The current decline in commercial real estate has been deeper and longer than any in recent memory. Real estate was one of the first segments of the U.S. economy to go into recession and likely will be one of the last to see sustained improvement. The pain felt in the real estate markets has been further compounded by the loss of jobs in the U.S. economy and the resulting decline in consumer spending. Today, even loans secured by high quality properties with strong ownership are at risk.
The steep declines in revenue generation and property value present very real problems for every commercial lender. Most of the underwriting assumptions underpinning the commercial loans originated over the last decade are now unlikely ever to be achieved during the term of those loans. Lenders must take a fresh look at their existing commercial real estate loan portfolios to determine which loans are sustainable and remain consistent with the lender’s strategic goals.
Once the problem loans have been identified, a lender must decide what to do with them. This article provides a brief description and discussion of the four most common strategies for recovering on defaulted commercial real estate loans: Loan Modifications; Discounted Payoffs; Loan Sales; and Foreclosure. Obviously, other options exist that may provide better results on some loans. In general, the issues which can arise in any commercial real estate loan and the lender’s options for dealing with them are potentially open-ended. The intent of this article is to look at the advantages and disadvantages inherent in just four of the most common methods of recovery. Additionally, this article does not address the special issues and concerns lenders must consider for hospitality or construction loans.
Prior to initiating any strategic real estate recovery program, a lender should engage in an exercise of self-evaluation to establish the framework and priorities for the program. The lender’s own capital requirements, liquidity concerns, and timing constraints are overarching considerations that will shape and direct any recovery program. Choosing a specific approach solely because it has the potential to deliver a full monetary recovery may not be the best course of action if, as a result, the recovery takes too long or entails too much continued risk. It is also critically important to confirm whether the lender has fully reserved for the loans to be included in the recovery program and, if not, what method and timing will work best for realizing any further losses.
However, identifying the lender’s strategic goals is only the first step in determining an appropriate recovery method for a loan. A lender also must know the current status of the loan and have a thorough understanding of the underlying real estate. For example:
- Is the property currently generating positive cash flow and, if not, at what level would there be positive cash flow?
- What is the present value of the underlying collateral?
- Will the property require additional money (now or in the future) to deal with maintenance, capital expenditures, occupancy issues or other concerns?
- Is the default the result of property or borrower issues?
- Has the borrower remained cooperative and engaged?
- Does the borrower have the resources and willingness to commit additional equity to the property?
- Are the market conditions for the property declining or improving?
- Does the property carry any environmental risk?
- What is the likelihood of the borrower filing for bankruptcy?
These are just a few of the questions which must be answered before deciding which recovery method should be selected for a particular loan.
Equally important is understanding the rights, remedies and limitations contained in (or absent from) the loan documents. Each loan file should be reviewed to confirm what remedies are expressly available and whether any applicable notice or cure rights have been granted to the borrower. For example:
- Does the lender possess all the necessary documents to carry out an effective enforcement action?
- Do the loan documents provide the necessary security interest in the collateral and has the security interest been properly perfected?
- What is the priority of the lender’s security interest?
- Does the loan include recourse against the borrower or any guarantor?
- Is the loan cross-defaulted or cross-collateralized with any other debt held by the lender?
- Do the loan documents require notice to or consent from any other party (potentially including any participants, junior lien holders or mezzanine lenders) prior to commencing an enforcement action or in connection with any loan modification?
Finally, a careful review of all previous interactions with the borrower should be completed to determine if the borrower has any potential defenses to the enforcement of the loan documents or possible counterclaims against the lender.
While undertaking such in depth review of each defaulted loan may be time consuming, it is well worth the effort to avoid wasted time and expense in an actual enforcement action or subsequent negotiation with the borrower or outside parties. Furthermore, to answer many of the relevant questions posed in the previous paragraphs, it may be necessary to engage third-party service providers. Before doing so, a lender should carefully consider having any such service provider retained indirectly by their outside counsel to help protect the information developed from later discovery if litigation should commence between the lender and borrower.
The loan review period is also an excellent time to request missing or updated information regarding the property and the financial status of the borrower and any guarantor. This may help the lender get a feel for the level of cooperation it can expect from a borrower and may even initiate a dialog with the borrower regarding the eventual recovery effort.
The most common method of dealing with a troubled real estate loan is to modify its original terms. Generally, this happens after the loan has defaulted, but restructuring is also common when both parties recognize that a default is imminent. Loan modifications are so frequent used and valuable to lenders because they can be tailored to address almost any situation and can help correct deficiencies in the structure or documentation of the original loan. The lender’s goal in a loan modification typically is to return the loan to performing status, while preserving and often enhancing the lender’s rights and collateral. This type of credit enhancement can take many forms, including requiring additional equity from the borrower, increasing or adding loan reserves, implementing a cash management structure, or taking liens on additional collateral. Furthermore, unless the modification includes some measure of debt forgiveness, a lender’s chance at a full recovery is generally preserved and additional revenue can be generated in the form of a modification or extension fee.
Attempting to modify a defaulted loan is usually the first option considered by a lender and it is often only the first step in implementing one of the other options. However, modifications are frequently not the best course of action and lenders should be cautious about modifying a loan when the underlying property fundamentals are still declining. Generally, modifications work best when the property is generating sufficient cash flow to at least meet the basic debt service requirements. Modifications are also well suited for addressing loans that were performing, but failed to repay at maturity. However, even in that circumstance cash flow should be a major factor in determining whether the loan can continue to perform. Modifications should also only be considered when the lender and borrower have maintained a constructive and engaged relationship. In these circumstances loan modifications can actually serve to strengthen a costumer relationship. An additional benefit is that all of the other options are still available if the property continues to decline.
Despite this usefulness, the risks of a loan modification must be clearly understood by the lender. Loan modifications do not yield an immediate monetary recovery and in most circumstances delay full repayment. Additionally, modified loans remain on the lender’s books and thus present a continuing credit risk, while also preventing the lender from utilizing the capital in potentially more lucrative ways. For these reason, loan modifications should not be used when the likely outcome is simply to delay the inevitable collapse of the loan or the borrower. This delay only serves the interests of the borrower and will ultimately make the loan more costly for the lender.
Discounted payoffs may be the second most common method employed by lenders to dispose of trouble real estate loans. Typically the idea of a discounted payoff is raised by the borrower during the course of implementing one of the other options, particularly foreclosure. However, it may be in a lender’s interest to seek a discounted payoff when there are concerns about the underlying collateral or the lender’s ability to enforce the loan documents.
While permitting a less than full repayment guarantees the lender will take some loss on the loan, discounted payoffs do offer several advantages. They permit an immediate recovery of a portion of the lender’s capital and remove the loan from the lender’s book. Discounted payoffs are also the lowest cost recovery option available to lenders, as little additional work or expenditures are required to complete them. In most instances they also allow the lender to maintain a positive relationship with the borrower.
However, discounted payoffs are a viable option only when the borrower is capable of obtaining new financing from another source. It is also very important for a lender to know the underlying value of the asset in order to determine whether the borrower and, in turn the lender, is receiving a fair deal. For this reason a lender should be very involved with the refinancing efforts, including requiring the borrower obtain more than one offer when possible.
As a final word of caution on discounted payoffs, many lenders try to preserve their chance at a full recovery by forcing the borrower to sign a so-called "Hope Note" for the repayment shortfall. This new note is usually left unsecured or becomes subordinate to the new mortgage loan. While some such notes are undoubtedly repaid, the vast majority are just what the name entails, a wishful hope on the part of the lender. In addition, these notes can negate one of the primary benefits of a discounted repayment which is to remove the loan from the lender’s books. For that reason, "Hope Notes" should only be used when some additional method can be used to transfer the loan off the lender’s balance sheet. If a lender truly believes in the possibility of a turnaround at the property, it should reconsider its own ability to modify the existing loan terms.
Selling a defaulted loan to another financial institution, investor or one of the many "debt funds" created in recent years is another possible solution. Similar in many respects to a discounted payoff, a loan sale allows a lender to receive an immediate repayment of some capital and removes the loan from the lender’s books. It is also a low cost option. While some additional time and expense will go into the loan sale, much less is required than for a loan modification or foreclosure. Finally, while a loan sale usually insures the lender will take a loss on the loan, it provides certainty as to the extent of that loss. It is also common for lenders to split larger loans into multiple traunches and to sell off one or more of the pieces to reduce their exposure to a particular property or borrower. However, this works best on performing assets and is extremely difficult to accomplish once a loan has defaulted.
A loan sale is usually the best method to dispose of a lender’s worst assets. A lender decides to sell a defaulted loan only after it has determined it is unwilling to own the underlying collateral. As a result, and because the purchaser will be seeking to maximize its own potential return, defaulted loan sales generally occur at a discount to the fair market value of the property. Any document defects or collateral security issues relating to the loan will further depress the loan’s value, and a lender should consider correcting as many of these issues as possible before marketing the loan. Defaulted loans are also difficult to value and prices can vary considerably. As a result, lenders should attempt to solicit bids from multiple parties prior to selling any loan.
Although foreclosure is the primary remedy in all commercial real estate loan documents, it is often the last remedy a lender implements. The negative perception lenders have regarding foreclosure often comes from valid concerns about the complexity, timing, expense and litigious nature of the process. Nevertheless, foreclosure can be a very effective and very lucrative means of recovering on a defaulted loan.
Prior to initiating any foreclosure action, a lender must determine if it is willing to own the underlying collateral and, if so, at what price. This is because so often the lender will be the highest (or only) bidder at a foreclosure sale. Lenders should view the underlying collateral as a potential real estate investment and decide at what price they would be willing to make that investment. It is often said that a lender should perceive its "cost" in an asset purchased at foreclosure to be equal to the next highest bid for that asset. A lender must also assess the increased liability it takes on if it acquires the asset. At a minimum, this includes obtaining a full environmental assessment on the property prior to acquiring title.
A lender should also have a good idea of what it ultimately intends to do with the asset prior to purchasing it at foreclosure. Will the lender hold and rehabilitate the asset or immediately try to resell it? In either circumstance, a lender must carefully consider the additional costs that it will incur as a result of owning the asset (taxes, insurance, maintenance, etc.) and the cost of the assets final disposition. In addition, a lender must determine if it has the right expertise on staff, or otherwise available, to execute on its chosen strategy. It some circumstances it may be better to allow a property to remain in the hands of an experienced borrower than for a lender to seek to operate it.
A foreclosure action, whether the lender obtains title or not, assumes that a lender will receive at least a "fair market" recovery on the loan, while at the same time removes the loan from the lender’s books. In addition, many states permit lenders to pursue a deficiency judgment against a borrower, preserving in theory the possibility of a full recovery. However, to obtain a deficiency judgment the lender needs to carefully consider the method to be used for the foreclosure (typically judicial verse non-judicial) and whether the underlying loan documents prohibit such a recovery. A lender should always retain outside counsel for advice on the best course of action for the state where the property is located.
The most common concerns raised by lenders when considering foreclosure is the associated time and cost. Additionally, borrowers frequently respond to a foreclosure notice by immediately filing for bankruptcy. When this complication occurs, very little can be done to avoid an increase in both the time and cost it will take to recover on the loan. In truth, it can add greatly to the lender’s loss on a loan. However, options such as accepting a deed-in-lieu or pursuing non-judicial foreclosure can help to reduce both.
Finally, if not already the case, foreclosure is the end of any constructive relationship between the borrower and lender. While this may not be much of a concern to a lender on the eve of a foreclosure, relationships must be considered if the lender holds other outstanding loans to the same borrower or an affilite, particularly if those assets are performing. In that circumstance a lender may achieve a better overall result with a borrower by seeking to modify the defaulted loan in a way that includes cross-defaulting and cross-collateralizing it with the performing properties.
The four recovery methods discussed in this article are not the only options available, just some of the most common. Furthermore, it is common practice to employ these and other options in combination on the same asset. For example, lenders often modify and improve loans prior to selling them. Likewise, lenders frequently enter into a loan modification for the implicit purpose of correcting any defects in the loan documents, before ultimately commencing a foreclosure action. However, the success or failure of any recovery method generally comes down to the level of knowledge the lender has about the loan and the underlying collateral at the outset. Charting the right course of action is the key to maximizing recovery.