The Workout Alternative
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.
Workout is Better than a Walk Away
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.
Income Producing Property
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.
About the Author: 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.