Commercial Real Estate Loan Workout Strategies

Increasing vacancies, decreasing rents, negative cash flows, rising cap rates, imprecise valuations, severely constrained financing, and personal guaranties will continue to put severe pressure on over-leveraged commercial real estate owners during the next few years. As the wave of commercial property loan defaults begins to crest, borrowers should be armed and prepared with practical strategies and solutions for dealing with their under-performing properties and maturing loans.

Foresight Analytics recently estimated about two-thirds of the $800 billion in commercial real estate (“CRE”) loans held by banks, maturing in the next 5 years, exceed the value of the property. U.S. bank regulators increasingly complain losses on souring CRE loans pose the biggest risk to lenders. “The most prominent area of risk for rising credit losses at FDIC-insured institutions during the next several quarters is in CRE lending,” FDIC Chairman Sheila Bair recently said. “Prudent loan workouts are often in the best interest of financial institutions and borrowers.”

Consequently, regulators have recently issued new guidelines to help the institutions modify loan agreements. On September 16, 2009, the IRS issued eagerly anticipated guidance of significant help to borrowers with conduit financing (securitized loans). This guidance will allow some commercial mortgage loans held by Real Estate Mortgage Investment Conduits (“REMICS”) to be modified prior to default, without triggering adverse tax consequences to the holder. According to Foresight Analytics, the flexibility recently extended by regulators will apply to about $110-$130 billion of the $800 billion in underwater loans.

Lenders and loan servicers will almost certainly become increasingly overwhelmed and inundated with troubled loans in 2010. Borrowers with distressed properties must prepare themselves to understand and compare all of their options, and then take a proactive and timely approach to alleviating their financial distress.

Maturing Loans

In a maturing loan situation, when no other financing seems to be available, it may be possible to simply extend the existing loan for a fee (usually ½ to 1 point), in order to buy up to 2 years. Under these circumstances, a borrower would be well advised to approach its lender, approximately 4-6 months before the loan matures, with evidence of the borrower’s unsuccessful refinance efforts and a specific proposal for the extension. As part of the proposed extension, the borrower might also request other modifications such as an interest rate reduction, if appropriate.

Good Money After Bad

In a distressed property situation, a borrower should first carefully consider whether it makes economic sense to even try to save the property. Throwing good money after bad makes no sense. In making this determination, the borrower must formulate realistic projections about the net operating income, cash flow and cap rate over the next 1-3 years, and consider the opportunity cost of nursing an ailing property back to health instead of investing the resources into something more stable and profitable. Tax ramifications should also be carefully considered.

Perhaps some equity and profit can still be preserved by a normal sale. However, if the borrower has no remaining equity, and his or her projections show little prospect for a timely recovery, then a short sale or deed in lieu of foreclosure might make more economic sense. Both of these options require the lender’s cooperation, and both may have significant tax and legal consequences, including with respect to previous tax-deferred exchanges and any forgiveness of recourse debt.

Loan Workouts and Modifications

In other situations, modification of various loan terms and other workout possibilities might provide the means for the investors and lender to salvage more of their investment and minimize their respective losses. The workout might include an interest rate reduction, amortization schedule adjustment and, in rare cases, a forbearance or principal reduction.

Several factors can influence the loan workout process. For example, a commercial bank will generally have more flexibility than a special servicer for a commercial mortgage-backed security (“CMBS”), especially with regard to principal reduction. The lender’s willingness to negotiate a workout may also depend on the story of how the property has changed, and whether the proposed modification will fix the problem causing the distress.

Certain strategies will also enhance the borrower’s ability to achieve a desired loan modification. The borrower should approach the lender early, before feeding the property for several months, and before going into default. Though not a necessity, it sometimes takes a monetary default for a CMBS loan to get transferred from a general servicer to a special servicer with workout authority.

Lenders and loan servicers have their hands full now and, therefore, the borrower should make its case easily comprehensible and thorough by including an historical and pro-forma cash flow model, credible and fresh market research, and a detailed strategy for emerging from the distress situation. The borrower must recognize that the lender/servicer desires a sound borrower and asset manager, who contribute to the modification and who will not default in the future. In general, the borrower will benefit by presenting multiple modification options. CMBS loan servicers may also require an illustration of the net present value of various modification options.

Illustration

The following example illustrates some typical differences in commercial underwriting criteria and economics for the same property in 2007 and 2009:

2007 Origination Underwriting

2009 Refinance Underwriting

Valuation/Price

$10,000,000

$4,533,333

Cap Rate

6.0%

9.0%

NOI

$600,000

$408,000

LTV

80%

65%

Loan Amount

$8,000,000

$2,946,667

Required Equity

$2,000,000

$5,053,333 additional

Amortization

Interest-only 2 years of 30

25 years

10 Yr Treasury

4.70%

2.85%

Credit Spread

45

500

Swap Spread

50

25

Total Interest Rate

5.65%

8.10%

Debt Service

$545,455

$275,261

DCR

1.10

1.30

In addition to more stringent underwriting criteria shown in the 2009 refinance column, the NOI in this example decreased after the loan origination in 2007, due to increased vacancy rates, rent reductions, and expenses. Assuming the vacancy rate is now 15% instead of 5%, and rents are now 20% less than they were in 2007, then the NOI might approximate $408,000 instead of $600,000, and the property might easily have gone from having a good positive cash flow to a distressing negative cash flow. Using today’s cap rate of 9%, the property value has plummeted from $10,000,000 to $4,533,333, as shown in the 2009 column, such that all equity has been lost, and refinancing has become economically infeasible due to the current equity shortfall of $5,053,333.

In this situation, the borrower might consider multiple concurrent strategies, including a short sale or deed in lieu of foreclosure (with a release of any guarantor), and a loan modification. The loan modification might include re-amortization over a longer period, with a reduction in the interest rate, and an elimination of principal reduction for a period of time sufficient to allow the property owner an opportunity to fill vacancies and improve rental income. In appropriate situations, the loan modification might even include a discount of the principal balance on the note as a means of incentivizing the owner to continue operating the property at least until it returns to stabilization. However, the lender may also require the borrower to demonstrate its continued financial commitment to the property by putting additional cash into an interest reserve or toward a principal pay-down.

Importance of Consultants

The importance of knowledgeable and experienced consultants to guide the borrower and guarantors through the process of a loan workout cannot be overstated. Borrowers will need to perform objective and sophisticated economic analyses and feasibility studies, income and expense projections, and property valuations. Terms and agreements will need to be negotiated with lenders and servicers. Transactions must be carefully documented for legal and tax purposes. Additionally, even a capable borrower would do well to employ a third party consultant to act as his or her negotiator and intermediary, and to provide emotionally and financially detached objectivity and advice.

In a typical workout situation, the borrower will need a team of professionals which include a CRE lawyer, tax advisor, possibly a broker to provide a Broker Price Opinion to the lender and/or to market the property, and an economic/financial consultant to assist with preparing income and expense projections, forecasts, valuations and feasibility analyses. In some less common situations, other consultants may be beneficial, including bankruptcy counsel and litigation counsel.

Planning and Preparation

Strategic planning and preparation will greatly enhance a borrower’s chances of preserving invested capital, minimizing economic losses, and weathering the CRE storm. Borrowers and guarantors should carefully consider all of their options, and the consequences of each, with the assistance of qualified consultants. Then, if the workout strategy includes a potential loan modification, the borrower should present the lender or servicer with substantiated cash flow models, credible market research, and a detailed strategy for emerging from the distress situation.

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* Larry Murnane is a broker and lawyer in San Diego, California, emphasizing commercial real estate transactions, including CRE loan modifications and extensions. He is also the founder of Regal Properties, a Commercial Real Estate Investment Company licensed by the California Department of Real Estate, which works with a team of experienced consultants handling a variety of CRE loan workouts.

This article is for general informational purposes only, and should not be considered legal, tax, business or investment advice for any particular person or matter. Each situation is unique in some respect, and the law as well as the real estate and financial markets and institutions are constantly changing, such that this article or the information in it may not apply to a particular situation, or may no longer be current and accurate.