Wednesday, January 21, 2009

The Battle of the Tranches

There is a very interesting story in today's WSJ that explains the incredible complexity of huge, multi-site deals, foreclosures and various investors in CMBS.

This story is about the John Hancock Tower (in Boston, not the iconic Chicago building). The tower was part of a seven site deal of a fund of Broadway Real Estate Partners two years ago. The deal's now in default, according to the story.

Back in the old days, when a deal went south, you had one lender, or maybe a syndicate of lenders with interests that were usually somewhat aligned. And you sat at a table, did conference calls or ever wrote letters back and forth working out the loan, or you proceeded to foreclosure.

Not so anymore, thanks to the complexity of CMBS. If you are a regular reader or know the business, then you are aware that CMBS has various tranches of debt, with senior tranches having the least risk (and lower return) and junior tranches having more risk but higher interest rates. The same is true in this deal, where you have multiple tranches of mezzanine debt, which was supposed to be a bridge loan pending sales or refis that went south with the credit market.

The interests of these lenders are not aligned. If a deal goes south, the senior lenders might be OK but the junior and B-piece folks are probably SOL (and I don't mean "statute of limitations" when I use that term). And that's what is going on here:

"Tranche warfare is starting," said John Zizzo, a real-estate lawyer at Cadwalader, Wickersham & Taft LLP, referring to the loan "tranches," or slices, that investors own. "It has never been tested before this current market meltdown."

The disputed $700 million of debt in the Hancock battle is mezzanine debt that was divided up among nine investors. With real-estate values declining, not all of the investors would be paid off in a liquidation.

As a result, investors who believe they would be in the money are pressing for an immediate foreclosure, according to people familiar with the matter.

Such investors include Five Mile Capital Partners, led by former real-estate financier Steven Baum, and Normandy Real Estate Partners, founded by property investor Finn Wentworth. Mr. Wentworth also is a founder of the New York Yankees' YES Network.

Investors likely to lose out in foreclosure want to give Broadway more time to repay the loan. Among those investors is a BlackRock Inc. fund run for outside investors. That fund owns the riskiest slice of the loan.

Also involved in the scrum are Chicago developer John Buck, who owns the most senior portion of the debt; the RBS Greenwich Capital unit of Royal Bank of Scotland Group PLC; Lehman Brothers Holdings Inc.'s bankruptcy estate; and hedge fund Petra Capital Management LLC, run by Andy Stone, a pioneer of commercial real-estate securities.

Complicating things further, State Street Corp. inherited stakes in two tranches from Lehman Brothers, according to a person familiar with the situation. The failed investment bank had pledged the loans to State Street as collateral for a short-term "repo" loan. State Street seized the collateral after Lehman filed for bankruptcy.

Ouch. What's more? This might be just the start. If there are more foreclosures like this -- and people expect there will be -- the fighting, pain and possibly litigation will only further complicate getting properties back out into the market and into the hands of people who can turn things around. One solution is to negotiate between the tranches and settle with a buyout, giving control to one or another group. There's some very sophisticated players in that list of lenders, and I would think they will all realize their interests are better suited through compromise.


Doug Cornelius said...

David -

I believe that the Boston John Hancock Tower is even more iconic than the Chicago version (although clearly not as tall.)

The tranche warfare really hinges around valuation. Since each tranche is stacked on top of the other, you get into a battle over who is in the money and who is out.

Valuation is a huge problem right now because of the lack of market activity to compare with. Commercial real estate is notoriously hard to value and even more so with zero activity is many markets.

David Stejkowski said...

Doug, I was hoping you would comment. Big John is still probably our most beloved supertall, but of course the John Hancock Tower is the tallest in NE.

The lower tranches are really going to fight hard in my opinion on this and other deals. No one wants to be out of the money, even though they took the risk when going into the deal. I think those fights could get ugly.

I of course agree 100% with your views on pricing. The days of 4-5 caps(e.g., the EOP deal) are long gone and may not be back for a long time if ever.