By Steven Jacobs and Matthew Theunick, Trott & Trott, P.C.
Commercial lenders and business owners are approaching a time in which tough decisions will need to be made on maturing commercial loans written during the real property boom of 2005 through 2007. According to a number of recent articles citing economic data for commercial mortgage backed securities, a large group of 10-year loans will be coming due during the next few years, many of them with large balloon payments or higher interest rates that may need to be re-negotiated.
There is one critical question: What should the lenders and property owners do to hedge against the potential risk of loss?
Some of the issues the parties are now contending with are the reduced values of the properties involved and the loss of profitability in the businesses themselves as consumers have reduced their spending, sources of income have dried up and/or other market forces have changed the initial dynamic of the commercial loan that was originated.
Lenders in many markets will be faced with the issue of a loan maturing on a security interest that conceivably could be worth significantly less than the property’s appraised value at the time the loan was written. Additionally, interest rates are still at all-time lows for commercial lending. Because of this, commercial construction is on the rise, resulting in excess available commercial space. This could impact existing commercial property values for years to come. Depending on the type of loan, the business being operated in the space and the financial strength of the borrower, it may make sense to take a closer look at the loan now as opposed to waiting for the loan to mature. This may also be a necessity as business owners approach commercial lenders seeking a possible loan workout, modification or review for relief from a high interest rate or an approaching balloon payment. Other business owners might be seeking an extension of financing beyond the pending termination of the loan.
The first item for the lender should be to engage in a thorough and comprehensive due diligence review of the current loan file and determine what information is present, what information is needed and what information is missing or needs to be supplemented. If any information is not current, the lender will need to contact the borrower and obtain this information for the file. For example, a retail strip mall would have rent rolls showing the current occupancy rate of the space. Additionally, the rent rolls would provide the tenants currently under lease contract, the amount and duration of the lease, etc. This information is pertinent to not only determine the amount of rent being paid to the property owner, but to understand how long the income stream could last. Other information the lender will want to update the loan file with includes profit-and-loss statements, balance sheets, tax filings and bank statements.
Most commercial loan documents will allow the lender to request a variety of documents for review on a regular basis. If there are questions as to which documents can be requested and how the lender needs to make the request, legal counsel can review the documents and assist in gathering this information or provide an opinion as to what steps the lender needs to take to acquire this information under the loan documents in addition to all of the lender’s legal options, including its options upon default of a loan.
Once the documents are provided, the review is completed and the viability of the business is determined, the lender must establish the next best course of action. If the business survived the economic downturn and is now starting to rebound, or even if the economy did not affect it greatly, and the business appears to be viable, opening up the lines of communication with the borrower may be the optimal first step toward avoiding a large loss on the loan.
The business and property owners’ investment is most likely not worth the same amount as it was when the loan was financed back in 2005 through 2007. So, what option(s) does the borrower have when the loan matures? Selling the property may result in the owner having to come to the closing table with funds to pay off the balance of the loan, which he or she may not have, or the willingness or desire to actually pay it off at that time. To avoid a default and foreclosure, the lender could consider offering a workout to ensure the loan continues to perform for the next five to 10 years while the parties wait to see if property values ever rebound from the record-low levels. If, on the other hand, the business is struggling, but this appears to be a result of the economy, the lender might consider reaching out to the borrower now to create a plan of action to aid the borrower in avoiding a default when the loan matures, or even prior to the maturity date. This plan could be a precursor to building a sustainable relationship that allows a loan workout in the event of a default.
There is no set formula for a workout between the lender and borrower. Financially, it must make sense for both parties. Interest rates are still at all-time lows and commercial lending is on the rise, so now is an opportune time to see if a workout of some sort can be accomplished, possibly in the form of a re-finance. Of course, a barrier to any re-finance is the appraisal of the property, which more than likely will be lower than before. However, if the loan has been performing, and the business is operating and profitable, the due diligence completed beforehand will position the lender and borrower optimally to make a determination of the next step in avoiding another wave of defaults and foreclosures where both lenders and borrowers will likely lose.
Steven Jacobs and Matthew Theunick are attorneys in the litigation department of Trott & Trott, P.C., a Farmington Hills, Mich.-based real estate law firm. The authors specialize in commercial litigation and land-use and zoning issues. Jacobs can be reached at firstname.lastname@example.org and Theunick is available at email@example.com.