The workout world: Understanding commercial real estate loans

We all hear about "workouts" in commercial real estate. Many CRE loans have problems. These loans may be referred to as loans that are "on the watch list," "troubled debt" or "non-performing loans." These loans have issues that fall into two very broad categories: (1) cash flow problems and the inability to pay current debt service after paying normal expenses, tenant improvements (TI), leasing commissions (LC) and capital improvements (CapEx); and (2) financing problems-the inability to find new debt to pay off maturing debt. Most CRE investors are aware of the distinctions between CMBS loans (securitized loans) and those that have not been securitized. When it comes to workouts, this distinction is important. CMBS loan workouts are handled by Special Servicers. The term Special Servicer is a "term of art." Major Special Servicers include: LNR, Midland, CW Capital (acquired by Fortress Investment Group), C-III Asset Management (formerly Centerline) and Berkadia (formerly Capmark). Securitized loans must be "worked out" according to the rules in securitization documents such as the Pooling and Servicing Agreement (PSA) and the tax rules that apply to REMICs (Real Estate Mortgage Investment Conduits). Loans that are held directly by banks, life insurance companies and others are not subject to these rules and are worked out by a designated group, which can be called Special Assets-or any other name the lender wants to use for these functions. Large commercial banks often have departments that perform both Special Servicing for CMBS loans and essentially the same function for the bank's own loan portfolio. What is a "Workout?" There is no precise definition, and yet it is fairly well accepted that the term means some sort of consensual resolution. When a borrower thinks about a workout they probably envision paying off their loan at a discount, getting an extension or modification or some other "good deal." From the lender's perspective a workout means a resolution that generates a higher return than the exercise of the contractual legal remedies (e.g. foreclosure and REO sale). In theory, workouts, at least where the debt and equity structure is simple-should also be simple. Since most CRE mortgage loans are non-recourse, it might be thought that it would be straightforward to compare the assets value with an offer from the borrower and then either do a workout or foreclose and sell the property, or sell the mortgage itself to a distressed debt investor. But the reality is that most workouts are lengthy matters taking from 6 to 12 months to resolve. When you get more complex capital structures (typically with assets over $25 million) such as multiple layers of debt - (maybe a first mortgage with an A Note and B Note and maybe a mezzanine loan) a workout can take far longer. In our experience, smaller CMBS loans with current loan balances of less than $5 million are unlikely to be modified (although their maturity may be extended). A workout on these loans frequently means a discounted pay-off (DPO) or note purchase. This is less likely to be true if the mortgage is a portfolio loan held by a smaller bank. They will typically be more willing to invest the time and expense to modify such a loan. However, they may also be more aggressive in pursuing a foreclosure or a personal guaranty (springing or otherwise). Few lenders, large or small, securitized or not, will modify any loan without an injection of new capital. Theoretically, you could justify a principal write-down purely based on diminished FMV value and diminished NOI. However, the lender will want the borrower to continue to have "skin in the game" just as the lender required an LTV of less than 100% at origination. New equity is generally required to facilitate a principal reduction, as well as many other modification terms. The lender will want to use that new equity to directly reduce the loan balance. The borrower may want to use its new equity infusion to fund near term CapEx or TI and LC. In the current CRE environment loan delinquency rates have increased significantly and while some loans will involve much strife and litigation, others will be worked out, while still others may languish in loan purgatory. Charles Altman is with Altman Law Group LLC, White Plains, N.Y.