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Editor’s Note: This is part of a series of monthly newsletters on topics we hope will be of interest to our partners, clients and colleagues. The general theme of FrontView’s approach to distressed real estate will be articulated through the series, which we intend to begin with foundational topics and proceed to more sophisticated issues over time.
The purpose of this article is to articulate a basic workout protocol for portfolio lenders. (Further protocols, specifically relating to securitized loans and to various asset class-specific issues, as well as discussions of substantive workout-related issues, will be covered in later editions of Distressed Real Estate Update.) This article is not intended to address the resolution of substantive issues, but as a guide to the procedural steps that should be taken to maximize the chances of a successful workout. The protocol outlined below may vary based on specific circumstances; but it should serve as a useful basic checklist for a portfolio lender to follow when loans of various types start to “go bad”.
FIRST, GATHER DATA
Interview the players to learn their mindsets, review the entire loan file, and otherwise gather sufficient data (with current updates, if they can be obtained while the borrower still has incentives to be cooperative) to be certain of understanding:
- The ownership and control structure of the borrower. It is important to know exactly who you are dealing with – who is the person really in charge - and until somebody reads the borrower’s organizational documents, it may not be clear who that person is. In particular, be cognizant of a limited partner’s major decisions rights as they relate to a workout.
- The physical and operational condition of the asset.
- The project’s economics, including historical financial statements and any projections, pro formas and business plans. (Note that the borrower may be eager to present a pro forma forecast of the asset’s future, which will undoubtedly be overly optimistic.)
- The nature, circumstances, extent and causes of the default.
- The parties’ responses to the default to date.
- All assets and liabilities of the borrower and all guarantors – and any other investors or other persons interested in the fate of the project, if possible. This data will be important both in determining the sponsor’s or a limited partner’s financial ability to “pay to play” in a workout scenario, the value of the “bad boy” guaranty as a disincentive to file a bankruptcy case, and the guarantor’s financial ability to satisfy a judgment on the note if the workout goes bad.
NEXT, CONTROL COMMUNICATION
Establish clear lines of communication, including the provision of default notices, if appropriate:
- Notices should not only be issued to the borrower and each guarantor, but also to all junior lienors and any other interested parties (except in special circumstances, such as where a strategic reason exists not to trigger the tolling of time periods for a party to take certain actions).
- Consider giving notice and an opportunity to cure defaults to all parties in interest, even if you are not technically required to do so - you never know who may step up as a white knight.
- Throughout the process, the lender must control communications by avoiding multiple lines of communication and by communicating in writing whenever practicable. Oral communications should be minimized, memorialized and confirmed in writing which is delivered to the borrower.
NEXT, ENGAGE SPECIALISTS
Retain independent specialists, as appropriate, to take action and/or to produce analysis and reports that will inform your decision-making. This process will take time, and/or may require obtaining borrower consent or cooperation from a court-appointed receiver – and, as such, may require entering into a negotiated forbearance period. Categories of professionals who may, depending on the circumstances, be indispensable to a successful result will include one or more of the following:
- Workout Specialist: A team of competent full-time workout professionals will in many respects be better suited than the loan origination team to achieve cost effective, timely and efficient realization on a troubled loan, because such a team should, among other things, (i) have special experience and expertise in workout negotiations; (ii) serve as a “quarterback”, orchestrating and guiding the other professionals and the lender team to a successful result; (iii) be objective (whereas the loan originator may be overly biased for or against the borrower); (iv) know not to inappropriately interfere with borrower operations, control borrower property or otherwise court lender liability risks; and (v) be familiar with and anticipate the other major risks of workout scenarios, such as bankruptcy, environmental liability and other risk management issues.
- Industry Specialist: In certain circumstances, it may be helpful to have an underwriting report from an expert in specialty property types.
- Insurance Consultant: An insurance consultant’s evaluation of any lapses in coverage can be important, inasmuch as the asset may be subject to waste, arson or other unusual risks at this time.
- Title Insurer: A title company – preferably not the one that insured title at the loan closing -- should provide a foreclosure search in order to identify and evaluate the rights of junior lienors, mechanics lienors, tax lienors and other parties in interest.
- Appraiser: An appraiser should be engaged to document the value of the collateral, via a FIRREA-compliant appraisal, in order to (i) comply with lender regulatory and accounting requirements, (ii) enable a realistic evaluation of the deal’s existing economics, (iii) support lender decisions to make or withhold protective advances and to bid specified amounts in foreclosure so as to avoid subsequent attack as not being reasonably equivalent value and otherwise minimize bankruptcy risks and (iv) determine the proper end objective of the workout negotiations.
- Construction Inspector: For assets under construction, a construction inspector should be engaged to estimate the cost to complete, audit construction loan advances, confirm that disbursed loan proceeds have been used properly, and provide documentation helpful in avoiding any borrower claim that the lender damaged the property.
- Engineer: For completed assets, it may be important to engage an engineer to provide inspection report detailing current maintenance deficiencies and assessing any capital commitments needed in order to make the asset viable.
- Broker or other Market Expert: It may be appropriate to engage a broker to provide a market study that evaluates comparable assets and quantifies supply and demand for the asset.
- Independent Accountants: It may be necessary to engage an outside accounting firm, in order to audit the property rent roll and operating statement and the borrower’s and guarantors’ financial statements.
- Independent Counsel: Outside legal counsel with specialized expertise should in most circumstances review the key loan documents and address issues relating to servicing conduct, the state of title and other sources of unforeseen problems.
- Environmental Consultant: The loan file should be scoured in-house for all relevant information, which should then be analyzed by an environmental consultant in conjunction with obtaining an ESA, in order to determine among other things whether the lender (a) exercised “all appropriate inquiry” as a basis for asserting the innocent landowner defense to environmental claims, and (b) can otherwise safely realize on the collateral and take title. In-house workout personnel should also learn the EPA Secured Creditor Rule, which limits the lender exemption from environmental liability in workouts prior to foreclosure.
NEXT, EXECUTE A PRE-WORKOUT AGREEMENT
The benefits to a lender of obtaining a pre-workout agreement from the borrower include the following:
- Sets the ground rules for (and manages the lender’s risk of inadvertently waiving rights in the course of) the negotiation process.
- Confines the borrower to a fixed period within which to negotiate.
- In order to avoid immediate exercise of remedies, the borrower may be induced to (a) agree that all discussions are without prejudice, (b) release all lender liability claims, (c) acknowledge the facts constituting the default, the amount of the debt and the validity of the loan, (d) agree to provide information to the lender and (e) agree to a lockbox or other protective arrangements as a token of the borrower’s good faith.
In exchange for these agreements, which facilitate a successful workout negotiation within a fixed period of time, the lender normally agrees to refrain from exercising certain of its rights and remedies during that period.
NEXT, PROTECT AND CONTROL THE ASSET
In consultation with an attorney who can help evaluate the risks, consider whether it is necessary to (i) make protective advances to prevent deterioration of the asset, and/or (ii) take control of the property in order to prevent the borrower from diverting rents. The latter goal is most generally pursued in one of three ways:
- By becoming a mortgagee in possession and operating the asset and collecting rents. This can be quick and inexpensive to set in motion (unless the borrower refuses to yield possession, in which case a suit for ejectment may be necessary). However lender-in-possession status carries with it very serious liability risks for the lender, inasmuch as it involves effectively becoming a quasi-fiduciary with a duty to manage the asset in a reasonably prudent and careful manner. As a result, this option will normally only be selected where (i) the borrower is seriously mismanaging or stealing from the asset, (ii) the borrower is expected to make bankruptcy filing that will stay lender action if it is not in possession, and/or (iii) a receiver cannot be obtained and the assignment of rents was not delivered or cannot be activated for some reason.
- By obtaining the court-ordered appointment of a receiver to take possession of the asset and collect the rents. This is a much slower and costlier process, which moreover generally requires commencing a judicial foreclosure, however, there is little risk of lender liability.
- By activating the assignment of rents.
NEXT, FORMULATE A GAME PLAN
Once all the data has been digested, a strategy should be established to meet whatever challenge is eroding the asset’s performance. There is a fairly clear hierarchy or spectrum of options that form a basic decision tree for the lender:
- At one end of the spectrum, it may be possible to improve the asset’s performance by merely sharpening the asset management. The existing capital structure remains untouched in this case.
- At the next level, the existing capital structure can be maintained, but with economic accommodations being traded off among the capital stack participants. This is the world of workouts – and the decisions to be made are tougher. Is the lender willing to trade an interest rate reduction or term extension, for example, for fresh collateral, new guaranties, a deed-in-escrow or some other set of concessions by the borrower?
- If it is determined that the asset cannot be turned around and ultimately enhanced using the existing capital structure, and that the existing capital structure must therefore be abandoned and replaced with something else, then the next group of strategic options are those in which the capital structure is re-worked, but in a cooperative, or at least non-litigious, fashion. This is the world of restructurings and “giving back the keys” – and the options here may range from the introduction of a new debt or equity investor that wipes out or dilutes the existing debt or equity, on one end of the spectrum, to a deed-in-lieu of foreclosure or a friendly foreclosure, on the other end.
- At the far end of the spectrum are the unilateral and coercive strategies for abandoning the existing capital structure. These of course include foreclosure, bankruptcy, action on the note and guaranty, and a variety of other forms of litigation and litigation-related strategies.
NEXT, RUN THE NUMBERS
Evaluate all economic implications of any strategic proposal. This is the time to perform disciplined modeling. It is also the final opportunity to uncover and think through all the hidden implications of a proposed strategy. It is easy to forget, for example, that:
- The “all-in” costs of a loan restructuring may include a big-ticket tab for income taxes, state and city transfer taxes, franchise taxes, gains taxes and/or recording taxes.
- A transfer of title to a lender may trigger “key man” provisions or other change-of-control provisions in franchise or other key property-level agreements.
- A title transfer may not be accompanied by a continuation of title insurance coverage in favor of the lender as successor owner, especially if the lender has relevant knowledge not shared with the insurer.
FINALLY, BE DECISIVE
Respond quickly, decisively and programmatically to borrower proposals. Once a strategy is agreed upon, act on it promptly and close the transaction as expeditiously as possible.
About FrontView Advisors
FrontView Advisors is a real estate investment advisory firm offering our clients and capital partners relevant and "current day" experience to source, underwrite, negotiate, execute and manage existing and new real estate investments and loan portfolios in today's challenging economic climate. FrontView's principals have handled in excess of $2 billion in the workout and restructuring of complex debt and equity positions throughout the capital stack since 2007.
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