Borrowers today are frustrated. Those confronted with distressed commercial real estate loans are up against declining prices, lower tolerance for risk by lenders, potential income loss and debt that often exceeds the equity in the property. We all know past factors -- low interest rates, easy credit, no-money-down real estate transactions, and overextension of credit by certain banks -- played a huge role leading up to the discontent that exists in today's lending market.
Lenders are frustrated, too. Not only is there additional scrutiny by regulators, many banks are forced to restructure, cut expenses and build reserves. As underwriting restrictions become more stringent and government reporting becomes more onerous, lenders are making loans at a lower loan-to-value ratio causing borrowers to bring more equity to the table or stack multiple layers of financing. Rather than making many new loans, lenders may be looking at putting money into reserves for losses, especially given declining property values and the inability of borrowers to put more equity into projects.
But instead of exacerbating the situation, there is value in knowing the options, the players, and some tips for getting along.
Know your options
Now may be time to be proactive if faced with a distressed commercial real estate loan. Options do exist and knowing what they are along with the ramifications helps in moving forward.
A workout or forbearance agreement lets the borrower and lender work together to negotiate options to resolve a defaulted loan. Such an agreement typically requires certain events to happen by specified deadlines or the lender may revoke it. If an agreement is amenable to both parties, they have the best of both worlds -- the lender hopefully can be paid back and the borrower has an ability to work out of the situation.
When an agreement cannot be reached, it may be necessary to discuss foreclosure or a deed-in-lieu arrangement. Typically, borrowers will avoid a deed-in-lieu-of-foreclosure unless released from personal liability and forgiveness-of-debt issues do not exist. (Forgiven debts may generate income tax liabilities.) Lenders will avoid one if there are subordinate liens or other issues with respect to the collateral. Deed-in-lieu workouts require cooperation between the borrower and lender, but can be an important mechanism in quickly transferring distressed real estate from borrower to lender in the right situations.
Sometimes foreclosure may be inevitable and in Minnesota, the two main types are by advertisement and by action. Foreclosure by advertisement is most often used when the lender does not need a deficiency judgment against the borrower, which is a judgment for the difference between what was owed on the note and the bid amount at sale. Foreclosures by advertisement typically take about nine months, do not involve the court system and are less costly.
A lender may foreclose by action to preserve the lender's right to obtain a deficiency judgment against the borrower, to correct any mortgage defects or if a receiver is needed. If unopposed by the borrower, this process usually takes about one year, involves the courts and is more costly.
Voluntary foreclosures -- essentially an accelerated foreclosure by advertisement --are more common now on real estate that is not homestead or agricultural. A short written agreement is signed between the mortgage holder and the lender, with immediate possession of the property turned over to the lender and no deficiency judgment is allowed against the borrower. This process minimizes the cost, wipes out junior liens and, from start to finish, is about 4 1/2 months quicker than a foreclosure by advertisement.
Not all lenders are alike
Generally, community banks are built upon an ongoing personal relationship, flexibility in options and easy access. Thus, in the current environment, community banks may be more comfortable in extending or renewing loans as compared with a larger bank.
Regional banks tend to fall between the friendly, relaxed approach of a community bank and the common perception of the "one-size-fits-all" approach of nationally based banks. Personal relationships are important but more-structured protocol is in place that could limit their flexibility. However, many regional banks tend not to engage in more risky activities such as hedge funds or mortgage-backed securities as some larger banks have done.
Larger banks have economy of scale with the ability to spread out functions, which can make it difficult to access the decisionmakers but can offer more product lines sometimes at lower price points. Further, national lenders have higher lending limits.
Working with lenders
Remember, lenders are not in the business of owning real estate. If there is a feasible way to extend a loan or work out of a distressed real estate deal, lenders will typically consider it. The key is to keep lines of communication open at all times -- good times and bad.
Be realistic about the value of the property, future revenue projections and the amount of debt it can service or that can be afforded. Always remember that banks are in the business of lending money out and being paid back.
Finally, keep in mind that this too shall pass. The current economy provides opportunities to brush up on real estate and lending knowledge and learn invaluable skills for future transactions.