Navigating CRE Asset Distress, Under-performing Loans and Workouts

By Alonso Cisneros, Esq.

Over the past few months, we have heard the alarm bells about a looming commercial real estate crisis due to decreasing office occupancy rates, crushing interest rate cap costs, high interest rates, exorbitant insurance premiums and a tsunami of maturities scheduled this year and next.

But what if you are a borrower with an asset in distress, or you are a borrower who could use a little help from your lender? Or you are a lender with a loan (or two) that is under-performing, but you think that you can help the borrower?

Both of you are aware of the impending precipice, but neither of you wants to get close to the edge, or worse, go over it. You both realize you are past the point of “extend and pretend,” and any further extending and pretending will accelerate your meeting with the abyss. You have decided to engage in the loan workout process. What do you do now?

Setting the stage

As the lender, it is important you set the stage for a fruitful process. If you have not operated under the strict terms of the loan documents up to this point, it is extremely important you do so going forward. Any notices and correspondence (with some exceptions) will be used as evidence in legal proceedings; therefore, you want to refer to your loan documents when it comes to the manner of notices, addresses, timing, method of delivery, etc. Be specific in the type of default, reference specific sections from the loan documents and include specific amounts and dates. Demand cure in accordance with the loan documents and reserve your rights and remedies as a creditor.

Another key part of the process is to include a pre-negotiation agreement, which will provide you, the lender, with the option to dual track your assertion of rights and remedies per the terms of the loan documents and be able to enter into negotiations with the borrower without prejudicing those rights and remedies.

With the correct pre-negotiation agreement, your discussions with the borrower will be treated as settlement negotiations; the discussions are non-binding until the parties enter into a written agreement executed by all parties.

As a borrower, you should not expect or rely on a loan modification and should pursue other alternatives during the workout process.

The borrower’s dilemma

One of the most important steps for the borrower is to come to terms with your strengths and weaknesses. Some of your strengths may be:

• Cutting costs even further and increase cash flow.
• Using unused or untapped equity to take care of deferred maintenance or complete some capital improvements.
• The asset in question is a complex or unique project that is not easily handled by someone else (much less the lender).

Additionally, perhaps you or your team have particular property management strengths and experience that are important to the project, such as experience managing a property with affordable housing reporting requirements. Or, finally, you have minimal personal liability exposure under the loan documents.

On the other side of the coin, you have some weaknesses for which you need to account:

• The project is still under construction with mechanics’ liens piling up.
• Your investors are not willing to invest any more money into the project.
• You have a high level of personal exposure under the loan documents.
• The property is not cash-flowing or is in considerable disrepair.
• Perhaps your third-party manager mismanaged the asset.

The lender’s dilemma

As the lender, you also need to start evaluating your strengths and weaknesses.

On the plus column:

• Your borrower and its equity partners have deep pockets.
• The under-performing loan is cross-defaulted and cross-collateralized with performing assets in your portfolio.
• The borrower principals are subject to considerable personal liability under the loan documents.
• Perhaps there is a third-party that is willing and able to perform capital improvements or has a better management structure that will take the property out of distress.

On the minus column:

• There are some potential lender liability claims that have some legs.
• You have withheld funding further construction costs because you saw that the project was being mismanaged or the construction costs were running away.
• There are large unpaid mechanics’ liens (or tax liens) that will prime the priority of your mortgage.
• The borrower does not have deep pockets (or partners with deep pockets).
• The project is particularly complex making it difficult to transition once you foreclose.
• You have substantial losses in that particular region, asset class, sponsor or loan type.
• A loss exposes you to considerable reputational or headline risk.

Getting through the workout process

The loan workout process has a higher likelihood of success when the parties are proactive and honest with each other and act in good faith. Do not bluff. Be realistic; but be creative. Do not spend time and energy on the impossible or the unrealistic. Put principles and egos aside.

Both parties need to determine their own objectives, lay out their options, evaluate the situation with the asset and the loan, evaluate potential courses of action and develop a strategy. Both sides need to involve all key stakeholders in the workout process.

Workouts are successful when the parties find common ground and all sides consent to the outcome — both sides had to give on something but then, of course, they also came away with something.