Loan servicers are in the business of risk management. Their primary role, in a nutshell, is to help lender and borrower clients in assessing, identifying and minimising risks. Yet, how these servicers go about doing their job – the approach and day-to-day focus – is undergoing a transformation at a time of rapid technological advances and dislocation in the commercial real estate finance industry.
“Our role has adapted. Lenders are looking for additional value, not just our administrative services,” says Michael Hulme, senior loan manager at loan servicing and advisory firm Solutus. “We are providing an ever-increasing level of vigilance across the portfolio, to provide an early warning system highlighting and identifying potential issues as soon as possible in order to maximise the likelihood of a positive outcome.”
Loan servicers today don several hats in the commercial real estate industry. A majority of their business comes from being a facility agent and security agent for lending transactions. Servicers are responsible for loan administration, including onboarding and monitoring the loans; collection and analyses of borrower reporting; review and completion of interest calculations; and issuing period notices, including interest statements.
They oversee cash management in the secured bank accounts, as well as preparing the distribution waterfall and making remittances to all counterparties.
They are also the designated point of contact for all loan-related questions and requests from the borrower to the lender. And when the loan matures, servicers liaise with all relevant stakeholders to ensure timely settlement of dues.
Then there are primary and special servicers of commercial mortgage-backed securities transactions that act on behalf of the issuer to ensure debt is repaid on time and on the right terms, and who also oversee the management of a suitable resolution in the case of a non-performing loan.
Across the industry, these loan servicers have traditionally been thought of as serving a ‘postbox’ or filling a backstage crew member role. Their job was typically believed to be manual and operational in nature. This label came with its own challenges, both for the servicer and the lender.
Clarence Dixon, global head of loan services for CBRE, believes the postbox view has been a “short-sighted and cost-efficient way of looking at the agency function”, given the differing requirements of all counterparties.
“The lender requires more loan oversight and loan asset management in a volatile market environment, but the definition of the ‘postbox agent’ does not obligate or remunerate the loan servicer to assume this required role. The borrower who ultimately pays the servicing fees only wants the agent to fulfil the basic postbox requirements and does not recognise the value, nor is willing to remunerate the value-added services of the agent. This puts the servicer in a difficult situation of wanting to provide the service but unable to find the party willing to pay them.”
Some servicers also ended up simply forwarding all communication from the borrower to the lender, without doing any of their own analysis or sharing recommendations with the lender to help it make an informed decision, says Vishal Soni, co-founder of Oxane Partners, which provides specialist services to real estate and alternative sector investors. This would tend to happen even in cases where the request could affect a financial covenant.
“There would be back and forth to get the right data before the lender could analyse the request and respond to it,” Soni adds. “This slowed down decision-making and was highly inefficient.”
This model is changing due to the changing needs of the market today. There is growing collateral and sponsor risk, given fluctuating capitalisation rates, decline in property investment, rising interest rates and decreasing bank liquidity.
“The postbox function is, in my view, a short-sighted and cost-efficient way to look at the agency function”
In January, Scope Ratings estimated that a third of commercial real estate loans in European CMBS that are maturing this year and next face “very high refinancing risk”, since their expected cashflows are too low to meet higher expected requirements from lenders. Certain regions and sectors are likely to be hit harder than others. According to Scope Ratings, refinancing risk is likely to be high for retail and shopping center loans as well as certain single-asset office loans maturing in 2023-24.
Meanwhile, real estate manager AEW has forecast that the commercial real estate sector in the UK, France and Germany could face a debt funding gap of €51 billion in 2023-25.
In such an environment, borrowers and lenders expect servicers to be front and centre, using a more hands-on and proactive approach to managing debt transactions. A few areas are receiving heightened attention from servicers. These include helping lenders process extension requests for loans coming up for maturity as well as monitoring cash and credit risk.
“There is a lot of focus on cash right now. There is a lot of focus on tenant-level cashflow, and we are closely monitoring any impact on net rental income. We are also analysing interest rate hedging proceeds very closely and tracking if there is any shortfall,” says Soni.
He adds that a lot of lenders are also calling on revised valuations. “LTVs have shot up, but the borrowers are willing to co-operate and are injecting additional equity into the deal to bring the LTV values down. We have also been doing a lot of stress testing on underlying cashflows, understanding the impact on [debt service coverage ratio], debt yield and so on.”
Technology and talent needs
Like most other industries, the loan servicing industry is being impacted by the tech revolution and talent shortage.
Hulme says that the industry has faced challenges related to adopting and integrating new technologies, given the unique tailoring of the facilities. Yet, progress is being made. An increasing number of loan servicers are incorporating technology for data management, automating workflows, monitoring and reporting.
Solutus, for example, has made upgrades to its loan management tools to streamline monitoring of loans. Oxane Partners is currently testing two artificial intelligence modules: the first is focused on automated data ingestion, and the second will allow users to run conversational searches to query data in any way they like, similar to ChatGPT.
“The fees for loan servicers can get quite tight, so most servicers need volume to scale the business. In our experience, leveraging technology has been the key to achieving this,” says Soni.
Meanwhile, to address the talent shortage, Solutus has developed a training programme to help create a bespoke induction plan for every member of the team. Hulme says the firm is also considering, recruiting and developing candidates with transferrable skills from various sectors such as the accountancy and property industries.
“This has given us the ability to review our loan positions from a different perspective, which can enable us to flag potential issues to lenders and borrowers very early,” says Hulme.
Strategy focus amid volatility
As servicers adapt their businesses to keep up with these long-term structural trends, they are also navigating short-term challenges arising from the ongoing market dislocation. Servicers are dealing with the impact of high inflation, increasing construction and financing costs, as well as with declining valuations that are causing pressure on loan-to-value covenants.
Solutus continues to be very active in the UK loan market, where the main transactions are in development loans. In addition, the firm is expanding into France and Spain, notes Hulme. Restructuring and advisory opportunities in Germany are also one of the firm’s key focus areas.
Hulme says: “Based on our UK portfolio, there is little evidence of widespread distress, but we are starting to see some levels of stress across the market. In contrast, our European portfolio is seeing increasing levels of stress due to the declining real estate values resulting in LTV covenant breaches and higher financing costs. This combination of factors presents an opportunity for refinancing and restructuring on the continent.”
Oxane Partners’ Soni reports he is also seeing appetite for broader asset-backed lending structures that include CRE loan-on-loan and corporate loan portfolio financing in addition to other receivables transactions.
“We are seeing growth across these sectors and that has kept us busy in Q1 and Q2 this year. We expect the dealflow to grow stronger in the last two quarters of the year.”
At the same time, however, Soni points to the challenges facing servicers that have a majority of their revenues coming in from commercial real estate, and he recommends a diversification strategy.
“While CRE dealflow has decreased, there is still a lot of momentum within the broader private credit sector. We are managing transactions across the broader real assets space that includes infrastructure, transportation and alternative assets while also doing corporate loan portfolio financing transactions, etc, where the dealflow is largely unaffected.”
CBRE’s servicing business has also diversified over the years with the addition of infrastructure debt to its platform. Yet, despite the negative noise all around, Dixon is relatively more optimistic about the fate of Europe’s commercial real estate lending and servicing industry.
“We have been faced with the potential of stress since the Brexit vote, but the market has proven to be resilient,” he says.
“Real estate always recovers, and as someone who has been through multiple cycles, I can say this with a certain amount of conviction and belief. Europe is different from other jurisdictions because of its jurisdictional diversity. Neither stress nor recovery occurs across Europe [as a whole] at the same time.”