The question

It’s similar to this but slightly different, and it’s also the #1 reason commercial spaces sat vacant even prior to Covid. A lot of these landlord cant lower rent due to the language in their commercial mortgages. Frequently there will be language like 'if rent is below $X, the borrower must recollateralize the loan.' That’s business language for (I’m making up the numbers here) 'if you rent this space for less than $10,000/mo, the borrower must write a check for $250k to account for the reduced value of the leased property.' In some cases, if the rent is below a certain level, the entire loan goes into technical default and the landlord loses everything.

The complicated part is that this isn’t just ‘evil banks’. The banks don’t hold these loans - they are parsed out to investors as CMBSs. So depending on the language in the CMBS origination document, you might have to get, say, 80% approval from the investors (which is really fucking hard) to approve even a single loan modification.

Real estate is just super complicated, and people think they have a grasp of it bc they (kinda) know how a home mortgage works, but commercial real estate is nothing like the housing market.

This is stupid complicated, but I’ll give it a shot. Also understand this is HUGELY ELI5 and I’m glossing over & simplifying a lot.

Commercial real estate is still very much a ‘handshake’ type of business where relationships matter. We can lump commercial properties and apartment buildings together here even though they are slightly different.

So you want to buy a building. You go to the bank with your business plan. “I’m going to buy this building that has 4 units. Currently, those 4 units are generating $20k/mo of rent.” As a very general rule of thumb, a properties value is about 12x to 14x annual rent - there are huge situation-specific variables, but this is a starting point. So let’s say, our building is currently worth ($20k * 12mo * 13x) or about $3.1M. This is roughly the current market price for this property; however, in reality everyone selling tries to get a little more so the actually selling price would be like $3.3M The bank will be willing to lend you about 85% of the ‘fair value’ ($2.7M) and you have to come up with the rest.

But that sucks bc you don’t want to put $600k of your money into it. So you’re clever. You go to Duane Reade, Starbucks, A new retailer and a new restaurant and get them to commit to leases on the new property (before you even own it) of $6000/mo. Now going through the same math above, you can argue that with your new plan, the building is actually worth ($6000 * 4units * 12mo * 13) $3.7M and you’re ‘only’ requesting a loan for $3.3M and the bank is getting a $400k cushion. So the bank will fund the whole project and you don’t need to tie up your money. But the bank isn’t stupid. They want a guarantee that you can get the $6000/mo and if you fail, you’re in default. Also, you are required to maintain that $400k cushion to protect the bank.

And a weird thing to understand about commercial mortgages is that while you have a vacant space, you can choose to take part of what you owe and tack it on the end of the mortgage. So if you have 3 spaces rented, you can choose to pay 3/4 of your mortgage and tack the 1/4 (plus interest) to the end of the lease.

So 2 years in, the restaurant and the retailer fail. You’ve got 2 spaces to fill. You ask around a lot, but the best offer you can get is, say, $5000/mo. The bank is gonna say, well your ‘new’ rent is only $22,000/mo (2 * $6k plus 2 new leases at $5k) so you building is worth $3.4M. The banks cushion is only $100k now. So they are gonna call you and say, 'if you sign those leases, you owe a check for $300k to restore our cushion.' So you can’t sign those leases economically. So you don’t sign the new tenant and you continue to tack the missing rent income on the end of the mortgage. You ‘prey and delay’ hoping that, say, Chase bank wants to open a branch in your building and pay you (over) $6000/mo. (Edit: in reality the metric isn’t rent, it’s actually ‘funds from operations’ which is basically your ‘cash profit’. It’s rent minus direct expenses and maintence/reinvestment and a few other things. I just used ‘rent’ to simplify things)

If the best you can find in rent is say $4000/mo, the fair value of the building is $3.1M but you owe $3.3M and the loan is underwater. You have to either write a gigantic check or you are in default and the building gets seized.

Why can’t you get a modification to the terms? You can, it’s just really hard. Your loan isn’t held by the bank. It was almost immediately sold to be put in a structured product called a CMBS that’s held by anywhere between 50 and 500 investors like mutual funds, hedge funds (me), pensions funds, endowments, etc. (Edit: CMBS = commercial mortgage backed security. It’s like a box you put a ton of mortgages in and it’s divided up and sold to investors).

In the CMBS origination documents, there is language about how to modify the underlying loans. Generally but not always, you need a vote of the holders to approve modifications; 60% to 80% is common but somethings you see 50.1% and sometimes you see 100% required.

Here’s the thing - investors in a CMBS will have invested in different order of ‘risk’. The first people paid are called ‘senior holders’ and the last people paid are called junior/equity holders. If I am a senior holder, I want the bank to modify the loan ASAP bc all the losses from the loan hit the lowest tranche of the CMBS - and fuck those guys. If I’m junior, I do not want to modify the lease bc it forces me to absorb the loss immediately. I’d rather ‘prey and delay’ and hope the landlord can find a good tenant. So the investors in the CMBS are voting against each other which makes getting a strong majority close to impossible.

That said, Covid is changing everything. I can honestly say I’ve seen 10x more modifications in the last 3mo than I saw my entire career including the great financial crisis. There is a HUGE flurry of activity happing in the commercial finance sector that nobody outside of the industry is talking about.