02/27/2009

Mezzanine Lender Snags Riverton Workout

The investor holding an apparently worthless $25 million mezzanine loan on the Riverton apartment complex in Manhattan is angling for a payoff in return for allowing a workout to proceed.

The investor, a finance company formerly managed by a CB Richard Ellis affiliate and now known as Realty Finance Corp., is seeking a payment in the neighborhood of $5 million.

Even though a sharp decline in the complex's value appears to have wiped out the mezzanine loan's value, Realty Finance has some leverage because it must approve any loan workout. The owner of the complex, a partnership led by Larry Gluck's Stellar Management, appears eager to modify the loan terms in order to salvage its investment in the property.

While the bondholders that own the securitized $225 million senior mortgage could foreclose and force Realty Finance out of the picture, the bondholders would incur a $7.5 million tax penalty, specific to Manhattan, for transferring the property's title. But if Realty Finance signs off on a loan workout, the bondholders would avoid the tax penalty.

Realty Finance is trying to persuade the bondholders that it would be faster and more cost-efficient to pay it to go away. The buzz is that the bondholders, represented by special servicer CWCapital, and the Stellar partnership have teamed up to make a counteroffer to Realty Finance. Negotiations are ongoing. All parties involved declined to comment.

The maneuvering demonstrates how junior investors in large loan packages can hold a trump card even when the value of their investment has been wiped out. The situation figures to be repeated often in coming years, as the sharp market downturn causes other loans to blow up.

In this case, the situation is relatively straightforward, because there is only one mezzanine lender. But many large debt packages arranged in recent years involve multiple subordinate lenders, which must all sign off on workouts. For example, after developer Harry Macklowe defaulted on a $7 billion debt package last year, lead lender Deutsche Bank stepped in to buy back a $66.7 million junior mezzanine tranche from Vornado Realty and a $298 million B-note at a discount to smooth the way for the sale of the collateral office properties, which were also in Manhattan.

The Riverton loan is an example of an aggressively underwritten mortgage, originated near the top of the market, that counted on a sharp increase in cashflow in future years.

New York-based Stellar and Rockpoint Group of Boston teamed up to buy the 1,230-unit Riverton complex in January 2006 for $132 million. Some 93% of the units were rent regulated, with only 7% carrying market rates. The Stellar team's game plan called for increasing the percentage of market-rate apartments to 53% by early 2011.

In December 2006, the Stellar team lined up a $250 million debt package from Deutsche - consisting of a $225 million senior fixed-rate loan and a $25 million mezzanine loan. Deutsche securitized the senior loan via a $6.6 billion pooled deal (CD Mortgage Trust, 2007-CD4). Deutsche placed the mezzanine loan with the CB affiliate, CBRE Realty Finance, which securitized it via a $684 million CDO (CBRE 2007-1 CDO).

The five-year debt package included $48.3 million of reserves, leaving the Stellar team with net proceeds of $201.7 million. Factoring in its purchase price, the duo effectively took $69.7 million of cash out of the property with the financing.

According to securitization documents, the complex, which is in the Harlem section, had a $260 million appraised value in December 2006. But the loan was underwritten based on a value of $340 million - the projected value in January 2011, by which time more than half of the units were expected to carry higher, market rents.

However, the conversion has gone much slower than expected. As of last July, only 10% of the units carried market rates. A new appraisal has put the complex's value at $196 million. And some observers think it could actually be worth much less. Either way, the mezzanine loan would be well underwater.

Last August, with the loan's reserves dwindling and default imminent, the loan was transferred to special servicer CWCapital. The Stellar team stopped making payments two months later, but continued to negotiate possible loan modifications with CWCapital.

At the end of last year, CBRE Realty ended its external-management agreement with the CB affiliate and it became internally managed, changing its name to Realty Finance. Kenneth Witkin continued as chief executive.

Meanwhile, Realty Finance has continued to angle to recover at least some of its mezzanine-loan investment. There are signs that CWCapital and the Stellar team might agree to loan-modification terms that would give the borrower more breathing room, but Realty Finance wants to be compensated to sign off.

Realty Finance has already taken steps to foreclose on the collateral for the mezzanine loan - that is, the Stellar team's equity interest in the property. That would give Realty Finance control of Riverton and position it to fight foreclosure of the property itself in the courts. While it would presumably lose such a battle, it could drag out the resolution of the loan - to the chagrin of bondholders.

Realty Finance is also using the tax liability as a sword. If the bondholders foreclose on the property, they would have to pay a transfer tax equal to nearly 3% of the outstanding debt, or almost $7.5 million, according to Deutsche analyst Richard Parkus. But if Realty Finance signs off on a loan workout, foreclosure - and the tax payment - would be avoided.

Given the rising degree of distress in property markets, special servicers are motivated to avoid foreclosures and negotiate loan modifications with borrowers. In this case, the cheaper alternative for bondholders and the Stellar team might be to pay off the mezzanine-loan holder to enable the workout to proceed. "They would probably view the payment as a consent fee," said one observer following the situation. "They just want to make it go away."

Realty Finance this month took a procedural step to foreclose on the Stellar team's interest in the Riverton complex. It scheduled a public auction on Feb. 20, at which it would bid on Stellar's interest in the property. Realty Finance presumably would be the only bidder, paving the way for it to take control of Riverton.

However, the auction was subsequently cancelled - signaling that a payoff was being negotiated. People familiar with the matter said that the bondholders and Stellar team had made a counteroffer to Realty Finance.

At the same time, the bondholders have begun foreclosure proceedings on the Riverton complex. The securitization's trustee, Wells Fargo, filed for foreclosure and receivership on Feb. 3.

The property is currently throwing off net operating income of about $5.5 million, well below the $13.7 million needed to service the senior mortgage, according to people familiar with the deal. Based on those figures, the $196 million appraisal value seems generous, given the renewed emphasis on in-place income when valuing properties in the wake of the market slump. Even at a generous 7% capitalization rate, annual income of $5.5 million would translate into only an $80 million valuation. But the property clearly has upside potential, which presumably was factored into the appraisal.

While there seems to be motivation on all sides to negotiate a loan modification, it's far from clear whether an economical arrangement can be reached, given the property's sharp decline in value. "We continue to believe that there is a very significant risk that the special servicer will eventually foreclose on this loan and liquidate it," Parkus said in research report on the Riverton loan last week.

S&P has downgraded six classes of the 2007-CD4 securitization and 12 classes of the CBRE CDO. Fitch has put four classes of the 2007-CD4 securitization on "rating watch negative" and has downgraded three classes of the CDO.

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