Over the past six months or so, “distressed asset” has become the Lord Voldemort of commercial real estate, that name no one dare speak. As a general rule, it is a much maligned title that strikes fear into the hearts of both borrowers and lenders.
Distressed assets are simply commercial real estate properties that are troubled in some way. Typically, the borrower is unable to make mortgage payments or cover maintenance and other debts. The servicer could even implement forced liquidation of the property to recover the funds owed under the loan, although not without some long-term fallout for the borrower.
There are multiple property types under the distressed assets umbrella that make up a huge number of properties in the U.S. Of these, retail and office properties are the primary battlegrounds. In markets that are getting back to business more or less as usual, a switch of the property manager or maintenance crew might be all that’s needed to correct course. Elsewhere, the damage may be too great, which means either a strategy reset, or new ownership and fresh capital. If a distressed building is beyond repair, one other tactic for lenders and borrowers alike is to repurpose.
Giving up and selling is usually not the best option. It’s not something any borrower, lender, or investor wants to do, but sometimes it is the only move to make. Though borrowers might see listing a property for sale as a solution to distressed assets woes, in reality the pool of potential buyers who would offer enough to offset outstanding debt and avoid capital damage may be non-existent, meaning that a sale would bring a loss for both the borrower and lender.
In talks with the lender, a borrower can ask for forbearance, a principal reduction, or even splitting the loan into an A note and a B note, where the B piece accrues. This would effectively defer payment on the current interest to a later date. Of course, you could also ask for capital to bring the building up to a point where it can compete in today’s market.
Michael Cohen, a managing partner at Brighton Capital Advisors in Charlotte and 25-year veteran of the restructuring world, said that banks rarely agree to a cut in loan value. The best way to react is to show up with your business plan, expense rundown and commitment to making the bank more money. Cohen adds that the best thing you can do is to show them you’ve exhausted every possible remedy, and then show that the property cannot regain its value even with a new infusion of capital.
The last thing to do is to believe that the lender is the enemy. The lender can help with a proposal to resolve a property’s problems. Shlomo Chopp, a managing partner at Terra Strategies, which advises on distressed assets, says borrowers should help the lender see that their opponent is the market, not the borrower.
The way borrowers explain their problems to the lender is often as important as the problem itself.
The Fine Print
There is a major disconnect between lenders and their borrowers that first appears at the point when a loan moves into distress. At the outset of the lending process, borrowers have an outsized focus on the rate, the proceeds, and very little else. When times are good, borrowers tend to breeze over a loan’s covenants or penalties for late payment. When things get ugly, the lender looks to the fine print in the loan documents. That’s a lesson that borrowers learn when they get into trouble.
A structured finance deal is built to deliver bigger proceeds at closing. But flexibility comes at a cost. With debt, it’s choose your poison: more money now or more flexibility later.
Commercial mortgage-backed securities loans are different, in Cohen’s eyes. No two CMBS loans are alike and the loans that go together into a CMBS deal have widely differing payment details. In CMBS, there is usually no personal relationship between borrower and lender. For borrowers, nobody has devised a programmatic solution to CMBS distress yet.
The bottom line is that your leverage as a borrower comes from the reduced value of the collateral. It has nothing to do with how tough you are or how good your lawyers are. The lender’s question is just as simple: what can you give me that is better than the collateral?
Distress isn’t limited to second-tier property. Even some prominent firms can’t refinance properties that used to perform, and are weighing handing underwater office buildings back to their lenders.
The biggest mistake a borrower can make is to let a loan slide into special servicing. Walking away from a property sounds simple. It rarely is. A foreclosure can mean personal recourse, and can bring tax liability.
Special servicers are often not eager to take the property back. Sometimes even the special servicer would be happier to see the loan revert back to performing status. A loan modification or extension can help make that happen.
Many Banks Are Addressing Problems Early
In talks with the nation’s bankers, Moody’s team found that many banks are addressing problems early, before trouble spreads.
More than one bank said it is already reviewing loans that could come due through the end of 2024 and reaching out to those borrowers now. They’re also reaching out to borrowers ahead of rate resets.
On paper, banks haven’t changed their loan-to-value or debt service coverage requirements. But interest rates are up. A borrower seeking the same dollar amount as they would have needed a year ago would need even more money to meet the coverage requirements today. So in practice the banks are harder to please.
Approaching the resolution of distress is a process of deciding which path would result in a project being worth the most in the future.
Selling a troubled building might be the best option for one owner, or a person who wants to move on to the next opportunity, and the worst option for another. The right choice varies depending on where the property stands and what the owner wants to achieve.
About Delancey Street
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