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Posted by Bob Bright, Esq.
Commercial real estate values have dropped an average of 40% to 50% from the peak of the market in 2007. The significance of this decline will become even more apparent as an estimated $700 Billion in commercial real estate loans reach maturity this year. Given this immense volume, combined with the backlog of distressed assets already weighing heavily on banks' books, investing in non-performing loans will be the hot market for the foreseeable future.
While these investments do have an attractive potential upside, they are not without a certain amount of risk. Properly assessing these risks prior to purchase can help you avoid or minimize the impact on your exit strategy.
1. Why is the Note is Non-performing?
Let’s start with the obvious issue first: why is the note non-performing? A note can be classified as “non-performing” either because, the borrower has defaulted on the regularly scheduled payments, has breached some other affirmative obligation in the note, such as compliance with a minimum DSCR (Debt Service Coverage Ratio), or, as will be a more common occurrence in the near future, the note has reached its maturity date and simply does not qualify for re-financing.
2. What is the Borrower’s Motivation?
If the borrower has defaulted on the regularly scheduled payments, this means that the property has most likely been adversely affected by the drop in rental rates and/or occupancy rates. The property is no longer generating sufficient revenue to cover its debt obligation and the borrower is either unable or unwilling to cover the difference. This could be a good indication that the borrower is in distress and is looking to get out from under the property. This borrower may be more likely to give you a deed in lieu rather than force the matter to foreclosure. If he wanted to keep the property and had the financial resources to fight, he would have probably been paying the debt obligation rather than risking forfeiture by default.
If the note is non-performing simply because of the maturity date, the problems with the borrower can be more difficult to assess. If the borrower has managed to remain current on the note and is still be able to make payments at the note rate, the problem most likely is that the property has taken a large hit in value and does not qualify for refinancing. Many of the properties that will reach their maturity date this year, were financed at, or near the peak of the market, factoring in the average declines, most of these properties are now at 130% of LTV (Loan to Value), or worse.
However, even loans that were written ten years ago can find themselves in this same situation. This is because the average commercial loan term is anywhere between 5 and 10 years; however, typical payments are based on a 30 year amortization. As a result, there has probably been little headway, if any, made against the original principal balance.
If the borrower has held the property for a long time and it is otherwise performing, this may be a situation that is ripe for a fight. In assessing this risk, determine whether the property is generating sufficient income to meet its debt obligation and whether there still remains enough equity above the unpaid loan balance sufficient to entice a borrower to fight to retain the property.
3. Is There A Risk of Bankruptcy?
If the borrower is a single asset entity, a common practice, it may be tempted to file a Ch. 11 bankruptcy in order to avoid foreclosure. In this situation, the borrower will either be looking to the bankruptcy judge to to modify the terms of the note to avoid losing the property, or may be simply looking to delay things in the hope that the market will turn around and the property value will increase enough to allow for refinancing.
If there are multiple liens on the property, you may also be at risk for a “cram down” where the bankruptcy judge reduces the principal balances on the secured notes and converts the excess into an unsecured debt. Obviously, this is a situation that should be avoided, if at all possible. Regardless, if the borrower declares bankruptcy, it will put an immediate hold on your efforts to recover the property.
4. How Solid is the Guarantor?
You may think that bankruptcy is not a concern if there is a guarantor. On the surface, there is a certain appeal to this line of thought. The problem is, you also need to consider how solid is the Guarantor and how solid is the guaranty.
If the Guarantor is solid and has control over the borrower, this may counteract the risk of bankruptcy, as the Guarantor will not want to put his own personal assets at risk. Conversely, if the Guarantor is on unstable financial ground, he may file bankruptcy right along with the borrower. In this case, there is little chance of escape from the bankruptcy court unless the bankruptcy is converted to a Ch. 7 and the court liquidates the estate.
However, you should also consider the strength of the guaranty. Some notes and some guaranties have exculpatory clauses buried within them. Read these clauses carefully to see what events, if any may trigger a release of the Guarantor’s obligation.
These issues however, can be legally complex. Law is much more an art than a science and different courts can read the same language in different ways. If you are uncertain about how solid a guaranty’s language is, ask an attorney to review to review the language and advise you accordingly.
5. What is the Note’s History?
Another factor that can be very helpful in assessing the risk involved with a particular note is to understand what the history has been between the borrower and the lender; or, more specifically, between the borrower and the special servicer. If you’re not familiar with a special servicer, this is the entity that attempts to resolve non-performing loans on behalf of a lender. Some lenders perform this function in house; others source it to third parties. Either way, the history between the borrower and the special servicer can provide you with valuable insight into what to expect with the borrower.
When a note becomes classified as non-performing, it is the role of the special servicer to determine whether the note can be brought back to a performing status, or whether attempts need to be made to recover the collateral. For any given non-performing note, there is a good chance that there is a history of discussions between the borrower and lender where the two sides attempted and failed to find a resolution to the problem. In many cases, there may have even been modification proposals submitted by the borrower; either on its own, or through an attorney, a broker or one of the countless organizations that have sprung up specializing in loan modifications.
By selling the note on in its non-performing state, you can assume that these talks proved to be unsuccessful. However, having an understanding as to where these talks left off, can give you a good forecast as to what you can expect when you start to engage with the borrower.
The bottom line is that when you purchase a non-performing note, you are investing in an asset with a distressed history. The result of that history is that the seller has decided to sell the note on rather than expend the capital and the efforts necessary to recover the collateral. As with any investment, there are always risks. The trick is to review those risks in a careful and calculated manner so as to minimize their impact, or at least prepare you for the steps ahead.
Bob serves as General Counsel for COMAC, a leading provider of premiere off market assets and notes. (www.offmarketassets.com). Bob Bright is also a principal of Bridgewaters (www.bridgewatersgroup.com) and represents clients in the US and Internationally in the acquisition, disposition and management of commercial assets and investment properties. This includes the buying and selling of distressed debt. Bob is dual qualified as a California attorney and a solicitor of England and Wales. He can be reached at email@example.com.