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Jeff Krasnoff’s special servicing empire powers up
Rialto has built an $11 billion business in distress
When Disneyland shut down at the onset of Covid, it plunged one nearby hotel into every real estate borrower’s unhappiest place on Earth: special servicing.
The property, a 285-room Sheraton in Garden Grove, California, had few guests and declining revenue. Late that spring, executives at the Kam Sang Company, which owns the Sheraton, tried to negotiate relief on a $20 million loan secured by the property. They were soon banging their heads against the wall as they waited months for replies to each communication about the terms of the relief.
On the other side of the negotiating table was Jeff Krasnoff’s Rialto Capital, the special servicer on the commercial mortgage pool that held Kam Sang’s loan.
“CRE borrowers did not choose Rialto as a contractual counterparty,” attorneys for Kam Sang later pointed out in a lawsuit.
They “could not have foreseen that Rialto would deploy a phalanx of attorneys and consultants to extract excessive default interest from CRE borrowers on a massive scale.”
The financial and legal travails that followed for the property illustrate an increasingly common sequence for commercial borrowers, especially as the pandemic crisis at hotels and offices morphs into a high-interest-rate environment rife with distress. Kam Sang, the lawsuit alleges, “was one victim of Rialto’s scheme, but there were many others.”
But special servicing doesn’t just happen. Krasnoff has spent four decades flexing what his old employer called “down-cycle skills” to develop an $11 billion business in distress, hedging investments in the riskiest slices of commercial mortgage-backed securities with the power of special servicing.
Rialto is now the named special servicer on more than $100 billion of CMBS debt, only a portion of which is active in special servicing at any time. That puts it in the upper echelon of servicers in CMBS, which is a trillion-dollar market on its own. And the number of loans transferred into special servicing has been on the rise for much of the year. As of July, there were more than $40 billion worth of securitized loans in special servicing, according to Trepp.
$20M loan, $6M workout
Borrowers denouncing their special servicers are nothing new: The two sides are almost inherently at odds. Kam Sang Company found the process excruciating. Beginning in the late spring of 2020, its executives spent 17 months going back and forth with Rialto about modification agreements, according to the lawsuit, which is still playing out in court.
It was also expensive.
Kam Sang had little money coming in — revenue per available room dropped from nearly $68 before the pandemic to $1.41 in April 2020 — but the longer the loan sat in special servicing, the larger the fees and interest it had to pay to Rialto.
Kam Sang’s attorneys said documentation showed that Rialto had dragged out negotiations with 450 different borrowers for longer than a year.
“TBH it’s not a bad business model.”
On March 29, 2022, Kam Sang had had enough. The firm paid $24.8 million to Rialto in order to refinance with a new lender. Included in that figure was some $6 million in additional costs — mostly default interest — that went to Rialto, not the bondholders.
Rialto’s entire business plan, Kam Sang alleged, rested on siphoning money from borrowers unlucky enough to wind up under its sway.
Rialto scoffed at these claims.
“These litigations in no way support [Kam Sang’s] claim that Rialto is involved in some widespread, nefarious scheme,” its lawyers wrote in a memo in November.
“It is hardly surprising that Rialto-serviced loans are subjects of litigations during a period of record-high levels of default,” they added.
The largest servicers have more to come. In November, the $160 million loan on the Trump Organization’s 40 Wall Street was transferred to Rialto. And the company may partner with Blackstone Group to buy $17 billion worth of Signature Bank loans.
The dollar signs in distress
In 1990, Florida-based homebuilder Lennar was sniffing out opportunities in distressed real estate amid the fallout of the savings and loan crisis.
Krasnoff, then a 30-something accountant, came up with an idea to make money off of busted real estate deals, co-founding what became the Lennar subsidiary LNR Property Group.
The federal government was selling bad loans for pennies on the dollar; almost anyone with an eye for a deal could make money acquiring real estate at steep discounts, and many investors launched their careers in those days. These were also the early days of CMBS, and entrepreneurs were building the plumbing of the market.
By 1997, Krasnoff’s venture was producing over half of Lennar’s earnings, according to a 2010 investor presentation. LNR Property became one of the first to buy the riskiest slices of those mortgage bonds, known as B-pieces, and then service the securitized loans.
“Special services really are sort of the gatekeepers for those transactions both up front in terms of determining collateral that goes into the transactions and after the fact in terms of overseeing the, you know, overseeing the loans to ensure that they get collected,” Krasnoff said on a 2015 call with analysts, a rare public utterance.
LNR became the biggest name in a small but crowded space. The top four or five servicers had captured 80% of the marketplace, he estimated that year. “But from time to time there are opportunities out there,” he added.
Krasnoff led his team through a series of spinoffs, buyouts and acquisitions, ending in a 2013 purchase by Barry Sternlicht’s Starwood Capital.
That was not the end of the road for Krasnoff. He left LNR and launched Rialto as a bigger, more aggressive version of LNR, working closely with Stuart Miller at Lennar.
In the 2010 presentation, Miller summarized their past work together and explained what they hoped to accomplish together in the future.
One goal: “Create additional income streams from investments and fees for managing investments,” with the word “fees” in bold.
Plan B
Today, the company, headquartered in Miami, has raised more than $11 billion to buy equity and debt and is a major real estate investor.
A big piece of that is buying CMBS B-pieces.
Since 2014, Rialto has been the largest purchaser of that risky debt, according to Trepp, having spent more than $93 billion. (The second most active buyer, KKR, bought about half of that.)
The B-pieces are key to Riato’s special servicing business, since B-piece buyers have a lot of control over the CMBS process, including what loans go into the bonds.
“They have a huge advantage since they are a B-piece buyer and can put any shit collateral they want in any pool, leading to wide spreads and massive points on all their deals which are almost exclusively shit collateral that they would kick out if they didn’t originate,” a user on Wall Street Oasis wrote in 2017.
“TBH it’s not a bad business model.”
The B-piece buyer usually also gets to select the special servicer.
Rialto is the fifth-largest special servicer, overseeing $106 billion worth of loans, according to the Mortgage Bankers Association’s 2022 ranking.
Borrowers sometimes note the inherent conflict of interest: The servicer collects fees as long as the loan is in special servicing, incentivizing long negotiations.
(One frequent complaint borrowers have is that their servicers are chronically nonresponsive. To that end, representatives from Rialto did not respond to requests for comment on this article.)
Servicers collect a monthly fee at an annual rate of 0.25 percent, and get a 1 percent fee once the loan leaves their jurisdiction. And they can tack on all kinds of fees: banking fees, treasury management fees, title agent fees, appraisal fees and insurance agent commissions.
Litigation in CMBS special servicing is also common.
In probably the most notable case, investors in CMBS bonds backing Stuyvesant Town-Peter Cooper Village sued the property’s special servicer, CWCapital, in trying to prevent it from collecting $566 million in default interest when the property sold in 2015.
The CMBS loan agreements are often stacked against the borrowers, who have to sign an agreement waiving rights to future claims in order to be able to go into special servicing to negotiate a forbearance.
In 2017 a group of issuers and investors sent a letter to the Commercial Real Estate Finance Council — the trade group that oversees CMBS standards — raising concerns about the process.
CREFC created a task force to study the issue, but it’s not clear what came of it. A spokesperson for the organization declined to comment.
The squeeze scheme
At the Garden Grove Sheraton hotel, Kam Sang claimed in court papers, Rialto applied a well-rehearsed scheme to squeeze the borrower.
First, when Kam Sang requested relief, the hotel’s loan was transferred to Rialto. Throughout the fall of 2020 and most of 2021, the property owner believed both sides were making progress toward a settlement.
By the summer of 2021, borrower and special servicer were putting finishing touches on a forbearance agreement, according to Kam Sang’s complaint.
Then Rialto “abruptly changed course.” Employees at the servicer declared that the loan had been in default since 2017, the year it was originated. Kam Sang owed millions of dollars in default interest and fees, Rialto said.
“Manufacturing these non-existent defaults ‘retroactive’ to the origination of the loan was the linchpin of Rialto’s profit-maximizing scheme.”
Kam Sang called that a ruse — a suspicion it said was confirmed when Rialto “pivoted to an entirely new and equally false” default.
Frustrated and facing the threat of foreclosure, the hotel owner decided the only way to get out from under the servicer’s thumb was to refinance the loan with a new lender. But in order to do that, it needed to get a payoff letter.
The Kam Sang executives said Rialto dragged its feet in order to be able to charge yet more interest and fees, providing the letter just 11 days before the refinancing closed. The hotel owner paid off the loan, but only under protest.
Rialto had backed the executives up against a wall, according to the complaint.
“Manufacturing these non-existent defaults ‘retroactive’ to the origination of the loan was the linchpin of Rialto’s profit-maximizing scheme,” Kam Sang’s lawyers wrote, saying that Rialto used false pretenses and “squeezed borrowers” with the threat of foreclosure.
Rialto’s attorneys have moved to dismiss the suit, arguing that Kam Sang waived its rights to seek damages for delays. In another telling point, Rialto points out that it has no obligation to negotiate a modification.
At least eight other ongoing cases rest on similar claims.
One involves a loan to the Mattone Group, owner of the Jamaica Center shopping and office complex in Queens, that went into special servicing after Covid shutdowns hit the complex’s tenants, which include Multiplex Cinemas and the State University of New York.
Mattone executives said they learned that Rialto was not applying their payments to the loan balance. Interest and fees on that balance started to accrue, but Mattone said Rialto deliberately worked slowly and refused to provide a calculation of the arrears. Rialto extracted millions of dollars through its scheme, according to Mattone’s lawyers.
“They did so through accounting tricks, by miscalculating and overcharging interest and by simply refusing to provide accurate and timely information to borrower — even in the face of court orders requiring them to do just that,” they wrote.
In the meantime, more and more borrowers are grappling with painful workout situations.
The special servicing rate has climbed for eight straight months this year, according to Trepp, topping out at nearly 7 percent in September.
As in other times of heightened distress, like the S&L crisis and the Great Recession, Krasnoff is looking to capitalize: Rialto is currently raising its fifth debt fund. As of August, the firm had secured commitments of more than $820 million — more firepower for the CMBS guru.