Troubled CRE Loan Resolutions Now

By Maura O'Connor

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As Europe limps towards resolution or further chaos, it seems there are signs of economic life in the US.  Some of this is playing out in the real estate world, where some resolutions are happening amidst the rubble of loans gone bad.

What’s driving this movement?  A growing awareness, over the last 12 – 18 months or so on the part of borrowers that they need to face facts about how much money they’ve lost, and that a hoped-for quick turn-around won’t come quickly enough for them to carry their troubled projects.  On the lenders’ side, more willingness for lenders and special servicers to do at least some restructuring (usually accelerated when the money from the project stops flowing in) and the greater availability of investors willing to buy troubled assets (both troubled properties and troubled loans), bringing new capital in to make something of the rubble – provided that the remains of the project or asset are priced low enough.  In other words, a little bit of give on all sides.

That said, the deals we’re seeing now in the trenches are still very much driven by the bottom line for the lender or special servicer.  Essentially, the lender or special servicer wants to get the best possible return on its investment in the loan, while paying the lowest possible cost (avoiding having to pay advances for tenant improvements, broker commissions and the like, keeping legal and title costs down, and minimizing personnel time).  For these reasons, the deals most likely to be made with existing borrowers in trouble are those where the borrower can come up with some money up front to pay some or all of these costs.  Essentially, the decision to work out a commercial real estate loan consensually, or to sell it, or to foreclose on the collateral, comes down to whether the proposed deal is better than the outcome the lender would get through a foreclosure and sale of the property, and whether the proposed resolution is allowed by the regulatory regime applicable to the lender or special servicer (where the lender is a bank, the governmental regulations and regulators must be satisfied; where the loan is in special servicing, the provisions of the pooling and servicing agreement and the REMIC rules typically apply).

What resolutions are actually being done right now depends, in each case, on the specifics of each loan and the real estate project that is collateral for it.  The project’s current value is key, as is its prospective value – if it can be improved within a foreseeable period of time.  How much hair the project has on it – such as third party claims, mechanics’ liens, junior or mezzanine creditors’ claims, poor physical condition, environmental problems and the like – obviously affects its perceived value.  Also part of the assessment of value is how difficult and expensive it would be to enforce the mortgage in the state where the property is located. All of these things are part of the lender’s or servicer’s assessment of how much leverage it has to enforce its rights, and whether a consensual workout with the borrower, a note sale, a short sale or a foreclosure would make more sense.

Here’s a brief overview of some of the deals we’re seeing being done now (which may be combined in a given deal), and a few thoughts on the current state of play:

1.                 Extensions (extensions of time to pay back the loan, but no other changes to loan terms);
2.                  Modifications (changes to the terms of the loan, such as interest rate, amount of payment due, and the like);
3.                 Note Sales (sales of troubled notes to a third party buyer; often this is done by institutions seeking to lay off the risk of enforcement to investors willing to take on those risks in exchange for a lower price at which the real property collateral could turn a profit);
4.                 Restructures (generally, a loan modification that significantly changes the basic deal embodied in the loan documents);
5.                 A/B Note Structures (restructures where the outstanding loan amount is split into two notes, an “A” note, which can be supported and fully and timely paid out of the cash generated by the real estate project securing the loan, and a “B” note, also known as a “Hope Note”, which reflects all or a portion of the remaining amount owed, and is paid at some future date, typically upon refinancing or sale of the real property collateral);
6.                  Discounted Payoffs (borrowers pay off their entire note at a discount, sometimes in cash, sometimes by obtaining new financing)
7.                 Short Sales, including Sales Through Receiverships (borrowers cooperate with lenders to sell their real property collateral subject to the existing financing to a new owner with more ability to operate the real property; a downside here is possible fraud, so this requires diligence on the part of the lender)
8.                  Foreclosures/REO sales (enforcement of the loan by foreclosing upon and selling the property; this may also include litigation against any guarantors if there is grounds for such litigation);
9.              Deeds in Lieu (where borrower agrees to give back the property to the lender or its designee; can be useful in states where enforcement is difficult; not desirable where there are significant junior liens; some lenders are getting “cash in” deeds in lieu, where guarantors are paying money in addition to handing over the property in order to be released from their guaranties as well as to be rid of the problem property);
10.             Bankruptcies, including Sales through Bankruptcies (judicial procedures where all sides haggle over the carcass of the real property collateral and a federal judge ultimately decides who gets what);
11.             Others:  lawsuits against sponsors, originators; cancellation of debt (Litigation against guarantors where there’s a recourse guaranty; litigation against borrowers for fraud or waste;  cancellation of debt is typically traded for a partial payment of the guarantors’ liabilities under the guaranty in such resolutions).

Many lenders and servicers would like to reach a consensual resolution of their troubled loans, primarily because in a down market, selling REO (foreclosed real estate owned by the lender or held by the servicer) rarely yields the highest value for a given property.  However, there’s still frequently a large gap between what lenders and servicers would like to get, and what the borrowers are willing to pay. 

Many borrowers are reluctant to bring in new capital, because any “white knight” usually demands a fairly large stake; but sometimes they wait too long or are unrealistic, and lose the entire property rather than give up a chunk of their equity.  Another argument frequently clung to by borrowers is the idea that since a successor lender bought the troubled loan at a discount (or, if a bank, was given aid by the federal government), the lender should be willing to pass the savings through to the borrower.  This argument, despite a plausible equitable appeal, is really pointless:  even a lender who bought at 5 cents on the dollar is entitled to enforce the loan it purchases on the loan’s stated terms. 

Lenders who have full guaranties from borrowers’ principals (such as banks) have more leverage, at least in theory, because they can pursue their borrowers’ principals’ other assets – provided they have other reachable assets – if the property won’t satisfy the debt.  This often leads to more pliable borrowers, since they don’t want to be chased by collections lawyers for seven or more years.  However, since most conduit loans are backed only by limited guaranties, servicers don’t typically have that ability.  They also know that many sophisticated borrowers will walk away completely from conduit loans, and “jingle mail” the keys if a consensual resolution cannot be reached.  That said, special servicers sometimes appear more able to act as they are specifically created to handle troubled loans, and taking actions to resolve a problem doesn't put the same obligation of explaining to the regulators for their institution, which can present a challenge for a bank lender seeking to keep on the good side of the regulators.

One way to get greater leverage, and better information about the property if the borrower is not providing current financial information, is to get a receiver put into place, so that the actual income from the property can be determined and collected.  This can be expensive, however; and some courts still treat receivership as an extreme remedy to be used only where there’s significant evidence of harm to the property collateral being caused by the borrower.  Bankruptcy, too, while generally anathema to lenders and servicers, can sometimes be used to their advantage by wresting control of the real property collateral or the information about it, from the borrower.

We are seeing more sales of notes through receiverships:  this allows the note to be exposed to the market and gives the lender or servicer some protections from liability; if the sale doesn’t close, or the desired price is not offered, the note can still be foreclosed.  Some states’ laws allow this; some don’t; and some (such as California) probably allow such sales under certain conditions but don’t yet have fully developed precedential case law addressing the issue (though the author believes that there’s a way to do such receivership sales in California, and has convinced a number of title insurers to insure them provided certain strict legal criteria are satisfied).

Bottom line, we are seeing some loans slouch towards resolutions, slowly and fitfully; and others lumbering on as the parties try to see who will bear the worst loss first.  Nothing in the economy outside real estate seems to be encouraging growth or even sufficient stability to suddenly return the ailing commercial real property projects to full health by creating a lot of demand for space.  So I suspect we’ll see another 3 to 4 years of this at least in many markets before the oversupply of commercial real estate is absorbed.

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