7 Questions You Should Ask When Considering a Commercial Loan Workout
Question #1How do I know if I need a workout?
More than any other time in recent history, businesses are struggling to meet their obligations on commercial real estate loans. Lenders previously had only one strategy for dealing with defaulting borrowers. That strategy was foreclosure, plain and simple. Because of the state of the economy and the increasing flood of defaults, lenders have become more willing to negotiate the terms of the loan or accept other creative alternatives to foreclosure.
Here are some questions to determine if you should consider a commercial loan workout:
- Are you struggling to make your payments because of a reduction in income?
- Are you facing an interest rate increase or balloon payment that will be difficult, if not impossible to pay?
- Have you already stopped paying your loan payments?
- Have you received a Notice of Default?
- Are you facing foreclosure?
- Have your distributions decreased or stopped altogether?
- Is your interest rate higher than the market's interest rate?
- Is your property worth less than what you owe?
- Are you part of a struggling investment group or Tenant-in- Common group?
- Are any tenant leases expiring soon?
- Has vacancy at your property increased?
Question #2What are the potential outcomes on a commercial loan workout?
There are a variety of desired out comes for any given commercial workout. One of the important steps in planning a workout is to align the goals of the borrower with what is possible, given the circumstances surrounding the loan. While it would be ideal to accomplish all of the desirable out comes in every workout, that is seldom possible. Certain objectives may include:
- Reducing Principal
- Reducing Interest Rates
- Extending Loan Terms
- Minimizing Tax Exposure
- Releasing Personal Guarantees
- Recovering Funds from Liable Parties
- Clearing Out Non-Performing Assets
Question #3What are the chances for restructuring my loan?
Every commercial loan workout is unique. While the causes are all broadly similar (over-leverage, insufficient cash flow), the specific factors related to a particular workout are myriad, and will largely determine the eventual outcome. Some important factors that need to be considered are:
Books could be written about this one aspect alone; the characteristics of your lender will have a major impact on the potential outcome. Is your lender a commercial bank, a CMBS (commercial mortgage-backed security) trust, an insurance company, or a private lender? Each of these lender groups has a different regulatory regime and approaches troubled loans in a different matter. Within these lender groups there can be a wide variation in strategy; a well-capitalized bank is motivated to clean up its balance sheet and sell off the loan at the current market value, while a zombie bank1 is much more likely to pursue an "extend and pretend" strategy. Other factors, such as the ownership of the lender, management style, corporate culture, management's attitude towards the borrower, and the lender's history with the borrower, will all play a role in the lender's level of cooperation during the workout process.
Workout strategies must be based on the type of loan being modified. From private money or hard money loans, to CMBS loans, to portfolio loans, from first position in the stack, to mezzanine, to last position, each loan has a different set of considerations. A CMBS loan will be handled differently from a portfolio loan. For example, CMBS loans that are managed by master servicers under normal conditions are negotiated with special servicers once the loan has become impaired. Understanding the nuances, motivations and regulatory constraints of a CMBS special servicer vs. a workout committee at a regional bank will greatly determine the outcome of a commercial loan workout.
Workouts may be successfully performed on virtually all asset types. The list includes:
• Agricultural (Farms &Ranches)
• Apartment Buildings
• Office Buildings & Complexes
• Condominium Projects
• Golf Courses
• Hotels &Motels
• Malls & Strip Centers
• Industrial Facilities
• Storage & Warehouse
• Manufacturing Facilities
• Medical Facilities
• Mobile Home Parks
• Land Development, and more
While all asset types can be candidates for a commercial loan workout, there ar eother considerations that may greatly affect your outcome. These considerations include the condition of the property, property value, location and real estate value trends in your particular market, marketability of the property from the lender's perspective, credit quality of the tenants, vacancy rates, the cash flow of the property, etc.
Lenders are very interested in the reason you need a loan workout and your current financial situation. As we said earlier, every situation is different and unique. The reason itself can be a major determining factor in the lender's willingness to negotiate, whether it's the result of a downturn in rental or business income, a change in loan terms, the maturation of a balloon note, or any number of other legitimate reasons.
Also important is the ability to tell your story in a way that will maximize your odds for success. This takes experience and a keen understanding of your position, and an ability to demonstrate how all of these moving parts tie together in one orchestrated strategy.
Leverage is the most crucial component of every workout, yet many borrowers are unaware of their leverage points. Contrary to wishful thinking, no lender is going to capitulate and reduce your interest rate or principal balance when they hear your story. It takes real leverage and the ability to effectively communicate those leverage points to accomplish your workout goals.
Understand that most lenders have heavy constraints within which they must work, whether they are regulatory in nature, or policies and procedures set down by management or the board. Well-communicated points of leverage can break through these constraints to achieve a satisfactory conclusion. It takes experience and a depth of insight to uncover the most effective points of leverage.
Your Counsel & Third-Party Negotiator
Properly-performed commercial loan workouts are complex, and require a plethora of due-diligence, sophisticated analyses, projections, property valuations, and hard-nosed negotiations with the lenders, and in most cases are best not handled by yourself. Lenders are very sophisticated and deal with situations like yours every day. They have a growing level of experience and legal firepower on their side. There is little chance you can take them on by yourself and win. Alternatively, you can engage an attorney, CPA, or broker, but they may lack the experience necessary to resolve your loan problem. And while they may be well-meaning, what they don't know about the process can really hurt you. The fact is, it takes a whole lot of finance, real estate, legal and banking knowledge, coupled with experience and negotiating a successful workout, to truly understand all of the moving parts involved in getting to your goal. You need a team that brings all of these disciplines together under one roof to maximize your chances for success.
Question #4When is the right time to approach a workout firm?
Time is of the essence! The rule is the sooner the better, as it takes several weeks to perform the proper due diligence, craft a workout strategy, organize disparate borrowers into a cohesive group (as in a investment group) and enter into negotiations with the lender on your behalf. Don't wait for a Notice of Default or foreclosure proceedings to decide to engage a workout specialist. Explore your options as soon as possible, but if you are in a last minute situation there still may be time, so don't assume it's too late without a proper consultation.
Question #5Is my property type unique from a workout perspective?
As noted in Question2, workouts can be successfully performed on all asset types and every workout is unique in some way. Some property types are relatively simple, such as an office building owned and occupied by the borrower; other property types must be worked out through a business turnaround plan, with considerations for existing and potential net operating income. Golf courses, farms, and Tenants in Common (TIC) properties of all varieties can utilize advantageous provisions in the bankruptcy code that incentivize lenders to negotiate a resolution outside of bankruptcy. Manufacturing facilities and other operating businesses require workout strategies that include an in-depth understanding of their unique business operations. Broken construction properties typically have significant legal and economic leverage. This is just a quick overview of some of the factors related to different asset classes. An experienced workout specialist team will be able to determine the unique attributes of your particular property type.
Question #6Can I protect my other assets through a workout?
There are many different reasons to complete a commercial loan workout.
preserving valuable assets is a primary motivator for many clients.
Depending on ownership structure and guarantees, one property in your guarantees on one asset, a negative outcome can cause you to lose your other assets. Removing personal guarantees on the troubled assets in order to protect performing assets is typically a high priority in most workouts.
An experienced workout group will look at your overall portfolio situation and recommend strategies that not only accomplish your single asset goals, but also protect your other assets.
Question #7Are there tax consequences involved in a workout?
In any workout, loan modification, or "forced sale" scenario, you must consider the tax consequences. While one workout strategy on the surface might look like the best way to go, it could trigger a crushing tax obligation.
Every potential strategy must be weighed against those tax consequences when crafting your workout strategy. Without a high level of tax expertise on your workout team, your perceived success could leave you in trouble with the IRS.
Whether short sale, foreclosure, or deed in lieu of foreclosure; all of these are a form of "forced sale." Forced sales are taxable events that trigger capital gains or losses and may involve cancellation of debt income (CODI).
Taxable capital gains for income tax purposes result if the outstanding mortgage loan secured by the real property exceeds the investor's "adjusted tax basis" in the property. This is often referred to as "debt in excess of basis" or "mortgage over adjusted cost basis." "Adjusted tax basis" is an asset's original cost, plus purchase costs, improvements, legal fees, selling costs, etc., less accumulated depreciation, casualty or theft loss or other costs (see IRS Publication 551).
Taxable gain resulting from "mortgage over adjusted cost basis" occurs because the conveyance of the real estate to the lender either through short sale, foreclosure, or deed in lieu of foreclosure is treated as if the real estate was sold (a forced sale, if you will) to the lender at the property's fair market value.
Recourse vs. Non-Recourse Debt
The determination as to how much taxable gain would actually be realized, and the exact character of the taxable gain depends on whether the outstanding debt is recourse (e.g., a loan for which the borrower is personally liable) or non-recourse (e.g., a loan for which the borrower is not personally liable).
If the outstanding mortgage loan is recourse debt, the investor is treated for income tax purposes as:
- 1. Having cancellation of debt income (CODI) to the extent that the outstanding loan balance exceeds the fair market value of the property; and,
- 2. A capital gain or loss equal to the difference between the fair market value of the real property and the investor's adjusted tax cost basis. Keep in mind that a capital loss does not offset CODI, which is treated as ordinary income.
If the outstanding mortgage loan is non-recourse, then the investor recognizes a capital gain equal to the difference between the mortgage debt and the investor's adjusted tax cost basis in the real property. In a non-recourse analysis, the fair market value of the property is treated as not less than the outstanding debt balance.
TIC Investors Beware
If a few borrowers are guaranteeing a loan, say for $1 million, and they negotiate forgiveness "individually and severally" for the entire amount, the IRS could potentially deem each guarantor liable for the full $1 million of forgiveness as each person was liable for the entire amount. In this event, any one borrower/ guarantor could be looking at $300,000 to $400,000 of IRS debt.2
Strategies to Avoid or Delay Tax Consequences
Many lenders are making efforts to sell their notes at a discount as an alternative to foreclosure. Note sales are not a taxable event for the borrower. A borrower can arrange for a "white knight" to buy their note and avoid triggering a taxable event. White knights will more than likely want a preferred return and substantial portion of the borrower's equity. However, borrowers can form their own white knight entity to buy the note. White knights may need to come in with cash but a lender may be persuaded to carry-back terms on its sale of a note. For example:
• Borrower owes $5MM
• Liquidation value of the property is $3MM
• Borrower offers to pay interest only on $3MM for three years
• Lender agrees to let borrower buy the note for $3MM after three years if there are no subsequent defaults
This scenario has the same affect as having the lender write down the outstanding balance now, but it avoids an immediate recognition of IRS Code Section 108 (income from discharge of indebtedness).
Cancellation of debt income may be excluded from gross income if:
• The discharge occurs in bankruptcy
• The discharge occurs when the taxpayer is insolvent
• The indebtedness discharged is qualified farm indebtedness (or)
• The indebtedness discharged is qualified real property business indebtedness (except for Corporations)
Strategies for Minimizing Amount of Tax Due
An IRS Code Section 108(c) election reduces basis. This applies if the property is qualified real property business indebtedness. The reduction of basis shifts the rate from ordinary income to capital gains. Using a Zero Basis 1031 Exchange, the taxpayer may buy into another property for less than the taxes that may otherwise be due.
Every client / taxpayer has his or her own unique tax situation and we urge investors to seek advice from a qualified expert in real estate taxation.
A commercial loan workout can be a powerful tool to get your real estate asset back on its feet during this struggling economy. We are anything Commercial llc, and our business is providing commercial loan workout, negotiation services, loans and funding to commercial property owners throughout the United States. We hope this free report has been helpful in your research in to whether one is right for you. As you can see from the report, a commercial workout is not something you should tackle on your own, and as many are discovering the hard way, it's also not something that can be done effectively by any attorney or accountant. Remember, your lender has a dedicated team that is dealing with commercial loan workouts every day. It takes a well-trained team of professionals with the right mix of core competencies and experience in a wide variety of workout scenarios to succeed against these well-prepared lenders. Our team's cumulative experience includes:
Certified Public Accountant, Financial Services Broker, Real Estate Investor, Financial Analyst, Loan Underwriter, Direct Lenders, Hard Money Lenders, Direct Broker, Trial Attorney.
Our best advice right now is for you to invest 30minutes on the phone with one of our specialists who can help you determine the best course of action for your unique situation. Please call us to set up a no-obligation, completely confidential phone consultation at 973-662-4141.
1. A financial institution that has an economic net worth less than zero but continues to operate because of government credit support.
2 While there is no case law on this point, experts are split on the issue.
This report is for general informational purposes only, and should not be considered legal, tax, business or investment advice for any particular person or matter. Each situation is unique, and the legal and accounting rules and regulations, as well as the real estate and financial markets and institutions are constantly changing, such that this report or the information therein may not apply to a particular situation, or may no longer be current and accurate.