No individual places their real estate investment funds into a deal thinking that it will fail, but it is an unfortunate fact that some will. No matter how much due diligence or how many inspections a real estate investor does, there are rare occasions where one or more unforeseen events can drive a property into bankruptcy, insolvency, and/or foreclosure.
In this article, we are going to discuss what happens when a borrower defaults on their commercial real estate loan, with a specific focus on a process known as receivership. We will define what receivership is, how it works, and its benefits/risks. By the end, readers will have a better feel for the receivership process, which may come in handy should they ever find themselves going through it.
At First National Realty Partners, we invest a significant amount of time and resources into the pre-purchase due diligence process to ensure all of our investments stay out of receivership. But, it is still important to be aware of this process, especially if we find ourselves on the other side with an opportunity to get a great deal on a property that meets our investment criteria. To learn more about our current investment offerings, click here.
What is Receivership?
Nearly all commercial real estate transactions are funded with some amount of debt. If the property is “cash flow positive” it means that its net operating income is more than the monthly payments on the debt. When this is the case, the lender is paid and the real estate investor can keep whatever money is left over. But, it doesn’t always work like this.
In some cases, the net operating income may be less than the monthly loan payments, which means that the real estate owner/investor must fund the deficit. If this situation persists for an extended period of time, it is likely that the owner will eventually run out of money or determine that it is in their own best interest to stop making loan payments. In either case, the missed loan payments constitute an “event of default” and the lender will typically pursue one of four paths to “cure” the default: workout, deed in lieu, foreclosure, or receivership.
Workouts and deeds in lieu are the “friendly” options. In a workout, the lender takes time to understand the borrower’s situation and may modify the loan terms to allow the borrower to resume making monthly payments. In a deed in lieu of foreclosure, the borrower basically acknowledges their default and voluntarily gives the property’s deed back to the lender so they can sell it and get their money back. But, not all borrowers are this cooperative.
The less friendly path involves foreclosure, which is a legal process that a lender can pursue to obtain title to the property. While this can be an incredibly effective strategy, it can also be extremely costly and time consuming. In addition, the borrower controls the property for the duration of the foreclosure process and they may not always maintain it to the lender’s standards. For example, they could purposely damage the property or use the income it generates for purposes other than making the required loan payments. This is where receivership comes into play.
Receivership is a legal process that takes control of a property and places it into the hands of a court appointed neutral third party, the “receiver”, who will oversee property management and/or liquidation on behalf of both the borrower and lender. Lenders like this arrangement because it is generally less expensive and puts control of the property in the hands of a neutral third party. In fact, financial institutions typically seek a receiver appointment to:
- protect the value of the collateral property
- Prevent the borrower from damaging the asset
- Ensure that the borrower uses the rental income to make loan payments
- Limit any potential liabilities that may come up as a result of the borrower’s failure to manage the property.
In order to achieve these outcomes, the receiver has a very important role to play.
Role of a Receiver
In most cases, a court appointed receiver is: an agent of the court, a fiduciary, and responsible for holding the asset in their custody to preserve and protect it. Under this broad mandate, specific receiver responsibilities include:
- Securing the property by changing locks and taking control of the information needed to operate it (leases, contracts, etc).
- Identifying themselves as the new manager to existing tenants, contractors, and vendors
- Managing leasing activity
- Collecting rent
- Maintaining the property in good working order and making repairs if necessary
- Paying property operating expenses like taxes and insurance
- Selling/liquidating the property for a fair price
- Reporting to the court
In essence, appointing a third party receiver means giving someone else near complete autonomy over the management and liquidation of the collateral asset. Ultimately, the goal is to either stabilize the property so that there is a resumption in loan payments or to sell it with the goal of repaying the lender.
How is a Receiver Appointed?
The specifics of the appointment process can vary based on the language in the mortgage, but the appointment of a real estate receiver typically follows the same general steps. Once a borrower has defaulted on their commercial mortgage, or as part of a foreclosure action, the lender may ask the court to appoint a real estate receiver. Depending on the court, they may do so without any additional evidence, but some may require the lender to show that the receivership request is reasonable and necessary. In general, the final decision to grant the receiver is up to the court.
Final receiver appointment is made via a formal court order, which typically details the following information: a description of the property; why granting the receivership is a justified action; the specific powers of the real estate receiver; the receiver’s reporting requirements; and the receiver’s right to possess the property. Once the receivership period is completed, the real estate receiver will ask the court for it to be formally discharged.
What Are The Pros and Cons of Receivership?
There are pros and cons to real estate receivership for both the lender and the borrower.
For the lender, the major benefit of receivership is that the receiver protects property value and even takes steps to increase it. They also act as a property management company by providing day to day management services like collecting rent, making loan payments, and working with outside contractors and vendors. All of these activities decrease the administrative burden of asset management for the lender.
At the other end of the spectrum, lenders typically have two major concerns regarding receivership, control and cost. By giving up control of the property to the receiver, they are also giving up control of the sale process, which they often rely upon to be repaid. With regard to cost, the real estate receiver does not work for free. In some cases, their fees and costs may exceed the value that they are able to recover which is a net negative for the lender.
For the borrower, there are two major benefits to the receivership process, value and settlement.
First, if the real estate receiver is successful in their actions to increase the value of the property, it means that the borrower’s liability to the lender is lower. This is an outcome that they should be rooting for. Second, because receivers are a neutral party, they are in a good position to negotiate a mutually agreeable settlement between the lender and borrower. This type of negotiated settlement is a generally more favorable outcome for both parties.
For the borrower/property owner, the risks are the same as for the lender. They lose control of the property and may be liable for some of the costs associated with receivership. Generally, all major questions and issues regarding management and sale will go to the court who will weigh the lender’s arguments against those of the borrower. The borrower may not always prevail.
Summary & Conclusions
Real estate receivership is a process in which a court appoints a neutral third party, the receiver, to oversee the management and sale of a distressed asset.
In general, the receiver’s role is to protect the value of the property by managing it towards a sale. To accomplish this task, their specific duties include things like managing leasing activity, collecting rent, restructuring contracts, managing vendor relationships, basic maintenance and repairs, and reporting all of their activities to the court.
The exact process for appointing a receiver can vary based on the specific language in the mortgage, but it generally happens when the lender asks the court to appoint one as part of the foreclosure process.
For a lender, the advantage of real estate receivership is that the third party is tasked with protecting the property, which may even result in improved values. For the borrower, the benefit of this increased valuation is that it results in a lower overall liability to the lender.
For both the borrower and the lender, the disadvantages of receivership are loss of control of the commercial property and the cost associated with paying the receiver for their efforts.
Although it can be expensive, receivership is generally a more cost effective, time efficient way to manage a property through the default/liquidation process. If it is successful, it can be a win/win for both the borrower and lender.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.