Among borrowers and investors, there is a common misconception that a commercial real estate loan is either performing or in foreclosure. This is not entirely correct. The truth is that a non-performing loan may go through several stages of the “workout” process before ever reaching foreclosure. These stages are the subject of this article.
But before the stages can be discussed, it is first important to understand how a traditional commercial real estate loan works.
High Level Overview of a Commercial Real Estate Loan
A typical commercial real estate loan is made to a single purpose entity (LLC) that was formed specifically for the purpose of the transaction. The LLC is the legal borrower, and its ownership can commonly be traced back to one or more individuals who are considered the “sponsors” in the deal.
The commercial loan is “secured” by a collateral property. During the underwriting phase of the loan, the lender will commission a third-party opinion of valuation and they will limit the amount of the loan advance to a certain percentage of the concluded value, usually 75% Loan-to-Value (LTV). For example, if a property had an appraised value of $1,000,000, the maximum loan amount may be limited to $750,000.
Finally, a typical CRE lender will consider up to three sources of repayment for the loan:
- Primary Source of Repayment: Cash flow from the sale and/or lease of the collateral property
- Secondary Source of Repayment: Sale of the collateral
- Tertiary Source of Repayment: Guarantor recourse
As long as the property is performing as expected and the borrower is making the required loan payments, there is no issue. Everyone is happy.
Where both the lender and the borrower can run into trouble is when the property does not perform as expected. If the borrower is consistently late with their payment or misses them all together, this is a sign that danger may be ahead for the lender. It is also the start of the workout process.
Stage 1: Is Everything OK?
After a series of late and/or missed payments, the lender’s first step is relatively simple. It starts with a phone call or site visit to check in with the borrower and to see if everything is OK. The lender may inquire about the property’s performance, recent new leases or vacated spaces, market rental rates, and the general financial condition of the borrowing entity.
The lender may also ask for updated financial statements and leases in order to perform their own assessment of the property. In many cases, the reason for the late payments is relatively innocent. The borrower’s accountant may have missed it or they were on vacation. In such cases, they quickly catch up and all is well.
However, if the situation is more dire and the borrower is in financial distress, the next stage is a bit more serious.
Stage 2: Negotiation and/or Restructuring
The key point to remember about this stage is that the lender’s financial incentive is to work with the borrower to prevent any further deterioration in the transaction. To that end, the lender will actively work with the borrower and/or their representatives to negotiate a solution that will get the loan back on track. The exact workout strategy is unique to the individual loan and to the borrower’s situation, but such strategies typically include one (or all) of the following:
- Forbearance: A forbearance agreement is a temporary suspension/waiver of the required loan payments. It could be for one month or longer depending on the situation, but generally not longer than 12 months. The goal is to allow the borrower to conserve cash during the forbearance period and come back stronger and ready to resume making their loan payments. However, a forbearance does not make the issue go away. The borrower is still responsible for the missed payments. They could be tacked on to the end of the loan, divided up over the remaining payments, or in some cases, due in full.
- Interest Rate / Payment Reductions: If the borrower’s weakness is temporary, they may be offered a short-term solution in the form of a lower interest rate and/or lower payments. For example, suppose that they are in the middle of negotiating a new lease that will turn the property cash flow positive. They could be given a lower payment for 6 months, which decreases their required debt service, to allow them time to get the lease signed and then get back on track.
- Restructure / Loan modification: If the situation is more serious, the loan could be permanently restructured. In such a scenario, the interest rate, payment, or term could be permanently altered. This change is reflected in updated loan documents, but the lender does not do this for free. Depending on the specifics of the deal, they could charge fees that are added to the loan balance.
- Additional Collateral: To further secure their position, the lender could require the borrower to provide more collateral for the loan. This collateral could be anything from additional property to cash, marketable securities, equipment, accounts receivable, or shares in a privately held company.
Ideally, these negotiations and/or restructuring steps result in a workout agreement that will allow the borrower to get back on track. They usually do. It should be noted that these negotiations can go on for months and the most likely outcome is that the loan does get back on track.
However, there are a certain subset of problem loans or borrowers who are in severe distress, in which case more serious steps need to be taken. These steps are a last resort and they are not pleasant for anyone, but they must be taken for the lender to protect its own financial interest.
Stage 3: Default and Foreclosure
Although the borrower was likely “technically” in default when they missed payments, the lender may not immediately declare an event of default. The timing of this declaration can vary, but it is in an important one because it can trigger accelerated payments, higher interest rates, and/or a number of steps outlined in the loan agreement that the lender can take to “cure” the default.
The most likely step has to do with the secondary source of repayment above, which is to initiate foreclosure proceedings, and to take back title to the property from the borrower. Depending on the state, this legal action can be a relatively simple extra-judicial process. In other states, it requires a court date and a long, drawn out process.
Again, the lender does not want to foreclose on the property. They are not in the real estate business and they do not want to have to pay for the insurance, maintenance, and taxes on the property while it is in their possession. This is a last resort.
Once the property is in their possession, the lender will prepare it for sale and liquidation. Once sold, the proceeds are used to pay off the loan balance. Much of the time, the funds are sufficient to do this, but there are other times where they are not. If the transaction sponsor(s) were required to provide a loan guarantee (often referred to in financial and legal contexts as a guaranty), the last step is to approach them individually for the outstanding balance.
The loan workout process is unique to each lender and to the specifics of each transaction. The most important point to remember is that it is a series of increasingly severe actions taken by lenders to protect their own financial interest. It can be unpleasant and uncomfortable for all parties involved, and the risk of financial loss often heightens the emotions surrounding the deal.
The best way for the lender and borrower(s) to avoid all of these steps is to underwrite and finance their deals conservatively and to maintain a strong relationship with good communication at all stages of the loan lifecycle.
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