| You have to love Warren Buffett. If nothing else, he | | | | Some lenders will focus on all events of default - |
| produces some of the best one-line words of | | | | even technical defaults such as failure to comply with |
| wisdom ever spoken - at least in the realm of | | | | loan covenants like debt coverage ratio, or loan to |
| investment. His business advice is unmatched in its | | | | value ratio. Question: Today, at this point in this real |
| simplicity and unsurpassed in its value. Though he | | | | estate recession, does it make sense to declare a |
| typically gives advice on investing in business equities, | | | | technical default when the loan is already fully |
| much of what he says easily translates to commercial | | | | funded? |
| real estate. That makes sense. While commercial real | | | | You may not agree, but it seems to me, in virtually |
| estate investment is certainly about real estate, it is | | | | every case in these challenging economic times, that |
| equally about business. Big business. And the problems | | | | a lender calling a loan by declaring a technical default |
| facing commercial real estate investors, developers | | | | because of a blown debt coverage ratio (DCR) or a |
| and lenders today are not actually real estate | | | | non-compliant loan to value ratio (LTV) stands at the |
| problems so much as they are business problems. As | | | | height of blind stupidity. How is this an exercise of |
| business problems they require business solutions. | | | | sound and safe banking practices? |
| Real estate has not changed. The business of real | | | | Let's be real. If you are a commercial real estate |
| estate has changed. | | | | lender and have a required loan to value ratio on a |
| Three of my favorite Warren Buffett quotes (and | | | | fully funded loan of.75 to 1.00 (75% LTV), but |
| there are many) are found in The Tao of Warren | | | | because of market conditions the collateral value has |
| Buffett, by Mary Buffett and David Clark (Scribner, | | | | declined, resulting in the loan equating to 90% of |
| NY 2006). It's a great read. Buy it. | | | | value - or worse yet, 120% of value (your loan is |
| "A pin lies in wait for every bubble, and when the | | | | "upside down") - do you, the lender, really want to |
| two eventually meet, a new wave of investors learn | | | | call the loan if your borrower is nonetheless making all |
| some very old lessons". | | | | payments on a timely basis? What is the upside for |
| "You want to learn from experience, but you want | | | | you if you do? What are you going to do with the |
| to learn from other people's experience when you | | | | property if you foreclose on it? Do you think your |
| can." | | | | borrower can refinance the project? Do you think it |
| "You don't have to make money back the same way | | | | will be easy to sell? Do you really want to own it and |
| you lost it." | | | | be responsible for managing it and maintaining it? |
| My commercial real estate practice is dominated at | | | | Alternatively, do you think you will collect on the |
| the moment with clients and projects in financial | | | | guaranty? Forget the financial statement you |
| distress. Fortunately - or unfortunately, depending on | | | | received when you made the loan; have you |
| your point of view - because I have been in practice | | | | considered the current financial condition of your |
| over thirty years, this is not the first time I have | | | | guarantor? |
| represented a wide range of commercial real estate | | | | Similarly, if a loan covenant requires a DCR of 1.20 (i.e. |
| investors, developers and lenders work their way | | | | net operating income equal to 120% of required debt |
| through a serious real estate recession. | | | | coverage payments), but the borrower has |
| Here's a basic truth: What worked two, three or four | | | | vacancies or delinquent tenants resulting in net |
| years ago probably doesn't work now - especially if | | | | operating income being 1.00 to 1.00 (i.e. net operating |
| you were momentum investing based on rising | | | | income equal to required debt coverage payments), - |
| property values instead of value investing based on | | | | do you really want to call the loan if your borrower is |
| discounted cash flows. For momentum investors, the | | | | current on all required payments? How are you going |
| current momentum for commercial real estate is | | | | to be any better off? |
| headed down and is not expected to hit bottom for | | | | Worse yet, what if the existing debt coverage ratio |
| another two to three years. If you are relying on | | | | is less than one, but somehow the borrower is still |
| rising commercial real estate values, the momentum is | | | | finding a way to subsidize the project and make its |
| against you. Pretty much like trying to swim against a | | | | payment? Are you sure you want to declare a |
| rip current. Try not to panic, but if you don't swim | | | | default? |
| quickly to the side, it could kill you. | | | | What if, even worse, the borrower cannot quite |
| Even value investors should stop and think. Can the | | | | make the full payment but is willing to essentially |
| revenue stream you are relying on to establish value | | | | work for free by continuing to manage the project? |
| be sustained? Most indications are that while we may | | | | The borrower may be willing to do this to protect |
| be near the bottom of the residential housing bust, | | | | itself from liability on a guaranty, or perhaps even in |
| challenges in the commercial real estate sector have | | | | the hope it can hold on until the economy recovers |
| only just begun. | | | | sufficiently to enable the investor/borrower to sell |
| Think about it this way: | | | | the project for an amount sufficient to recover part |
| Until unemployment stabilizes and starts to decline, | | | | or all of its equity investment. Are you going to |
| and housing prices stabilize so consumers stop feeling | | | | maximize your recovery by declaring a default? |
| poor, consumers are not likely to increase spending in | | | | You may suffer from lender fatigue with this |
| any significant way. Until consumers increase | | | | borrower, but do you really believe the loan is in |
| spending, retailers and service providers (think office | | | | default because the borrower is a poor manager? |
| workers) will continue to suffer, and in some cases | | | | Are you sure? Have you heard about the recession |
| will fail. If they don't fail, many will continue to | | | | we're in? How does adding another layer of expense |
| downsize which, of course, adds more fuel to the | | | | by hiring an independent property manager or having |
| unemployment fire. | | | | a receiver appointed help you maximize your |
| As retailers and service providers fail or downsize, | | | | recovery? If the borrower simply walks away, then |
| commercial space will become vacant or, at least, | | | | of course, you must. But if the borrower is serious |
| underutilized. They won't be acquiring new space or | | | | about continuing to work with you and manage the |
| expanding until they are again fully utilizing the space | | | | property, does it make sense to say "no", or to |
| they have. That's not likely to occur until consumers | | | | make it so difficult or painful that the borrower is |
| have begun to feel confident and start spending - | | | | forced to give up? |
| and do so for a long enough period, and in big | | | | Think about this: Until this economy recovers, your |
| enough amounts, that the retailers and service | | | | chance of selling the project for enough to pay off |
| providers regain their financial footing and feel | | | | your mortgage is probably not very good. |
| confident that the consumer part of this recession is | | | | Remember, you just concluded the project cannot |
| over and a consumer lead recovery is in full swing. At | | | | support your mortgage. Do you think some other |
| that point, we will be at only the beginning of the | | | | investor is going to pay you more for the project |
| commercial real estate recovery. | | | | than you have already concluded its worth? Probably |
| For commercial real estate developers, investors and | | | | not. If you believe the project is worth substantially |
| lenders to recover, not only do retailers and service | | | | more than your loan, have you considered the risk |
| providers need to expand, they need to expand | | | | and consequences of the borrower filing a Chapter 11 |
| enough to re-fill the huge number of retail and office | | | | bankruptcy? |
| vacancies that exist today, and which are likely to | | | | The more sensible and cost effective solution may |
| become more prevalent until the commercial real | | | | be to amend the loan documents to reflect loan |
| estate downturn hits bottom. With so much vacant | | | | terms that actually work in today's market. [See: |
| space available, the bargaining advantage will be with | | | | Loan Workouts, Part 1 - Note to Lenders]. Ask |
| the new or expanding tenants. This means rents are | | | | yourself: Is it better to accrue interest at 8%, or to |
| likely to be lower and, in turn, that net operating | | | | actually receive interest payments at 3%? What is |
| income is likely to be lower. Applying the often used | | | | your current cost of funds? What if the loan is a |
| cap rate method of valuation - even if we apply the | | | | non-recourse loan, or has effectively become a |
| historic low cap rates of the past few years - this will | | | | non-recourse loan because the borrower and its |
| result in property values being lower. To compound | | | | guarantors are financially compromised [read that as |
| the problem, capitalization rates are rising as investors | | | | effectively broke] and the collateral is worth less than |
| seek a higher yield to cover what they perceive to | | | | the loan? |
| be higher economic risk. Real estate values move | | | | Depending upon the answer to these questions, the |
| inversely to cap rates. With cap rates up and net | | | | lender and borrower may have something to talk |
| operating income down, commercial real estate | | | | about. Perhaps enough common ground can be found |
| values will continue to suffer a double whammy. | | | | to satisfy both the legitimate needs of the lender |
| It is going to take a long, long time to get back to | | | | and the legitimate needs of the borrower. If so, the |
| where we were. Consequently, commercial real | | | | workout solution is to amend the loan documents to |
| estate loans are going to continue to be upside | | | | reflect those terms. |
| down, leaving borrowers and lenders in trouble unless | | | | Pretend: This is the tough one. It's tough because it's |
| they find a way to work together to right the ship. | | | | what a lender does when it is either unable or |
| As lenders and borrowers see the light and conclude | | | | unwilling to face reality. Don't get me wrong. |
| it is in their mutual best interests to work together | | | | Borrower's are just as susceptible to pretending as |
| to get through this mess, I want to caution | | | | are lenders. In either case, it is a prescription for |
| borrowers once again to be mindful of the dangers | | | | disaster. |
| discussed in my prior article, Loan Workouts, Part 3 - | | | | If you won't face reality, you won't find a real |
| Call to Action. It is not that lenders cannot be | | | | solution to real problems. It's as simple as that. Loan |
| trusted. In fact, they can be trusted. But what they | | | | workouts are based on finding real solutions. A real |
| can be trusted to do is to act in a manner that is | | | | solution is one that actually works and is achievable |
| consistent with their own best interest. If you keep | | | | under circumstances as exist today. Not conditions |
| that in mind, always, you can workout a solution that | | | | the lender and borrower wish existed. Conditions that |
| protects your interests as well. If you are lulled along | | | | actually exist. You may not like the solution, and it |
| until your lender doesn't need you to get out of its | | | | may not make you entirely whole, but if you are not |
| loan without a loss, you are virtually certain to sustain | | | | willing to connect with reality and be honest with |
| a loss. The time to make your deal is now - while | | | | yourself about what can actually work under |
| you both need each other. | | | | circumstances as exist today, you are engaged in a |
| It has been observed that in the current economic | | | | real world game of pretend and will suffer the |
| climate, commercial real estate lenders have three | | | | consequences. |
| basic choices when it comes to dealing with | | | | Recommendation: If you have not read the book |
| distressed commercial real estate loans. Simply | | | | SWAY - The Irresistible Pull of Irrational Behavior, by |
| stated, they can extend; amend; or pretend. | | | | Ori Brafman and Rom Brafman, Doubleday, ©2008, |
| Some will say they have a fourth choice, which is to | | | | I highly recommend it. I found it so useful for placing |
| sell their distressed loans. I discuss that option in | | | | loan workout negotiations in context that I read it |
| greater detail in my next article, Distressed Note | | | | twice. [... and, no, I don't get a commission.] |
| Transactions - Panacea or Poison which will follow | | | | Successful loan workouts must be built on reality. |
| shortly. Until then, let me just say that it is the | | | | There is virtually no case in which pretending you |
| "pretend" choice that creates to greatest obstacle to | | | | don't have a problem, or pretending that the problem |
| successfully buying or selling distressed loans. | | | | will go away on its own, will work for very long. |
| So that we are on the same page, let's review the | | | | Since pretending seldom works, extending or |
| three basic choices in the order stated: EXTEND; | | | | amending likely represent the best solution in today's |
| AMEND; or PRETEND. | | | | market. |
| Extend: If a loan is essentially performing (that is, if | | | | These are tough times. We understand that you |
| at least payments are being made on time), the | | | | have been successful in real estate by following your |
| lender and the borrower can buy time by extending | | | | instincts in the past. But understand this: The bubble |
| the loan term and hope the loan can continue to | | | | has burst and the economy wide rules of the real |
| perform until the economic climate improves to the | | | | estate game have changed. How else can you explain |
| point where the lender can get paid off through a | | | | the unfamiliar financial obstacles you currently face? It |
| sale or a refinance of the property. If the loan is not | | | | may not be your fault that you got caught in this rip |
| in default, and the only problem is that it is maturing, | | | | current of financial havoc. The choices you made and |
| this may be the best solution. Tip to Borrowers: Right | | | | the deals you got into may have been sound and |
| now, lenders really don't want any more defaulted | | | | reasonable based upon conditions as existed at the |
| loans. You have some leverage. Fight to get yourself | | | | time you made them. But make no mistake: it will be |
| a long enough extension to have a fighting chance to | | | | your fault if you fail to act rationally to do what is |
| come out of this alive. | | | | necessary to extricate yourself from this quagmire. |
| Amend: If the loan is in default, or about to go into | | | | Don't pretend. Get help if you need it. |
| default, merely extending the loan may not be an | | | | Thanks for listening, |
| adequate solution. You may also need to amend the | | | | R. Kymn Harp |
| loan terms. It is in the interest of both the borrower | | | | P.S. While I'm recommending books: Please allow me |
| and the lender that commercial real estate loans not | | | | the liberty of recommending my own book: Intent to |
| be in default - especially not as to payment. Especially | | | | Prosper, Vol. 1 - Commercial Real Estate available |
| now. | | | | through your favorite online bookstore. Enjoy! |