A failed attempt to sell a New York City office tower helped cause more than a year-long delay for two credit rating agencies to downgrade a commercial mortgage bond to junk, according to a source familiar with the situation and a review of filings from the agencies.
The delayed ratings cut of 1740 Broadway bonds blindsided investors in the safest tranche of the commercial mortgage-backed securities (CMBS). The 26 per cent loss on their US$157.5 million investment sent shockwaves across financial markets that rely heavily on ratings as an assessment of credit quality, and marked the first loss on a AAA-rated bond since the 2008 financial crisis.
Credit rating agencies S&P and DBRS Morningstar downgraded the top-rated AAA tranche of a commercial mortgage-backed security (CMBS) on 1740 Broadway to below investment grade in August and November 2023, respectively.
But it was March of 2022, at least 17 months earlier, when private equity firm Blackstone Group, the owner of the building, turned the keys over to investors after the anchor tenant decided to move out in the aftermath of COVID-19, according to the agency reports.
While the loss on the CMBS is known, the Reuters review of the agency reports and interviews with a half dozen mortgage experts, including a person who was involved in the situation, for the first time piece together the sequence of events that led to the delay in ratings downgrades.
They show that a failed attempt to sell the property in late 2022 and delayed property appraisals led to the overly optimistic view for months of how much money the building could fetch to repay investors.
S&P and DBRS told Reuters they shared the rationale behind their actions on 1740 Broadway and its ratings criteria and methodology, as well as research that highlighted the challenges in the office sub-sector, including price discovery, through published reports. They had no additional comments.
A Blackstone spokesperson said the investment firm "worked with relevant parties to reach a resolution."
Credit ratings are used across the financial system to assess the risk of defaults, helping financial institutions and investors determine how much capital they need to keep on hand to absorb any losses. Many more bonds worth billions of dollars are in a similar position, and critics said the failure to downgrade in a timely manner is worrying.
"Investor losses in 1740 Broadway, even at the AAA tranche, call to mind the ugly specter of 2007's housing crisis and the ratings agencies' participation in that horrific destruction of wealth," said Paul Feinstein, CEO of Audent Global Asset Management, which invests in real estate.
SPECIAL SERVICER
Blackstone bought 1740 Broadway in 2014 for $605 million. The debt that financed the purchase was packaged into the CMBS the following year. The building's main tenant was L Brands, which at the time was the owner of Victoria's Secret and other brands.
S&P and DBRS rated the top tranche of the security – the first to be paid interest from the building's income – as AAA. At the time of the CMBS issuance, DBRS noted in its rating report an issue with how cash from the L-Brands lease was not being saved for a rainy day. But it took into account "strong sponsorship in Blackstone" as a mitigating factor.
Trouble started when L Brands said they would move out in March 2022, prompting Blackstone to default on the loan.
In a commercial backed mortgage security, distressed properties are turned over to a special servicer, an agent for investors in the bond who must then resolve the property, usually by selling it.
Soon after Green Loan Services was appointed as the special servicer in April 2022, it identified a buyer that was offering the full value of the property, something that would have paid back all the bond investors, according to the source familiar with the matter.
Over the ensuing months, the discussions between the special servicer and the potential buyer, previously unreported, got advanced enough for them to start drawing paperwork for the sale, the source said.
But around the same time, the Federal Reserve was raising interest rates to tackle runaway inflation as the country emerged from the pandemic, hurting property values.
More than seven months later, in December 2022, the buyer eventually balked and the deal fell apart, the source said.
The lengthy sales talks meant that an independent appraisal for the building was never ordered, ratings agency reports show. An appraisal would have revealed the market value of the property at the time and if it was sufficient to pay down bondholders.
Absent that, agencies relied on their models, which projected the value to be more than it was worth. In an April 2022 review, for example, S&P estimated the property was worth US$270.4 million, giving it comfort to keep the rating intact.
LOW APPRAISAL
The appraisal was expected to be ordered, according to S&P, in the second quarter of 2023. In late February 2023, Green Loan was replaced by Midland Loan Services, a unit of PNC, as the special servicer.
The switch put the appraisal on hold again, S&P said in a March 2023 report.
DBRS, too, said Midland reported ongoing discussions "to determine the appropriate disposition strategy."
Midland and PNC did not respond to requests for comment.
An appraisal was finally provided in July 2023, according to a DBRS report. It valued the building at just US$175 million, which meant there was not enough money to pay what AAA holders were owed.
S&P cut its rating on the bonds to BB+, which is below investment grade. The AAA bonds, which were until then hovering around 90 cents to the dollar, declined to 75 cents and then to 60 cents, said Jeff Berenbaum, head of CMBS strategy at Citigroup.