Distressed Debt Monitor: A Conversation with Mayer Brown Partner Jeffrey O’Neale
MBA NewsLink interviewed Jeffrey O’Neale, a partner in Mayer Brown’s Charlotte, N.C., office and a member of the Real Estate Markets practice, about hotel sector workouts and other distressed debt.
O’Neale focuses his practice on representing institutional lenders, financial institutions and servicers in a variety of secured and unsecured financial transactions including commercial mortgage loan originations, single-family residential mortgage loan originations, loan workouts and restructurings, repurchase and warehouse facilities, credit facilities and equipment lease transactions. A primary focus of his practice is representing special servicers in loan workouts, restructurings and modifications and repurchase facility buyers in the servicing and administration of their commercial mortgage loan portfolios.
MBA NEWSLINK: During the last downturn you worked on several large hotel workouts including the Atlantis property in the Bahamas and the Jameson portfolio of limited service hotels throughout the Southeastern United States. Are there any best practices from those workouts you would apply to the current burgeoning pool of distressed hospitality properties?
JEFFREY O’NEALE: The primary best practice, which is of even greater importance in the current COVID environment, is understanding the importance of conducting extensive legal and property-level due diligence at the onset of the workout. A core component of the value of the mortgaged hotel property will be “the flag” or the franchise brand, marketing and operational expertise available to the mortgage borrower pursuant to the terms of the related franchise agreement. The lender will want to ensure that it receives a comfort letter from the franchisor containing market standard terms, conditions and protections that is either addressed to the lender or contains appropriate provisions to enable the protections of the comfort letter to run to the successors and assigns of the original lender. The comfort letter will provide the lender with assurances that the property can continue to operate under the existing franchise arrangement while the lender pursues its potential enforcement rights and remedies under the loan documents.
In the current COVID environment, in which many hotel properties have ceased operations and FF&E and capital expenditure reserves have been suspended and/or reallocated to debt service, tax, insurance and other carry costs pursuant to forbearance agreements, the lender will want to ensure that the mortgage borrower has not defaulted in performing its obligations under the terms of the franchise agreement which could result in the loss of the flag and that the physical condition of the mortgaged property has not materially deteriorated during the course of the pandemic.
However, in terms of the workout strategies themselves, the available options for hospitality properties will be markedly different from the last economic downturn. During the last downturn, effective hotel workout strategies often focused on repositioning the property such that it could expand its market share to ensure profitable operations. The sample transactions you mentioned were ultimately successful as a result of improving hotel operations, management and marketing combined with meaningful capital expenditures and improvements. In the current environment, increasing market share by repositioning the property will not be an effective workout strategy for many hotel properties.
The supply of hotel properties will outstrip demand for hotel rooms for the foreseeable future. This dynamic is reflected in comments by the owner of the Palms Resort in Las Vegas who recently stated that the hotel may never reopen as a result of the pandemic. I would anticipate a greater focus on repurposing rather than repositioning certain hotel properties during the upcoming economic cycle. Certain Midtown Manhattan hotel properties might be better repositioned as start-up office space and the highest and best use for certain hotel properties in suburban or rural communities through the Midwest or Sun Belt might be as affordable housing apartments. The question then becomes which parties are best situated to guide the upcoming conversions and how extensive are the potential losses that lenders and investors will face during this conversion process.
NEWSLINK: COVID-19 has driven a large number of borrowers to seek short-term forbearance agreements, many jurisdictions have halted or slowed evictions and rental assistance is being considered by Congress. How do you see this landscape impacting loan workouts this cycle?
O’NEALE: The current landscape is unlike any landscape we’ve previously encountered during an economic downturn. Previous downturns were structural in nature and certain assumptions could be made regarding the anticipated length, duration and severity of the economic downturn and the impact that it would have upon certain asset classes and geographic markets. This cycle is defined by uncertainty, including uncertainty regarding the severity and duration of the pandemic, the political, regulatory and statutory environment, the scope of available economic assistance for tenants, borrowers and lenders and potential long-term changes in consumer and business behaviors.
This uncertain landscape will demand great patience amongst borrowers, servicers and lenders to determine the most effective strategies to maximize and preserve the value of the related commercial mortgage loans, mortgaged properties and the industry as a whole. Given the current high level of uncertainty it may be prudent for lenders and servicers to enter into extended forbearance agreements throughout the balance of the calendar year for those properties truly experiencing economic duress, at which time there should be greater clarity regarding the short-term economic environment enabling lenders and servicers to identify the most effective long-term workout strategy for each individual property.
NEWSLINK: Your practice focuses on supporting senior lenders as well as mezzanine lenders. We’ve seen New York recent court decision determining a mezzanine lender’s ability to exercise their rights. Do you envision a large number of mezzanine lenders exercising their remedy to take over ownership of borrower and thereby operate properties in situations where cash flow is significantly impaired in the next year?
O’NEALE: As you’ve mentioned, after some initial uncertainty, there have been positive case law developments for mezzanine lenders in recent New York judicial decisions regarding a mezzanine lender’s ability to exercise their rights and remedies in the COVID environment.
In the 1248 Associates Mezz II LLC case, after initially granting the mezzanine borrower’s temporary stay, the New York Supreme Court ultimately ruled that the existing executive orders limiting commercial real estate foreclosures in New York do not apply to non-judicial mezzanine foreclosures under the Uniform Commercial Code. In the recent D2 Mark LLC case, although the court granted the mezzanine borrower’s preliminary injunction and acknowledged a higher burden for a commercially reasonable sale in the COVID environment, the court reaffirmed that UCC foreclosures in the current COVID environment are not commercially unreasonable on their face and do not violate any executive orders currently in effect in the state of New York.
Even in consideration of the higher standard for a commercially reasonable mezzanine foreclosure sale in the current COVID environment, mezzanine lenders will have the ability to enforce their rights and remedies in a much more efficient and expedited manner than their mortgage loan counterparties, who face potential month or year long delays due to executive order moratoriums and the anticipated backlog in the judicial court system.
The availability of expedited remedies, combined with attractive long-term investment properties (which but for the pandemic would not be in distress), will likely lead to increased acquisitions of mezzanine loans by opportunistic investors with an eye towards taking ownership of the related mortgage borrowers and operating the properties.
For investors who have the capital to operate the properties, relationships with qualified property managers and an investment horizon targeted toward long-term returns, this could lead to tremendous investment opportunities. The potential mezzanine foreclosures may also be a net positive for mortgage lenders, who may benefit from their mortgaged properties being managed and operated by well-financed funds and investors in lieu of their initial mortgage borrowers who may be facing capital shortfalls and operational challenges across a portfolio of distressed properties.
NEWSLINK: This cycle’s growth included active lending across various capital sources; however, debt funds and mortgage real estate investment trusts have been uniquely positioned, growing substantially both in terms of individual volume of select institutions as well as number of new entrants facilitated by an active field of warehouse lenders and secondary market. How have trends in warehouse lending evolved over the last several months and what may come next?
O’NEALE: Warehouse lenders have served as a vital source of liquidity for debt funds, mortgage REITs and CMBS loan aggregators over the past several years and have played a key role in the expansion of the CMBS and CRE CLO markets and the proliferation of non-bank lenders.
During the last several months, which I think of as the “defensive phase”, warehouse lenders have acquainted themselves well by serving as true partners with their seller counterparties. Although several warehouse lenders have understandably utilized their margin rights to reduce their credit exposure in the current environment, most have also entered into margin holiday agreements, accepted additional collateral (i.e., commercial mortgage loans) in lieu of cash pay downs and approved various loan modifications and forbearances in an effort to tailor solutions that are mutually beneficial for both the warehouse lenders and their seller counterparties.
Over the next few months, which I think of as the “offensive phase”, I believe that warehouse lenders will have an important and vital role to play in providing the necessary liquidity for the rebounding commercial mortgage real estate market. While warehouse lenders will still provide financing for term loans slated for CMBS transactions and bridge loans for potential CRE CLO transactions, the versatility of terms that warehouse lending can provide will be available to finance (i) commercial loans not situated for current CMBS or CRE CLO execution via static warehouse or private CRE CLO transactions and (ii) distressed loan acquisitions. Warehouse lenders’ ability to structure their facilities or individual transactions with customized pricing, advance rates, margin rights, contemplated repurchase timing, portfolio cross-collateralization and payment recourse will enable them to tailor unique financing solutions for an evolving pool of financeable commercial mortgage loans.
NEWSLINK: CMBS is a challenging product when it comes to loan recovery in distressed situations given not only the rights and remedies afforded in loan documents but also constraints and rules of pooling and servicing agreements. These documents vary across by transaction and evolve over time. Does anything stick out as potentially challenging this cycle in particular for CMBS borrowers and special servicers to manage?
O’NEALE: Two words, tranche warfare. In CMBS transactions, the controlling class of certificate holders has the right to appoint and/or remove the special servicer and has consent rights over certain major decisions including modifications of monetary terms, selection of enforcement remedies and acceptance of discounted payoffs.
As the first or second round of forbearance agreements for CMBS loans expire in the near future, appraisal reduction events in the form of delinquent principal and interest payments and/or modifications to the material economic terms of the CMBS loans will occur. Upon the occurrence of these appraisal reduction events, the special servicer must obtain an updated valuation of the mortgaged property, which may result in the controlling class shifting to another class of certificate holders if the updated valuation results in a diminution of value beyond a certain threshold.
For a successful four- or five-star hospitality property in California, there’s likely consensus around the value of such property in 4Q 2019, but how does one value such property in the current environment? Is the valuation based upon applying a discount to the prior valuation, upon projected short-term occupancy or upon projected long-term occupancy? The difficulty in obtaining an accurate appraisal or determination of value for commercial mortgage properties in the current environment will likely lead to disputes between various classes of certificate holders, which could lead to delayed loan workouts with CMBS borrowers and potential litigation amongst the various classes of certificate holders and special servicers.
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