By Barry Katz, Arnstein & Lehr LLP
In the next five years it is estimated, according to The Trepp Report and Real Capital Analytics, that about $1.7 trillion to $2 trillion in commercial real estate mortgages will mature, of which about one-half of that amount will be “underwater.” Breaking this down, on an annual basis, during the next five years, about $150 billion $200 billion in commercial mortgages with debt in excess of the market value of the property will need to be refinanced. The only marginally positive news for owners of many of these properties is that they have been able to pay existing debt service, avoid foreclosure and maintain control over their asset during the great recession.
However, the owners of underwater properties will be faced with significant difficulties in their efforts to refinance. Because of the decrease in market value, the amount of available financing will be reduced, which will require either recapitalization and/or additional cash investment from ownership or investors. At the same time, underwriting standards have become more stringent. This last point is significant; If the current loan is non-recourse, as a condition to any extension/refinance, the existing (or new) lender may require a personal guaranty, generally for the full amount of the debt. Given the decrease in the asset value and the probable loss of equity in the property, most owners will not be willing to execute a personal guaranty and will choose to review other options.
The earlier the owner of a property that is “underwater” with a looming maturity recognizes potential problems and starts the planning process the more likely options other than giving the property to a lender (either voluntarily or through foreclosure) will be available. The first step for existing ownership is to start a dialogue with the existing lender to determine if the existing lender is willing to extend the loan. If the answer is “yes,” then the next step is to discuss the terms of the extension.
Before discussions with the current lender, ownership should have an idea of its goals and, if possible, position itself with available alternatives. These alternatives range from offering the terms of a loan modification; solicitation of additional capital from third party investors; availability of a third party willing to purchase the note at a discounted amount or exploration of the short sale of the property to a third party.
When initiating discussion with the current lender, the primary goal of a owner should be to offer a solution to the problem of insufficient funds to repay the loan at maturity. In approaching a lender, the crucial concept for the owner is to help the lender realize that no two “distressed properties” are the same and that the facts related to each property will drive analysis and solutions. When a lender appears to have a “cookie cutter” approach to distressed real estate, the more prepared the owners are the more likely a proposal will not be rejected out of hand by the lender. Having a ready alternative for the lender can be pivotal.
If the existing lender is unwilling to extend the term or write-down the loan to recognize the loss in value (which existing lenders, in general, seem unwilling to do), then other options will need to be explored, including finding alternative sources of financing or the possibility of strategic default (which are not mutually exclusive solutions).
Let’s place this in perspective with a hypothetical case study. In 2006, a borrower received a $4 million non-recourse loan on a property with an appraised value of $5, million. The property is now 75 percent leased, market rents have declined 30 percent and the appraisal ordered by ownership shows a market value of $3 million. The property is $875,000 underwater. The borrower has done its homework: It has prepared a financial projection, obtained an appraisal and scheduled a meeting with the lender. At the meeting, the lender tells the owner that (i) it will agree to refinance $2.4 million as long as the owner pays the amount due on the initial loan and executes a personal guaranty or (ii) if ownership will not meet these terms, that it is prepared to foreclose.
The question becomes: what are the options of ownership for this “underwater” property that needs to be refinanced? Several are as follows:
1. Convey the property to the bank by way of a deed in lieu of foreclosure. This decision might revolve around whether the loan is non-recourse. If the borrower executed a guaranty for the benefit of the bank, then the discussion with the bank may center on whether the bank is willing to waive the deficiency between the amount of the loan that is due and the original amount of the loan (in other words, not seek collection from the borrower under the guaranty) in exchange for delivery of a deed without a court proceeding. To the extent the property is located in a non-judicial foreclosure state with a faster timeline of legal conveyance of the property to the lender, the less leverage a borrower has on this point. In a judicial foreclosure state such as Illinois, the borrower can use the time of the foreclosure process as a bargaining chip. The risk to borrower is that a lender will file foreclosure and immediately seek appointment of a receiver, which would take day-to-day control of the property and any cash flow/income from the borrower.
2. Seek alternative financing from “non-traditional sources.” In the last several years numerous private investors and funds have entered the real estate arena by offering to pay off the existing lender and to grant a short-term loan to a borrower. In this scenario, the third-party investor will negotiate on behalf of borrower with the lender. The incentive for the lender in this process is that the third-party investor will offer the lender a payoff (generally within a short time frame) for the loan, generally at or near the value set forth in the appraisal. There is incentive for the lender to accept market value and write off the loan from its books: its alternative is to spend the time, cost and effort to foreclose, take title to the property and then, once in ownership, market and attempt to sell the property. Since the market value of the property at that time most likely will be similar to the market value of the current appraisal there is no assurance that after the time, cost and effort of a foreclosure that the lender will receive any more money than that offered to the lender by the third-party investor.
If approved by the Lender, the third-party investor pays off the existing loan and holds the note for a negotiated period of time while the borrower seeks alternative funding and, if necessary, additional capitalization. The third-party investor will make sure it is adequately collateralized for the risk (which likely will include personal guaranties) and may charge a higher-than-market interest rate. There is also a small possibility that the third-party investor also may be willing to structure a longer-term solution by investing in the property for a piece of ownership.
The benefit to ownership is while there is a price for this funding (higher interest rate for the interim period), if the lender accepts payoff from the third party, the value of the asset has been written down to market value, making it easier to obtain traditional financing from another lender and retain ownership of the property.
If the lender is unwilling to reach an agreement with a third-party investor, then the borrower and lender will most likely be exploring the options set forth in Paragraph 1 above.
By doing its research, knowing the market value and projected cash flow for its property, and, if possible, having a third-party investor available with cash in hand, a borrower can react to the decisions of its lender and make pragmatic decisions as to whether future ownership of the property is worthwhile and in its best interest.
Barry Katz is a partner with the Chicago law firm of Arnstein & Lehr LLP. He represents lenders, corporations with real estate needs, real estate entrepreneurs, condominium associations, not-for-profit corporations and management companies in the Chicago area and nationwide with issues related to the acquisition, sale, financing, work-out and operation and management of real estate.
