Lawrence J. Friedman, Esq.
Pick up any newspaper or magazine, navigate to any online news site, or click to any TV news station, and the number one topic is the economy and the nation-wide recession.
This recession has hit all sectors, not only in real estate and banking, but now in energy, manufacturing, and high-tech as well. Lenders have become reluctant to lend any money for fear that any existing loans they renew or any new loans they extend will go bad. Therefore, the country has found itself frozen in a state where every existing loan is a distressed loan.
WHAT IS A DISTRESSED LOAN?
A loan is distressed when a borrower does not have the capacity to pay according to its terms, and when either one or both of the following circumstances are present: the borrower is demonstrating adverse financial and repayment trends; or, the loan is delinquent or past due under the loan contract. Either of these circumstances, together with inadequate collateralization, presents a high probability of loss to the lender.
Today, loans are becoming distressed loans in a variety of ways. For example, a loan can become distressed if the lender stops funding the loan proceeds under the terms of the loan agreement, even though there are funds in the loan still left to fund. Another example is when tenants go out of business and there is not enough revenue from the property to make the mortgage payments or pay property taxes. A third instance is if the value of a property (collateral) has decreased and the lender requires that the principal of the loan be paid down or it be provided with more valuable collateral. Additionally, if all or part of a mortgage payment can’t be made, a payment is late and the lender declares the loan in default, or if a loan matures and the lender won’t renew or extend the loan, it will become distressed.
Any one of these events, in the eyes of the lender, indicates an adverse financial and repayment trend by the borrower and supports the lenders decision to transfer the loan to their bad asset division, or commence foreclosure proceedings. It’s then that the countdown begins.
Once a loan is distressed, the situation can become very complex; there are many competing interests to consider, each of which has various options. In addition, it is usually wise to involve a lawyer to help identify and evaluate alternatives. Different courses of action involve consideration of different factors, such as current market conditions, completion of construction, enhanced operational performance, or availability of new investors or new money.
OPTIONS TO CONSIDER WITH A DISTRESSED LOAN
There are viable options, and there are borrowers who are working out problems with their lenders right now. Of course, it’s not easy, but it is being done as we speak. Here are some things that can be done.
First, you can approach your existing lender. That should be done as soon as possible; don’t wait until the loan has matured. Inquire about restructuring the existing loan. This option includes restructuring, reamortization, rescheduling, renewal, deferral of principal or interest, monetary concessions, and/or taking other actions to modify the terms of, or forbear on, a loan in any way that will make it probable that your operations will become financially viable. Have a specific written plan and be prepared to make a principal reduction.
Another strategy would be to offer the lender additional capital via a reserve account that would pay the monthly interest to coincide with the extended loan term. Let the lender know that you are committed to the project, that you have an exit strategy for yourself and the lender — and, don’t be a stranger. Lenders like to see you in person.
Second, seek out another lender. Be prepared to take out your existing lender and refinance the loan. There are still lenders out there who are making real estate loans, albeit, under very, very tight lending conditions. However, if there is value in your property and your appraisal is right, it is still possible to get a real estate loan today.
Third, raise equity from investors. There are people with money to invest who are looking for deals. These are people who did not lose their money with Bernie Madoff or in the stock market, and they would still be satisfied with a reasonable rate of return on their investment. These are not vultures looking to make a killing.
Fourth, put together what is becoming the most popular way to acquire new money right now, and that is an equity sharing program. Equity sharing is an old concept that has been given a new life as a direct result of the current economic crisis. It gives the owners of existing property a way to survive a bad deal, work out of a distressed loan, and retain an opportunity to share in the profits from the sale of their property in the future.
BRINGING IN NEW INVESTORS
Most existing projects have significant equity and existing loans in place, but owners find themselves in need of additional capital to carry those properties until times get better and these properties can be revived or sold. New investors can be brought in that will only have to service the debt to participate in the project, make no down payment, and have no personal liability since the existing loan is already guaranteed by the original property owner.
The new investor’s only commitment is to service the debt of the existing property. The original property owner continues to market and sell the property under the full control of the new investor. Once the property is sold, the new investor receives his or her debt service investment back first, plus a preferred return after the debt is paid off. The remaining equity is shared between the new investor and the original property owner in a formula that is agreed upon up front.
This allows the new investor to leverage the existing equity and debt and yield a high rate of return with no equity investment, no personal guaranty, no liability, and receive the benefit from the profits. This vehicle benefits the property owner, the lender and the new investor and is a win-win for everyone. Some investors refer to this methodology as a mezzanine loan because money is funded and serves as an additional loan to the property but is subordinated to the existing loan.
The advantages of this approach for the property owner is that it preserves the equity in the existing project, keeps a good relationship with the lender, keeps a foreclosure off of the owner’s record and preserves his or her credit reputation. The advantages for the lender are that it prevents the loan from defaulting, it helps an existing customer survive, and it saves the lender all of the time, expense and aggravation of litigation over the foreclosure on its collateral. It also introduces the lender to a new customer and gives the lender an opportunity to develop a relationship with the new investor going forward.
The advantages for the new investor are numerous. It’s a low risk, high-return investment, the investment requires no equity investment by the new investor, the cash investment is spread over a long period of time, the new investor gets immediate control of the deal, there is no personal liability, no personal guaranty is required, the new investor gets capital gains benefits, and the investor can also offset interest income during the investment period.
We all will have to continue to find creative ways to deal with our real estate financing issues in Texas until the lenders get more money to lend to the market, either by the government lending more federal money to the lenders or by buying the bad loans and other assets and taking them off of the lender’s books (as the government did in t