Commercial Property’s Twilight Zone

As we move into 2012, there are a myriad of theories about what will happen with distressed commercial properties on the market.  Regardless of the outlook, a common theme adopted by the industry is that lenders continue to delay action on distressed assets for as long as possible. 

The fact is that this scenario is borrower-specific. If a borrower is acting in good faith, the lender may allow the asset to continue operating, resulting in a commercial property “Twilight Zone.”

The Twilight Zone is made up of properties on which loans have defaulted or in which default is likely imminent, but the borrower is still willing to provide all available cash flow to the lender, even if it is not enough to cover the payments. The lender agrees to accept net rents and, in turn, keeps the building operational, albeit in a limbo period. 

While ‘kicking the can" denotes an image of a lender who does not want to deal with the problem, the reality is that many lenders are consciously making the choice not to act on defaulted loans. From an economic standpoint, “doing nothing,” at least for a period of time, can be the best course of action.

One reason this limbo period is so attractive is that it’s a way for a lender to potentially recover more of its initial investment, or at a minimum, focus on more immediate problem loans with their limited staffing and resources. The lender is still receiving some cash from the asset, and is not yet responsible or liable for the expense of running the property. 

From a regulation standpoint, this limbo period is perfectly acceptable. In fact, there is no requirement in loan documents that forces a lender to do anything. While lenders have the right to foreclose on an asset, they are not required to do so.

Naturally, there are times when foreclosure is inevitable. In the instance of a Twilight Zone property, the trigger is usually the moment there is a need for capital that is deeper than the current cash flow or cash on hand. For example, if a major tenant wants to renew or relocate within a property, or there are improvements that are needed on the property; there is no way to obtain that capital for a property in limbo. At this point, banks will usually move forward with the foreclosure process or step up borrower negotiations to resolve a distressed loan.

Of course, sometimes “doing nothing” is not an option for a lender, and often lenders must act for reasons that are not real estate-related. 

While every bank and special servicer is different, one similarity they share is that each faces regulatory and political issues resulting from reserve requirements or obligations to raise and hold capital. For that reason, some lenders do need to foreclose on deals in order to attempt to maximize recovery on the initial loan and shore up their balance sheets. 

Once a lender takes a property back, it must put strategies in place to operate the asset. It is at this point that banks usually hire a third-party partner to advise them, and to handle the strategy, management and ultimate liquidation of the asset.

From a bottom-line standpoint, taking a property back is a scenario lenders hope to avoid.  Having properties on the books increases both cost and responsibility, and can lead to liability issues.  Banks are simply not set up and staffed to operate real estate.

For example, a bank may have a loan on a property with environmental issues such as lead paint or asbestos. The potential liability brought on by owning properties with these conditions is often viewed as too risky, and lenders may choose and alternate strategy to avoid being in the chain of title. A solution for a property like this might be a discounted payoff, through which the lender allows the borrower to buy the note back at a discount.

Another alternative may include structuring an A/B note, allowing a reduction of the initial loan in exchange for an infusion of additional borrower capital which can be recovered before paying back the B note. This structure allows the existing borrower to play through the asset’s business plan and live for another day. 

The sale of discount notes is also a practice that is becoming increasingly popular by banks and special servicers in the commercial real estate sector. While there is an inherent risk to investors who, upon acquiring a note, must go through a foreclosure process and risk and long drawn out process, including potential bankruptcy filing; adequate capital seems to be chasing these deals, create a dynamic market.

Additionally, oftentimes the risk premium from investors acquiring notes rather than the real estate has not been so great as to outweigh the benefits of a quick and relatively painless close for the banks. The new note owner takes over whatever headache may have ensued if and when foreclosure was necessary, and the lender is left with a financial recovery that meets their objectives and requirements without a need to take title and operate the real estate through disposition. 

Note sales can be especially useful in liquidating pools of loans all at once, allowing the banks to generate significant revenue quickly to serve their capital and regulatory needs. As deals continue to be made in the distressed market, the trend of note sales is likely to increase in popularity throughout the industry.

Matt Stephenson is asset manager at Voit Real Estate Services. He may be contacted at mstephenson@voitco.com. The views expressed here are the author’s own.