Purchase of Distressed Mortgage Loans: Why the Lender May Sell and What the Buyer Should Consider Before Buying
June 8, 2009
At this time a wide variety of loans secured with mortgages of commercial real estate are in distress because (i) current economic conditions have reduced the ability of tenants to pay the owner the amount necessary to service those loans, or (ii) refinancing of maturing loans has become extremely difficult or impossible. This difficulty has been caused by the decline in real estate values and by the dearth of lenders in the market, largely as a result of the evaporation of the market for commercial mortgage backed securities.
What’s a Lender to Do?
In this environment, the holder of such a mortgage loan is faced with some difficult choices. It could elect to pursue foreclosure, but this can be a long and expensive process.
If the lender does successfully foreclose, it will become the property owner, which for many lenders is not a desirable result. Most lenders do not have the experience necessary to effectively manage commercial real estate. In addition, many lenders do not want to incur the liabilities of ownership, including real estate taxes and duties to tenants.
A lender not wanting to go through the process of foreclosure and not wanting to become property owner may choose to market the loan for sale prior to commencing or completing a foreclosure. Because the lender is selling the loan, rather than the property that secures the loan, the lender likely will only attract a buyer of the loan at a discount. While this may not seem desirable, if the lender has written-off all or a portion of the loan, the sale proceeds may reflect favorably on the lender’s financial statements.
Assuming the lender does decide to sell the distressed loan, there are a number of issues which the purchase of such a loan must consider.
Due Diligence.
The purchaser of a loan secured by commercial real estate should conduct due diligence both on the loan itself and the property that secures it. The due diligence for the property is the same due diligence as would be done with purchasing any real estate. Due diligence on the loan will include a review of the loan documents, verification of amounts owed, and obtaining any information about the borrower, including whether the borrower has any claims against the original lender.
This due diligence may be difficult because the buyer may not have the borrower’s cooperation. For example, the buyer may be unable to obtain estoppel certificates either from the tenants or from the borrower. Because the loan buyer will not have the comfort of estoppel certificates, the buyer may not know whether the borrower has any claims against the original lender or exactly what is owed on the loan. The loan buyer also will not know if the tenants have any claims against the borrower. The lender also may not have complete records of the leases. As a result, the lender may not be aware of the material terms of these leases, such as rent, expiration dates or options to extend or terminate. The lender also may not be aware of any amendments to these leases.
A Bankrupt Borrower Creates Problems.
Another potential obstacle which the loan buyer may face is a bankruptcy petition filed by the borrower prior to the foreclosure sale. Although such a petition is not likely to be successful, in the event the borrower owns only the mortgage property and has few creditors, bankruptcy still causes delays and results in additional expenses for the loan buyer. If the borrower has mortgaged more than one parcel of property to different lenders or has many creditors, the borrower may be able to get a bankruptcy court to modify or “cram down” loan repayment terms in a way that is unfavorable to the loan buyer.
Beware of Third Party Buyers.
The last risk for the loan buyer is that a third party may outbid the loan buyer for the property at the foreclosure sale. Loan buyers ordinarily have an advantage in a foreclosure sale because they can bid an amount not exceeding the amount of the loan. Unlike an ordinary buyer at such a sale, the loan buyer need only pay delinquent and current real estate taxes, conveyance fees, and other fees owed in connection with the foreclosure procedure. The law does not require the lender to advance cash to pay what the lender will receive as the purchase price at the foreclosure sale.
What Does the Future Hold?
Because lenders generally are greatly adverse to becoming owners of property secured by mortgages, we anticipate an increasing market for the sale of mortgage loans. Even though most lenders likely will sell such loans at a discount, the reasons for sale may be compelling, particularly if the lender has already written off the loan on its books as non-collectible and it obtains a recovery on the loan.
Because financial institutions do not have as much money to lend for commercial real estate as they once did and because the commercial real estate securitization market has evaporated, potential purchasers and the source of funding for loans to finance the acquisition of mortgage debt are somewhat uncertain. The most likely purchasers of these loans are investors with cash who are seeking to invest equity in commercial real estate to take advantage of the recent decline in the value of commercial real estate. Current holders of commercial real estate loans that are willing or able to accept discounted purchase prices for loans that they hold may be willing to finance a portion of the purchase price for these loans. We have recently seen examples of both types of transactions in the market.
Purchasing the distressed loan may also be a useful tool for a non-recourse borrower who has affiliated principals or entities with cash and borrowing ability sufficient to purchase the loan at a discounted price. The affiliated entity can purchase the loan at a discount and then modify the payment terms in a way the borrower can afford. This gives the borrower a way to save the property and preserves the potential upside if and when property values increase to the levels in place when the loan was made. In many cases, however, this may be treated as if the borrower acquired the loan and could therefore trigger forgiveness of debt income. (See discussion of tax consequences associated with forgiveness of debt).
Attorneys in Taft’s Real Estate Practice Group have a great deal of experience working on the types of transactions outlined in this article. Taft attorneys also call on the practitioners practicing in the bankruptcy, taxation, and litigation areas on a team approach to assist in these transactions. We would be happy to talk to you should you need assistance in connection with such a transaction.
What’s a Lender to Do?
In this environment, the holder of such a mortgage loan is faced with some difficult choices. It could elect to pursue foreclosure, but this can be a long and expensive process.
If the lender does successfully foreclose, it will become the property owner, which for many lenders is not a desirable result. Most lenders do not have the experience necessary to effectively manage commercial real estate. In addition, many lenders do not want to incur the liabilities of ownership, including real estate taxes and duties to tenants.
A lender not wanting to go through the process of foreclosure and not wanting to become property owner may choose to market the loan for sale prior to commencing or completing a foreclosure. Because the lender is selling the loan, rather than the property that secures the loan, the lender likely will only attract a buyer of the loan at a discount. While this may not seem desirable, if the lender has written-off all or a portion of the loan, the sale proceeds may reflect favorably on the lender’s financial statements.
Assuming the lender does decide to sell the distressed loan, there are a number of issues which the purchase of such a loan must consider.
Due Diligence.
The purchaser of a loan secured by commercial real estate should conduct due diligence both on the loan itself and the property that secures it. The due diligence for the property is the same due diligence as would be done with purchasing any real estate. Due diligence on the loan will include a review of the loan documents, verification of amounts owed, and obtaining any information about the borrower, including whether the borrower has any claims against the original lender.
This due diligence may be difficult because the buyer may not have the borrower’s cooperation. For example, the buyer may be unable to obtain estoppel certificates either from the tenants or from the borrower. Because the loan buyer will not have the comfort of estoppel certificates, the buyer may not know whether the borrower has any claims against the original lender or exactly what is owed on the loan. The loan buyer also will not know if the tenants have any claims against the borrower. The lender also may not have complete records of the leases. As a result, the lender may not be aware of the material terms of these leases, such as rent, expiration dates or options to extend or terminate. The lender also may not be aware of any amendments to these leases.
A Bankrupt Borrower Creates Problems.
Another potential obstacle which the loan buyer may face is a bankruptcy petition filed by the borrower prior to the foreclosure sale. Although such a petition is not likely to be successful, in the event the borrower owns only the mortgage property and has few creditors, bankruptcy still causes delays and results in additional expenses for the loan buyer. If the borrower has mortgaged more than one parcel of property to different lenders or has many creditors, the borrower may be able to get a bankruptcy court to modify or “cram down” loan repayment terms in a way that is unfavorable to the loan buyer.
Beware of Third Party Buyers.
The last risk for the loan buyer is that a third party may outbid the loan buyer for the property at the foreclosure sale. Loan buyers ordinarily have an advantage in a foreclosure sale because they can bid an amount not exceeding the amount of the loan. Unlike an ordinary buyer at such a sale, the loan buyer need only pay delinquent and current real estate taxes, conveyance fees, and other fees owed in connection with the foreclosure procedure. The law does not require the lender to advance cash to pay what the lender will receive as the purchase price at the foreclosure sale.
What Does the Future Hold?
Because lenders generally are greatly adverse to becoming owners of property secured by mortgages, we anticipate an increasing market for the sale of mortgage loans. Even though most lenders likely will sell such loans at a discount, the reasons for sale may be compelling, particularly if the lender has already written off the loan on its books as non-collectible and it obtains a recovery on the loan.
Because financial institutions do not have as much money to lend for commercial real estate as they once did and because the commercial real estate securitization market has evaporated, potential purchasers and the source of funding for loans to finance the acquisition of mortgage debt are somewhat uncertain. The most likely purchasers of these loans are investors with cash who are seeking to invest equity in commercial real estate to take advantage of the recent decline in the value of commercial real estate. Current holders of commercial real estate loans that are willing or able to accept discounted purchase prices for loans that they hold may be willing to finance a portion of the purchase price for these loans. We have recently seen examples of both types of transactions in the market.
Purchasing the distressed loan may also be a useful tool for a non-recourse borrower who has affiliated principals or entities with cash and borrowing ability sufficient to purchase the loan at a discounted price. The affiliated entity can purchase the loan at a discount and then modify the payment terms in a way the borrower can afford. This gives the borrower a way to save the property and preserves the potential upside if and when property values increase to the levels in place when the loan was made. In many cases, however, this may be treated as if the borrower acquired the loan and could therefore trigger forgiveness of debt income. (See discussion of tax consequences associated with forgiveness of debt).
Attorneys in Taft’s Real Estate Practice Group have a great deal of experience working on the types of transactions outlined in this article. Taft attorneys also call on the practitioners practicing in the bankruptcy, taxation, and litigation areas on a team approach to assist in these transactions. We would be happy to talk to you should you need assistance in connection with such a transaction.
