It's no secret that default rates in commercial real estate loans have been increasing and are continuing to grow. Bloomberg reports that "the default rate on commercial mortgages held by U.S. banks may rise to the highest in 17 years in the fourth quarter as debt for refinancing remains scarce and the recession drags down rents."Across our firm's nationwide real estate practice, we are seeing increasing defaults and resulting workout and foreclosure activity. Some projects fail for reasons that are too difficult to resolve: for example, they may be too far underwater to be saved. But many other distressed loans that result in foreclosures could be worked out if certain simple, and seemingly obvious, steps are taken by both sides, lender and borrower/developer, so that they can cooperatively work out a consensual resolution.Often both the lender and the borrower/developer could obtain better results if they thought through the other party's motivations and constraints. So, at the risk of stating the obvious, here's a brief overview of issues often overlooked by both sides in working out problem loans. (I'll go into more detail about some of the specific points of leverage in later posts.)Borrower Mindset. Borrowers want to get their projects built and make a profit. And they usually come to a deal as optimists - they have to be, in order to get projects developed. Fundamentally, they also are creative: they like designing and doing the work, and are used to keeping control of it. One downside of this, in a downturn, is that some borrowers aren't quick to see themselves as in trouble, when a financed property starts to fall short of its covenants or cash flow. And even many of those who know that they are in trouble are hesitant to approach their lenders early, when trouble is foreseen but not yet happening, to seek a workout or forbearance. Instead, they may be tempted to act only after the trouble hits and their rents dry up; and then sometimes only by trying to obscure or shut down the flow of information to their lenders. This strategy generally does not work well.Lender Mindset. Unsurprisingly, lenders want to get their loans repaid. Their mindset is, "you borrowed the money and said you'd repay it; now it's time to pay it or surrender the collateral."But most lenders don't really want to take over the development of the financed real estate. They typically don't have the skills needed to develop, lease up or manage property, nor do they want the liability of an active developer. They also know that if they foreclose, rather than doing a workout, they likely will recover less.So, if they can see a reasonable plan for doing so and have enough flexibility, lenders usually would rather extend or modify their loans. This can leave the borrower/developer in charge, operating the property, as long as there is some realistic possibility of a repayment over time. If a workout or extension is done early enough, some types of lenders may be able to avoid having to reclassify the loan as a bad loan, which often costs them extra, as they must reserve additional capital against the potential loss. (Whether the lender is a portfolio lender, who originated and holds its own loan, or a CMBS lender, where the originator sold off all or most of the interests in the loan, and the loan is being serviced by a servicer, may to a large extent determine the flexibility the lender has to modify the loan.) However, while most lenders would rather complete a consensual workout than a foreclosure, they typically don't want to loan more money into a troubled project, unless they can see a clear exit that will result in a full repayment of the loan.Most lenders will typically assess fairly early on whether a distressed loan can be repaid in a reasonable time and what the current value of the project is. If the project is not salvageable, the lender typically will foreclose on and sell the collateral to collect as much of the outstanding amount as possible. In deciding whether to negotiate a workout or to foreclose, many lenders assess whether a borrower falls one of two informal categories: first, the borrowers that are straightforward about the project and that add hard-to-replace value to the collateral (for example, by working hard to increase the project's income, or by providing more equity or more collateral); or, second, borrowers that are not likely to add value or are not playing straight with their lender. In the current market, lenders' distressed loan departments are often overworked and understaffed; so these "good or bad" decisions sometimes will be made quickly and cursorily, not after careful study. In seeking a workout in a downturn, first impressions count. A borrower that falls into the "bad" category will typically not be able to negotiate a workout - the lender's representative will make triage decisions to spend time negotiating only the workouts that are likely to lead to a deal.Leverage. Once a borrower defaults or is in danger of defaulting on its loan, the lender has more leverage: if the borrower won't or can't pay back the loan, the lender can and will foreclose on the project. And there is usually no obligation on the part of a lender to work out a loan - a lender typically has the right to enforce its loan documents by foreclosing on the collateral and may also have the right to pursue additional repayments from borrowers or guarantors.A borrower who knows its project is having cash flow or other problems should analyze its cash position, when it is likely to default on its loans and what would be needed to get the project cash flowing again. This should be done as early as possible. It is usually advisable to bring in experts, such as asset managers, to help evaluate the financial position of the project, and lawyers, to help evaluate the borrower's legal position and develop a strategy. This analysis will help determine if the borrower has any leverage it can use to negotiate a deal with its lender, and what the lender's position is likely to be.Finding Common Ground. As early as possible, but only after a careful analysis of the parties' positions and potential leverage, a borrower with a salvageable project should approach its lender and open discussions about working out the loan, confirming any oral requests in writing. If the lender is not responsive, the borrower should resend its request for workout discussions in writing, with a brief summary of its proposed workout plan, until it gets a response. (Using a lawyer can help - the borrower's lawyer can chase the lender's representative until a response results.) Most lenders won't enter into workout discussions with a borrower unless the borrower signs a "prenegotiation agreement" or similar form. Usually these agreements provide that, although the parties agree to talk about modifying the loan, there will be no change to the loan terms until they both agree to and sign formal loan modification documentation. Lenders require such letters to avoid any misunderstanding that they have agreed to some deal unofficially. Signing a short, reasonable prenegotiation agreement should not be a problem for borrowers. On the other hand, some lenders try to materially improve their positions by including waivers of claims and defenses, full releases, and similar concessions in these agreements, so such agreements should always be carefully reviewed by legal counsel before they are signed.Once it gets the lender's attention, a borrower should consider proposing a plan likely to work over a reasonable time that, if possible, does not require the lender to put more money into the project. In exchange for a loan modification and more time to pay off the loan, borrowers might consider offering any or all of the following concessions, or any others specifically tailored to the project:* borrower or its principals may put in more equity;* borrower or its principals may sell shares in the project to investors, giving up some upside;* borrower may agree to defer any payments to itself or any affiliates;* borrower may provide the lender with other collateral;* borrower may scale back the quality and expense of the tenant improvements it wants to put into the project;* borrower may agree to sell other properties to raise cash to put into the troubled project.The point of such concessions is to limit the lender's loss exposure and thereby incentivize the lender to extend and modify the loan. While such concessions may be painful to consider, a rational borrower will almost always be better off starting with its own list of suggested scaling-down changes, rather than a less-informed list that its lender might confect.A lender may or may not provide detailed comments on a borrower's workout proposal - generally, lenders are not willing to tell the borrowers what to do, as they are usually concerned about not incurring lender liability for taking over a project. But a rational lender ought to be able to let its borrower know what about the borrower's proposal will work for the lender, and what doesn't. Then, if the parties find common ground, they and their lawyers can negotiate a modification and extension that puts the loan and the project back on track.What not to do. My next post will talk more about the parties' tactical and business options. For now, here's a summary of obvious missteps to avoid in an early stage workout.1. Lie to the other side, or be so unreliable that they can't put trust in you. (This includes making inaccurate statements or unfulfilled promises through your lawyer.)2. Become silent and unresponsive.3. Ask for something before analyzing your real economic position (you may be asking for the wrong thing).4. Start the conversation too late to have any viable options for returning the deal to a performing, healthy one.5. Ask the other side to do your work for you.6. Be rude (or allow your lawyer to be rude) to the other side's people and other representatives.

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Workouts 101: Mindsets and Prenegotiation Agreements

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