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An inescapable result of high interest rates and post-pandemic trends is downward pressure on commercial real estate valuations, especially in the office sector. Given commercial mortgage-backed securities and other deal structures in which control of the loan rests with the lowest priority interest that is in the money, reduced valuations will likely become the flashpoint for CRE litigation.
Parties seeking to shift control their way in these disputes may seek to rely on the judicially made-up standard of materiality recently developed in pre-financial crisis residential mortgage-backed securities (RMBS) litigation, rather than the parties’ commercial understanding.
Overall, more than 50 percent of outstanding commercial mortgages will need to be refinanced in the next two years. In the office segment, the Mortgage Bankers Association has predicted that $190 billion of the $750 billion in outstanding office loans are maturing in 2023, and another $117 billion are maturing in 2024.
High interest rates are currently depressing CRE values. Going forward, refinancing at a time of higher interest rates will require more money in deals or more expensive financing.
In the wake of recent bank failures, regional banks, which could be counted on to originate a majority of CRE loans, are dealing with the burden of FDIC special assessments and lack of public confidence, potentially reducing access to funding.
As a solution to the dilemma created by hybrid office usage, residential conversion sounds good in theory, but massive overhauls will require sales at low values given the costs of wholly repurposing buildings. At best, it’s a long-term solution to an immediate problem.
The foregoing market pressures mean events that typically result in a reappraisal by the servicer — such as delinquencies, borrower insolvency events, or modifications of material economic terms — are likelier. Further, interest holders not in control of the loan may be more likely to find fault with current servicing.
Whether such conduct or event triggers reappraisal may depend on its “materiality,” or its ability to have a “material adverse effect” on the property, loan or interests of holders. Here, if a court were to apply the materiality standard created in the RMBS context, it could require reappraisal based on a “material increased risk of loss” to the claimant. Such a relatively light standard would not necessarily reflect the business understanding of the parties based on custom and usage in CRE.
Once a triggering event is established, it may result in an appraisal reduction amount (ARA) that reflects unrealized losses. An ARA can impact subordinate interest holders through reduced distributions of principal and interest and shifting of control rights (generally held by the most junior class that has 25 percent or more of its initial balance left).
With so much at stake, disputes may arise over whether a triggering event has occurred, the appraisal, the ARA, the formula utilized to calculate the ARA, or whether control rights have shifted.
For example, a court may be called on to decide whether a subordinate interest holder’s prospect of recovery, following a default, is so diminished that it could no longer be said to have a sufficient economic stake in the loan. In such a case, it would be critical whether the agreement intended the ARA be allocated in part or in total against the subordinate interest.
Disputes may also arise concerning whether an appraisal reduction should be taken into account to determine voting rights.
The recent case of Icahn Partners v. Rialto Capital Advisors in Nevada state court involves a special servicer of an outlet mall that is alleged to have manipulated and inflated appraisals by interest holders. Those interest holders claim the special servicer’s maneuver was prompted by its desire to salvage the property and to keep operating it, although a sale would have been the rational course of action to mitigate the interest holders’ losses. While the case is at an early stage, the complaint has survived a motion to dismiss.
Other special servicers may face similar claims by interest holders that appraisal timing and calculations improperly deprived them of control rights. Ultimately, such actions may turn on the materiality of any breaches of servicing standards.
Valuation, as the touchstone for economic viability and the basis for control rights, is likely to be a driver of litigation going forward. Whether reduced valuations are the motivation for claims or the subject of dispute, lessons learned from subprime RMBS litigation regarding materiality standards may help determine winners and losers.
Joseph Cioffi is a partner and the chair of the insolvency and finance practice group at Davis+Gilbert, and has extensive experience in ABS litigation.
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