing interests. After all, when was the last time a wave of securitized mortgages featuring freshly created, esoteric structures that even stakeholders did not fully comprehend passed through the foreclosure court circuit?
‘As we enter into a particularly stressful period of the economic cycle, we must remember that many of the components of the real estate mortgage investment conduit structure have yet to be tested in a court of law,’ warns rating agency DBRS in a recent report (which was published before the latest news on the Hancock Tower battle came out).
Uncharted territory, of course, means a dangerous absence of legal guideposts – and the temptation to write some new rules on the spot. In particular, ‘Lacking extensive legal precedence, interested parties will frequently feel compelled to seek a favorable interpretation with regard to enforcement of an intercreditor agreement or the rights of a mezzanine debtholder,’ the company predicts.
DBRS' fears appear to be materializing already, as the fight for the fate of the Hancock Tower – made even more complicated by the ghost of Lehman Brothers' stake in a few investment tranches – is widely expected to result in an extended court battle and, possibly, the formation of some new principles to guide future commercial foreclosure battles.
‘As an industry, we need to have a heightened awareness of the legal challenges that will need to be defended in the coming years,’ DBRS states. All the advisory firms in the world will not negate the need for adherence to basic legal principles and careful consideration of the precedents set in these convoluted cases.
– Jessica Lillian, Commercial Mortgage Insight