Pre-Foreclosure Workouts
Artful Dance or [Bloody] Contact Sport?
Over 60 real estate professionals gathered on March 12 for a ULI LA Capital Markets Breakfast Seminar: Pre-Foreclosure Workouts - Artful Dance or [Bloody] Contact Sport? Focusing on the process of pre-foreclosure workouts with balance sheet lenders, the program featured a distinguished panel moderated by John Rozelle, Co-Founder of CBI Capital Strategies. Panelists included Bill Hoffman, CEO and President of Trigild; Bill Hyatt, Senior Vice-President of iStar Financial; David Poitras, Bankruptcy Partner at JMBM; and Martin Taylor, Real Estate Partner at JMBM. It was held at the offices of Jeffer, Mangels, Butler & Marmaro LLP, and hosted by JMBM real estate attorney David Waite.
This following article covers the the event's highlighted topics. From the borrower's perspective, it covers what should be done to increase the chances of finding viable solutions with the lender and continue managing the property.
Defining the Workout Playing Field
What is a workout? The term is loosely used to describe both the negotiation and the resolution agreement between a borrower and its lender, which provides both borrower and lender with concessions that maximize the likely recovery by the lender. The property being worked out is either currently in default or in imminent danger of default. Each workout situation is as unique as each property and its corresponding loan documents. There is no clear roadmap that will apply to every workout, but central to every workout is a viable recovery plan that the borrower can prove it is well suited to complete.
When a property is in distress, whether due to over-leverage or cashflow constraints, there are limited remedies available to a lender. Upon default, a lender will always file the Notice of Default and begin the foreclosure process regardless of whether there is a potential alternative solution. It's worth emphasizing again: a lender will consider forestalling the foreclosure only if the borrower's plan for resolution maximizes their likely recovery and the lender is convinced that the borrower is both trustworthy and the right party to execute the plan.
From the lender's perspective, the best solution is a discounted purchase of the note by the borrower and/or an investor. If a resolution plan can be affected in a short period of time, say less than 6 - months, a lender may provide a short-term forbearance. Any plan requiring a longer timeframe to stabilize the property will likely require an adjustment to the loan terms. While both the lender and the borrower are always eager to avoid the cost, impact to collateral value and negative publicity of a foreclosure, federal reserve requirements at regulated banks are severely impacting the future profitability of holding onto a "recovered" non-performing loan. This has raised the bar on what lenders are willing to grant borrowers in the way of a workout, and in what a borrowers plan must provide in the way of value recovery.
Steps for the Borrower
When a borrower realizes it has either defaulted on its loan-or is in imminent danger of default-it should take the following steps to address the situation.
1. Review Existing Loan Documents
The borrower should work with its financial and legal counsel to understand and identify which loan covenants will or have been breached and what defenses, if any, are available. Careful attention should be paid to any violations of required notices or performance, as this may fundamentally alter the offending party's negotiation options.
2. Communicate Early and Often With the Lender
No one will argue that facing a loan default can be a traumatic as well as a humbling experience. A fundamental mistake that many distressed borrowers make, however, is to keep the lender in the dark while the property's financial situation is deteriorating. Aside from establishing a good working relationship, by presenting a viable workout early a borrower enables the lender to take thoughtful action and often permits them more flexibility in considering alternatives to foreclosure. It is also critical for loans that include personal recourse to be addressed quickly, as the declining values will only increase the borrower's financial exposure.
Ideally, a borrower would alert its lender 3-6 months before either 1) the maturity date of the loan; or 2) the imminent default is realized. The lender will need time to get up to speed on the property and to conduct due diligence, but earlier notification will find your loan triaged behind more immediate issues. To expedite the due diligence process borrowers should provide lenders the appropriate information upfront.
3. Establish a Realistic and Achievable Plan of Action
The burden on the borrower to articulate how the existing problems will be addressed can not be understated. Merely identifying the obstacles to fulfilling a loan agreement is not productive. The borrower's plan of action should honestly address why the property is not meeting the original business plan and provide specific, actionable near-term solutions to each issue along with a new capital injection. A detailed timeline for each action item with measurable milestones and a breakdown of the resources required is the kind of informed presentation that can help a borrower maintain control of its property.
Lenders are sympathetic to the problems affecting real estate today and realize many properties are suffering due to systemic economic conditions as opposed to a borrower's mismanagement or malfeasance. Lenders still want to see a plan that stabilizes a property within a 6- to 12-month timeframe, however, not 2-3 years. Furthermore, a "blameless" borrower still needs to be prepared to defend its estimates and prove they have the right person for the job of recovering the maximum value of the property. If the borrower has failed to give proper notice or communicate with the lender in a pleasant and honest fashion, a question of integrity can quickly lead to the appointment of a receiver and removal of the borrower from future property management decisions.
With forecasts calling for at least 4 more quarters of declining commercial real estate values, it is in everyone's best interest to move quickly and with great impact. The borrower should articulate how its past experience, local market knowledge, and understanding for the property provides the recovery plan its greatest chance for immediate success. Additionally, the borrower should detail how its new injection of capital will be sufficient to complete the plan, or how the additional collateral provided will enable the loan to meet its loan-to-value covenants through the remaining life of the loan.
Bankruptcy Isn't What It Used To Be
The Bankruptcy Abuse and Prevention and Consumer Protection Act of 2005 ("BAPCPA"), has dramatically altered the landscape for real estate bankruptcies. In short, for the single purpose and/or single asset entities used to hold real estate, there is little ability to extend the automatic stay from foreclosure. For more complex ownership structures with multiple assets within a single ownership entity, bankruptcy can be more impactful. However, the courts have taken an increasingly negative view of schemes to "delay, hinder, and defraud creditors". Naturally, legal counsel should be sought, but borrowers under most scenarios will gain little assistance from bankruptcy other than a brief delay in foreclosure.
Understanding The Lender's Objectives and Constraints is Key to A Successful Workout
Lenders are under extreme stress due to both falling revenues and increased reserve requirements. First, the evaporation of the secondary market for mortgages has seriously impacted liquidity, both in the lender's inability to sell newly originated loans and in the much hyped collapse of the securitized mortgages it already owns. The inability to sell new originations impacts the lender's income, and the collapse in existing asset values means more of the reduced income goes towards shoring up balance sheets. Second, as real estate values fall and ever more loans are categorized as "non-performing" the quantity of cash reserves regulated institutions are required to hold for loss provisions continues to escalate. Regulated lenders, depending on the institution's health, are required to hold from 6-9% in reserves on each loan. As a loan becomes distressed however, and moves up the risk-rating scale, reserve requirements quickly reach 100% of the outstanding loan amount.
A major impediment to working out these distressed loans is the requirement to continue holding elevated loss reserves on loans even after they have re-stabilized and returned to "performing" loan status. Obviously, cash held in reserve is unprofitable. The relative profitability of a low interest rate vintage loan with large reserves compared to other opportunities in today's market means there's a financial incentive to clear these problem loans from the books. A discounted note sale may involve a near term loss, but over the period, re-issuing those dollars could more than make up for the loss. Similarly, foreclosure and sale or a medium-term hold of an asset until values recover will free up more scarce liquidity than many potential workout scenarios. Profitability aside, during these uncertain times banks are unsure what their future liquidity needs will be and are very focused on retaining capital. Borrowers should keep this in mind as they propose concessions to their lenders, and adapt proposals based upon the health of the bank.
What to Expect During the Workout Discussions
The first thing a lender will request of a borrower is a "Pre-Negotiation Agreement" prior to entertaining any discussions. It is important to negotiate for the appropriate language in this agreement, and lenders do not expect a savvy borrower to sign the agreement unamended.
If a borrower has other loans with the lender, it is helpful to broaden the discussion to encompass the value of the entire relationship. A lender may be more willing to work with the borrower if the current distressed loan is an isolated case. Conversely, a series of loans under imminent threat of default may mean the borrower is best served to focus energy on amicably giving up the assets and limiting personal recourse liabilities.
Borrowers should pay careful attention to the incurred tax liability of any workout or foreclosure. Reductions in principal and foreclosed values in excess of a property's basis are treated by the IRS as income. Furthermore, the borrower will most likely have to pay ALL legal fees as well as any of the lender's other costs (consultants, accountants, appraisals, etc) associated with the workout.
Key Takeaways
- Borrowers should approach lenders about 3-6 months before the problem may arise. Because lenders currently have a lot on their plates as they balance deteriorating loan portfolios and increased scrutiny by regulators, earlier notice could result in your issues being overlooked.
- Borrowers should be proactive -don't just go to lenders looking for answers. Bring the lender a well thought out recovery plan to remedy the current issues. In this plan, don't forget to include why the lender should keep the borrower involved in the asset.
- The borrower will incur noticeable costs associated with the workout.
- The lender will increase monitoring until the issues are addressed and the property is stabilized.
- Trust and integrity are absolutely critical throughout the workout process.
Coming Soon
A follow-up event will be held in May to cover how to best approach pre-foreclosure workouts with conduit loans.
This article was written by ULI Young Leader Jonathan Chew with the support of John Rozelle of Zisler Capital Partners and David Waite of Jeffer, Mangels, Butler & Marmaro, LLP.
