What to Expect When Expecting Distress: A Special Servicer Roundtable

Photo: Pittsburgh, Pa. Photo courtesy of Igor Oliyarnik via Unsplash

Special servicers are often based far from Wall Street, and they generally draw little attention when the economy is growing. Their role involves managing troubled securitized mortgage loans, so their visibility and workloads rise during economic downturns.

Once a recession hits, special servicers help determine the fate of loans secured by offices, shopping malls and apartment buildings when the bets placed on these properties go sour. With many pandemic-related challenges behind the industry, it is worthwhile to consider how far the industry has come and where things are headed. 

With interest rate hikes, recession talk and rising inflation defining themes for commercial real estate, MBA NewsLink asked three special servicing executives to get their takes on labor, property and capital market dynamics.

Lindsey Wright joined K-Star Asset Management LLC, a KKR company, in 2022 as Managing Director and Head of Investment Services for the firm’s Real Estate Credit business. Prior to KKR, she was a senior managing director and head of special servicing at Greystone, where she managed the loan and REO workout teams as well as the surveillance, investor reporting and due diligence teams.

Brian Hanson, Managing Director of Industry and Client Relations with CWCapital Asset Management, joined CWCapital in 2006. His responsibilities include maximizing strategic relationships with key industry constituents, clients and business partners of the firm and its affiliates RealINSIGHT and RealINSIGHT Marketplace. He also supports business development initiatives and is involved in certain aspects of operational oversight. Hanson sits on the Mortgage Bankers Association’s Commercial/Multifamily Finance Board of Governors and is a past Chair of both the MBA CREF/Multifamily Servicer Council and of the CREFC Servicers Forum.

David Harrison is Chief Operating Officer at Midland Loan Services, a PNC Real Estate business. Midland provides third-party loan servicing, asset management and technology solutions for lenders, investors and other clients across a broad spectrum of industries. David’s background in commercial real estate includes capital markets, asset management, underwriting, workouts, business development and client relations.

MBA NEWSLINK: How is your company addressing retention and recruitment challenges?

LINDSEY WRIGHT, K-STAR: K-Star was incorporated in April 2022 and we mindfully chose Dallas for our office location due to the deep talent pool of real estate, credit and servicing personnel. We have successfully recruited and hired an experienced six-person executive team; all but one of us worked in the Dallas area already. The strong hiring momentum has continued as we build out our other functional teams, sourcing through our executive team and KKR’s relationships, the company’s career page and various other channels including our colleagues across the MBA network. 

We have found that a headhunter can be valuable when looking for a candidate with a specific skill set, but we have only utilized that in limited circumstances. The challenge of retaining employees in the current market and macro environment is a concern for many companies, and K-Star has made it a priority to offer a culture, compensation plan and growth plan that attracts strong talent. 

DAVID HARRISON: For years we’ve been incredibly intentional about fostering the right culture at Midland and more broadly at PNC to better attract and retain talent throughout our businesses. Through August of this year, Midland has filled more than 100 positions with internal or external candidates–a testament to the work we’ve put in and our focus on finding the right talent for the right role.

We continue to find that highlighting PNC’s corporate values, competitive employee benefits, leadership transparency and employee-focused programs, such as Employee Business Resource Groups, are key to our success. We’ve also taken steps to organize our teams more thoughtfully to encourage mobility and we’ve implemented stronger career pathing resources and advancement paths to retain the great talent that we already have.

Not to be overlooked, we’ve also opened two new strategic offices in Birmingham, Ala. and Dallas, both of which provide us with the opportunity to recruit from a broader geography and access to a larger, more diverse talent pool.

NEWSLINK: Office demand is a key issue for commercial real estate. What are your thoughts on class B office from observations in Midland’s master servicing and special servicing portfolios?

HARRISON: We believe the current dynamic in the office market is far more complex than the turbulence experienced during the COVID-19 pandemic.

Hospitality properties saw almost immediate impacts when people stopped traveling and leaving their homes. While the actual physical consumption of office space is down today, the office market is buttressed by long-term leases, which remain intact.

As corporate America continues to sort through future work arrangements, we believe that there isn’t a one-size-fits-all forecast for the office market. Many say class A office space will always be in demand, but it’s important to look at relocation and suburb movement trends that many Americans pursued during the pandemic and how that will impact consumption moving forward. Ultimately, we think that location, amenities and general consumption trends will be the key factors into the fate of these properties, as well as whether the property can be strategically repurposed into a productive alternative use.

It’s just too soon to tell how this will impact special servicers.

NEWSLINK: Are there any remaining or expected thematic issues in your lodging portfolio you would highlight?

BRIAN HANSON: In our portfolio, we have seen a significant decrease (almost 60% in UPB) in active specially serviced lodging assets since September 2021. This reflects improved market conditions and our ability to respond and take advantage of them either through successful workouts or use of our Marketplace online sales platform. 

Current distress is continuing in secondary markets where business transient demand hasn’t returned in a meaningful way. Much of our in-house hotel loans/REO are comprised of older, limited- and select-service hotels that fall within the economy, midscale and upper-midscale segments, with perhaps some geographic concentrations in the north and northeast. Higher-end business travel seems to be doing OK, and drive-to leisure seems to have also held up. 

National average daily rents have been growing robustly in 2022 across most sectors; occupancy has been slower as it relates to getting back in line to pre-pandemic levels. This takes into account markets that are not performing as well as others and also those that are performing above expectations.

Certain major leisure markets are seeing incredible growth and have been ever since consumers started going to drive-to destinations and once COVID restrictions were lifted. However, there are many markets that are not leisure-oriented or don’t have a base of consistent business transient demand that simply have not come back. Secondary markets outside of major metropolitan areas that rely on compression from the city-center seem to be facing challenges. Leisure markets and luxury branded hotels continue to do very, very well.  It should be noted, from our perspective, that a recession or continued economic issues will potentially have an impact on leisure travel. 

NEWSLINK: Could you describe recent workout trends and the existing pipeline for KKR’s conduit special servicing portfolio?

WRIGHT: To date, minimal losses have been incurred by KKR as an investor, with many successful reinstatements consummated. Currently, a small percentage of loans are in special servicing, and of those, over 95% are performing. We expect that at least 25% of the special servicing portfolio should be corrected and returned to the master servicer; for those assets remaining in a non-performing state, we would consider a note sale, through the receiver if applicable, as a faster and simpler option, if the price maximizes our returns.

Otherwise, if we cannot secure near par returns, and we believe there is further recovery value with time, we will direct a move toward foreclosure. With regard to the pipeline for future special servicing transfers, we are monitoring closely as the macro environment may drive an increase in transfers through 2023.

Certain asset classes remain resilient with strong demand, such as industrial, multifamily, student housing and self-storage; but other problematic sectors such as office and retail will continue to be a concern. 

NEWSLINK: How are you seeing the evolution of retail performance play out for regional malls and other product types?

HARRISON: One of the more shocking stories out there in commercial real estate is the rebound of retail. The brick-and-mortar retail industry was struggling prior to COVID-19, and what many thought would be the final blow–stay-at-home orders and the rise of e-commerce–turned out to be a mere setback for the industry.

Today, foot traffic counts are trending up and well-positioned regional malls continue to be successful. Consumers are looking for experiences, and well-located, well-tenanted and well-managed properties are benefiting. Of course, there are some retail locations that will still struggle, but we’re seeing that those are typically unanchored and poorly tenanted.

As far as other property types go, the hospitality industry has bounced back as evidenced by consistently jammed airports and crowded hotels. Somewhat lucky for the industry, hotels were forced to optimize their operations models during COVID-19, which has carried over into their new business-as-usual models and led to operating cost savings.

One sector to watch could be warehouse and industrial properties. Prior to the pandemic, these were a hot commodity for companies across the U.S., especially as businesses looked for shipping efficiencies and fulfillment solutions. Now we are seeing companies pull back and scale down these operations, which could have an impact in the property type down the line.

NEWSLINK: Auction platforms have been instrumental over time for efficiently resolving some distressed loans and maximizing recoveries. What are you seeing in this business line presently?

HANSON: Auction platforms have established themselves as an accepted method to market and sell commercial real estate assets. The use of online auctions for national scale sales hit its initial stride during the 2008/2009 recession. Servicers like CWCapital were looking to react quickly to take advantage of market conditions, and online auctions allowed them to do so while maximizing recoveries, ensuring closure and minimizing the risk of re-trade.

Online auctions are also ideal for distressed debt because they cut down on the due-diligence period, getting both the buyer and seller a more efficient, guaranteed close.

The real estate market has experienced a variety of changes since, but online auctions have steadily become more popular. In addition to the factors laid out above, there are several reasons for this:

1. Certainty of execution. The transaction will close, and it will do so faster than it would in a traditional sale process.
2. Wider audience. Sellers have the comfort of knowing their asset is being seen by the highest possible number of qualified buyers, no matter where they are located.
3. Scalability. Online sales platforms give sellers and servicers increased flexibility and scalability in dealing with varying volumes of asset sales.
4. Transparency and fairness. The data from sales lives online, so anyone who needs to can see mountains of useful data like how many marketing emails were sent, how many bidders there are, if they got the best price, etc. There is also no risk of favoritism, the highest bidder will get the deal, which evens the playing field for buyers.

A lot of the factors that make online auctions so appealing for distressed assets are the reason we have seen much wider industry acceptance of the use of auctions for more stable, non-distressed assets. Over the last several years, we’ve seen a large uptick in the amount of stable assets sold at online auction, and we expect that trend will only continue. Concurrently, we’ve seen growth in the use of online auctions on our platform across almost all property types and geographical regions.

(Views expressed in this article do not necessarily reflect policy of the Mortgage Bankers Association, nor do they connote an MBA endorsement of a specific company, product or service. MBA NewsLink welcomes your submissions. Inquiries can be sent to NewsLink Editor Mike Sorohan at msorohan@mba.org or NewsLink Editorial Manager Michael Tucker at mtucker@mba.org.)