January 19, 2011
Published in Business in Savannah
According to the February 2010 Oversight Report provided by the Congressional Oversight Panel, approximately $1.4 trillion in commercial real estate loans will reach the end of their terms between 2010 and 2014.
At present, about half are considered ‘underwater,’ meaning that the borrower owes more than the underlying property is worth. While unfortunate for most, these circumstances stand to create an unprecedented mix of loss and rare opportunity for commercial property buyers.
Many of the commercial loans made at the height of the real estate bubble, when property values were at historic highs, were interest-only for the entirety of the term. These loans were non-recourse and were made with 5, 7 or 10 year balloons — meaning that these loans must be paid off or refinanced for the full principal amount at the end of the 5, 7 or 10 year term.
Since these loans were made, the country has fallen into a severe recession, which has translated into a dramatic drop in consumer spending, failing national and local businesses, and decreased demand for office and commercial rental space.
Another component of the recession is that lending in this country has, for the most part, turned its back on loans secured by real estate. Most banks would no sooner consider making a loan for a piece of commercial real estate than they would consider handing out money to the public. The reason the banks cannot make real estate backed loans is that they made too many of the real estate loans described above during the market peak and are paying the price now. Not only are banks ladened with real estate they now own and cannot sell, but the regulators are demanding that the banks lower the percentage of real estate backed loans on their books.
When a bank is looking at a failing loan secured by commercial real estate, they are often deciding between two choices, foreclosure or selling the loan. Often the facts do not support foreclosure — either the bank does not want to take on the cost or liability of owning particular types of commercial real estate. This leaves the bank with the possibility of selling the note. Notes can be bundled and sold as a group — thus the purchaser takes the good with the bad — or notes can be sold off individually if there is enough value and/or interest in one particular note that the bank will fetch a reasonable price for just the one note.
When purchasing a note from a bank, either in a bundle or a one-off transaction, the purchaser needs to organize its approach, which is often dictated by the purchaser’s expectations. If the purchaser is looking to purchase the note or notes for the purpose of continuing on as the “new” lender, the due diligence to be preformed pre-closing is different than the due diligence performed by a purchaser that intends to foreclose and acquire title to the underlying real estate.
In either scenario, a thorough review of the loan documents, the bank’s course of performance with the borrower, borrower’s potential defenses or claims of wrong doing against the original lender, an updated title search and the lender’s title insurance is key. If a purchaser intends to continue on as the “new” lender many dimples and defects within the loan documents (which there almost always are) can be worked out during any workout or loan modification entered into with the borrower.
If a purchaser intends to proceed to foreclosure shortly after acquiring the note more time and attention should be given to any defects in the loan documents, borrower’s potential defenses or claims of wrong doing against the original lender and the lender’s title insurance. If upon acquisition of the note the title company is not willing to provide the new note holder with a down date endorsement insuring the first priority lien of the security deed, the purchaser has a significant problem.
However, all risks can be addressed at a price. Since the purchaser of the note is the one exercising the foreclosure remedy, and thus is the party at risk if the borrower contests the enforcement actions or files for bankruptcy, the purchaser may be willing to take on these risks if the purchase price of the note is low enough.
If the purchaser of the note is intending to foreclose and obtain title to the underlying real estate an additional layer of due diligence should take place before closing. The purchaser should attempt to do as much due diligence on the real estate itself as may be possible – which can be very difficult if the borrower does not want to cooperate with access to the real estate.
Often the loan documents provide the lender with certain rights to enter upon the real estate and conduct certain examination in the event of a defaulting loan; however, the selling lender may not want to push its rights and create borrower claims or defenses. Instead the selling lender will tell the purchaser of the note that is purchaser’s issue to work out post closing.
With so many uncertainties that cannot be absolutely determined by a purchaser of a note, some may consider purchasing a note a risky proposition; however, if analyzed and priced properly the potential benefits of purchasing a note far outweigh the risks.
Consulting a specialist in commercial finance is always recommended when navigating the potential risks associated with purchasing notes.
