The Workout Alternative
By: David
Allen
During the real estate "boom" years, the only time that the word
"workout" ever entered the mind of real estate developers and
investors, was when they were deciding which posh health club to
join, at which they could spend some of the wealth they were
accumulating through the rampant escalation of prices of real
estate. Now that the real estate market is well into a period of
diminishing values, those same developers and investors find
themselves talking to their lenders, with increasing frequency,
about the possibility of a "workout," or restructuring of their
loans, to help them avoid bankruptcy, or avoid foreclosure
proceedings.
As is the case in any situation where two or more parties
attempt to negotiate an agreement, all parties to the negotiation
need to acknowledge at the outset that the outcome of the
negotiation will probably yield a better result than that which
would occur absent a negotiated settlement. For a borrower who is
either in default, or is about to go into default, under the terms
of a real estate loan, it is almost always advantageous to enter
into a "workout" agreement with their lenders, than to simply "walk
away," and allow the lender to avail itself of all of its legal
remedies. These could include non-judicial or judicial foreclosure
proceedings, or legal action to collect a deficiency judgment,
and/or to enforce a loan guarantee agreement. For a lender, the
advantage of a negotiated workout is to turn a non-performing, or
potentially non-performing, loan into a performing asset, and to
avoid ending up owning real estate that it does not wish to own,
and which may not be easily liquidated for more than a fraction of
the amount of the indebtedness.
After the borrower and the lender have agreed to engage in
workout negotiations, there are varieties of solutions that can be
considered, either independently, or in combination with each
other. Which solutions to consider will depend upon a number of
factors, including the type of property involved (under
construction or already built; income producing or non-income
producing); the type of loan in default (construction; short term;
or long term); the liquidation value of the property compared to
the unpaid balance of the loan; the amount of income, if any, being
generated by the property; the long term prospects for the property
to recover; and the financial strength of the borrower. The
solutions that may be considered include, among others, the
infusion of additional equity by the borrower, personal third-party
guarantees, an extension of the loan term, the conversion of an
amortizing loan to an interest-only loan, the writing-off of a
portion of the principal, the lowering of the interest rate, the
forgiveness or abatement of payments, or the making of additional
advances under the loan.
In the case of an income producing property, a lender who is
willing to agree to one or more of the above possibilities will
probably want assurance that whatever income is being generated by
the property is being used to service the restructured debt. The
mechanism used to provide such assurance is through a cash
management, or "lock box" agreement, whereby the borrower and
lender agree that all of the rent being paid by the tenants of the
property is paid directly to a bank account controlled by the
lender. Pursuant to such agreement, upon collection of the rents,
the lender then disburses funds to other accounts controlled by the
property owner in amounts needed for the operation of the property,
while retaining the balance of the cash to apply toward servicing
the restructured loan.
Although most owners would prefer to avoid such an arrangement
for obvious reasons, entering into a cash management agreement
assures the lender that the borrower will not divert income from
servicing the indebtedness, at a time when the lender has made
concessions to allow the borrower to continue its ownership and
management of the property. Although most entities which are
involved in real estate, whether as owner or lender, recognize the
cyclical nature of the real estate business, and thus anticipate
that the existing downturn in the real estate market will
eventually reverse its course, there is, of course, no way to know
when such reversal will take place. Until it does, there will
continue to be compelling reasons for both lenders and borrowers to
concentrate their efforts on achieving negotiated workouts that,
while often not "ideal," will yield a better result than the
alternatives.
David
Allen is a partner at the Phoenix law firm of Jaburg &
Wilk. He works with clients on real estate issues including
acquisition, workouts, leases, landlord/tenant issues and
litigation. David can be reached at 602.248.1082 or dla@jaburgwilk.com.
Provided by Jaburg & Wilk.