FEATURE ARTICLE, JUNE 2008

WE CAN WORK IT OUT
Commercial loan workouts offer both borrowers and lenders many advantages over foreclosure or bankruptcy.
Andrew S. Gabriel

Gabriel

Commercial real estate lending has hit some bumps in the road. Much has been written about the residential mortgage crisis and resulting foreclosures, with Las Vegas, for example, prominent among affected communities. Commercial developers and property owners in Southern Nevada, as elsewhere, have also seen very tight credit markets. With virtually no CMBS financing, more conservative underwriting by portfolio lenders, increasing retail and office tenant defaults, and limited buyers for newly constructed or converted condominiums and single-family homes, more and more commercial loans may be headed towards foreclosure. Professionals in the loan workout field have geared up for business levels not seen since the early 1990s.

Simply defined, a loan workout occurs when the lender and borrower of a troubled commercial loan agree to make changes that benefit the borrower, usually to avoid the equally unappealing prospects of foreclosure or bankruptcy. In Southern Nevada, some very high-profile projects, according to local press accounts, have been going through the workout process. One project, a $3 billion hotel-condominium and casino resort on the Las Vegas Strip, ran into problems in mid-construction when it was unable to refinance maturing debt, with its lender reportedly starting foreclosure proceedings on the $760 million loan. On another front, a very large master-planned community developer, well known for winning bids at BLM land auctions, reportedly received default notices on approximately $765 million. The loans, which it owes in partnership with a number of national homebuilders, are on 1,940-acre and 1,710-acre tracts of land. In another case where bad timing is likely to blame, a local casino company is reportedly faced with the prospect of bankruptcy court protection if it is unable to restructure $1.14 billion in debt.

All of these borrowers have, reportedly, been in talks with their lenders to workout their loans. From a lender’s perspective, the cost and time of foreclosure, and then ownership of troubled real estate with low demand, is not appealing. From a borrower’s perspective, neither option of losing a project to foreclosure or filing for bankruptcy reorganization is particularly appealing either. Thus, there is incentive on both sides to try to modify the economic terms of the loan, to work out and through the difficult times. However, as in any commercial real estate loan transaction, there are a myriad of details — multiple parties, conflicting agendas, high stakes coupled with a sense of urgency and sometimes adversarial animosity — where the original “win-win” transaction evolves into a restructuring based on compromises and concessions.

In a typical workout, lenders must first evaluate whether or not the project will be viable even with modified loan terms. A good market appraisal and analysis of income potential is the usual starting point. The actual deal terms of a workout are varied and project specific. Lenders may forgive a portion of the debt outright by writing off part of the loan (which has adverse tax consequences to the borrower). But they are more likely to forgive default interest or late penalties, forebear from bringing default proceedings, temporarily postpone collection of loan payments with a larger balloon payment on maturity or reduce the amount of loan payments in exchange for a longer term. Some workouts are structured to convert an amortizing loan to interest-only payments for an interim period and even convert the payments to a net-cash basis, collecting whatever income is available from the property after operating expenses. If construction is complete, the lender will prepare a detailed financial analysis of the project’s income and expenses, as well as vacancies, leasing opportunities and other prospects for increasing project cash flow. Lenders may also participate in borrower negotiations with troubled tenants, with the goal of providing rent relief in order to maintain occupancy and rental income.

Lenders face multiple additional issues with construction loan workouts. These loans typically run into problems when developers experience cost overruns, construction schedule delays and slow sales in projects such as condominiums or production housing, which depend on individual closings to pay down the loan. Borrowers may find their interest reserve used up, with no prospects for refinancing. Lenders often must inject more money into the project to complete construction. However, they typically are not eager to foreclose in mid-construction if this means they must take over the completion of the project. In some cases, lenders negotiate equity interests in the developer and a more active role in overseeing the project. However, this could create additional lender liability or borrower defenses to lender claims that may not justify the risk.

In any workout, the lender must assess its business relationship with the borrower and its confidence in the borrower. Some lenders may conclude that their borrower cannot turn a project around, even with loan relief. In these cases, the lender may be reluctant to delay a foreclosure that may be inevitable. At this point, the parties may discuss a “deed in lieu of foreclosure,” whereby the borrower conveys the property to the lender to avoid foreclosure. A deed in lieu may save both parties considerable time and expenses in negotiating a more detailed workout or in the foreclosure process. However, there are disadvantages for a lender, particularly if there are subordinated liens encumbering the property, such as junior deeds of trust and mechanics’ liens. While a foreclosure sale would wipe out these subordinated liens, a conveyance by deed in lieu transfers the property subject to the subordinate liens. In states such as Nevada that permit fairly quick non-judicial foreclosures by power of sale, there may be few advantages to a lender taking a deed in lieu.

Finally, lenders must always keep the prospect of a borrower bankruptcy in mind when working out troubled loans. Borrowers may rely on bankruptcy for relief from foreclosure pressure and prospects of reorganization that are not as easily achieved in direct negotiations with their lender. Secured lenders are in a better position in bankruptcy court than unsecured creditors, and many commercial loans are made to single-purpose, “bankruptcy remote” entities that make it easier for a lender to foreclose following bankruptcy. Some lenders may conclude that they could achieve a better result through bankruptcy court. There are many bankruptcy issues that may arise from troubled loans, and no workout should be negotiated by a lender or borrower without bankruptcy counsel.

Andrew Gabriel is a partner in the Las Vegas office of McDonald Carano Wilson LLP.

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