When a borrower defaults on a loan secured by commercial property, lenders are aware of most, if not all, of the options that are available to them. The real dilemma lies in choosing the most appropriate course of action or combination of actions, to best protect the lender and to achieve its goals. The best course of action will depend on a multitude of factors.
It would be easier to pass a camel through the eye of a needle than it would be to explore a fraction of the possible combinations of factors which impact the optimal manner in which to approach a specific default scenario. Therefore, in the interest of time and maintaining sanity, the following is a summary of a typical scenario and some potential options:
- The borrower is a single purpose entity (SPE). This fact is important in the analysis as the borrower will not have additional sources of income or collateral to offer lender.
- The property is retail, occupied by a single tenant that has been performing pursuant to a lease that has ten years remaining. Since there is only one tenant, the placement of a receiver is not as complicated. A performing tenant will allow lender to mitigate losses by receiving rents.
- The loan matured 9 months ago and borrower has not been able to refinance and has not attempted to sell. Since maturity, borrower has not made any payments to lender. The value of the property is greater than the balance owing, but as a result of accruing interest and other default fees and costs, it is likely that within 6 to 9 months the loan will become under secured.
- Lender wants the loan paid-off, would prefer not to own the property, and does not want to take a loss.
Typically a forbearance agreement is a short-term agreement between the borrower and lender whereby lender agrees to delay the enforcement of rights under the terms of the loan in exchange for borrower agreeing to cure a default within a specified period of time. Other than the temporary delay in proceeding with collection, the forbearance will not modify the terms of the loan. In this scenario, the loan has matured, so the only cure of the default is satisfaction of the loan by (i) sale of the property; (ii) refinance of the loan; (iii) modification/extension of the loan; or (iv) in rare occasions a cash pay-off by the borrower.
Lender wants to get paid-off, but has a limited window of time under the scenario to fully recoup its investment. A skillfully drafted forbearance agreement will help lender achieve this goal, or at a minimum help move things along and provide it additional protection. Ideally the forbearance agreement should include the following:
- If the borrower is seeking time to refinance, the forbearance should include a deadline for borrower to provide a commitment letter, to open escrow for the loan, and for the escrow to close. In addition, lender should require borrower to simultaneously list the property for sale, as discussed below.
- If borrower is seeking time to sell, the forbearance should require: (i) that the property be listed by a specified date, with a lender approved broker;
(ii) that the initial listing price be set with a mechanism to reduce the price based on benchmarks in order to ensure that the borrower and broker do not collude to delay lender; and (iii) a “drop dead” date for the sale to occur. It is also advisable to set a “drop dead” date for opening escrow, which will avoid the borrower‘s delay tactic of opening a long escrow at the eleventh hour to deter lender from foreclosing.
- Regardless of the purpose of the forbearance, lender must begin receiving rents. Although over 99.999% of commercial loans include an assignment of rents, it sometimes can be difficult to actually start receiving the rents; as well as inadvisable, since the rents are often used to pay the property manager, maintain the property, pay taxes, and to pay numerous other ownership expenses. Therefore, if lender is agreeable to maintaining the current management structure of the property, a “Lock Box” agreement can serve as an effective means to ensure that the expenses of the property are still being paid, borrower is no longer taking money from the property without servicing the loan, and lender can receive some type of debt service in order to keep the balance owing under control while the borrower tries to sell or refinance. The “Lock Box” provisions require the rents to be deposited into a bank account controlled by lender, and to be disbursed, in lender’s sole and absolute discretion, to pay expenses associated with the property.
- The negotiation of a forbearance agreement is an excellent time to obtain from borrower a comprehensive release of lender from liability.
A loan modification is similar to a forbearance agreement; however, there are a few crucial differences. First, a modification changes the terms of the loan rather than temporarily delaying enforcement by lender. Second, a modification will result in the cure of the default, requiring lender to initiate a new foreclosure action in the event of borrower’s default after modification. In the instant scenario, modification of the loan does not meet the lender’s goal of the outstanding balance being paid. Nevertheless, if an adequate forbearance agreement is not possible, a modification may be preferable to immediate foreclosure since lender does not want to own the property. The advisability of a modification would require the incorporation of the following:
- “Lock Box” provisions similar to those which would be incorporated into a forbearance.
- Provisions requiring the borrower to sell the property, with definite “drop dead” dates.
- Payment of an extension fee by borrower.
- Comprehensive release of lender from liability.
Deed In Lieu of Foreclosure
A deed in lieu of foreclosure can be an ideal solution for lender, assuming the circumstances are appropriate. By giving a deed in lieu of foreclosure, borrower is transferring the property to lender in exchange for lender not foreclosing against the property. Additionally, lender may pay a lump sum payment and release borrower and any guarantors. Since lender does not want to own the property, this may not be a feasible option; but when weighed against the prospect of foreclosing and ultimately still owning the property, a deed in lieu becomes much more appealing and economical. In accepting a deed in lieu, lender should take the following precautionary measures:
- Obtain a title report to ensure that lender will not be taking the property subject to any liens, voluntary or involuntary; defaulted taxes; litigation or any other encumbrance which will cloud lender’s title to the property.
- Enter into a transfer agreement with borrower in order to ensure that there is no question concerning the nature of the deed in lieu. The transfer agreement should include borrower’s comprehensive release of lender from any liability.
- Use an escrow and obtain an owner’s policy.
- If for some reason lender takes the property subject to an existing first trust deed, there should be a Consent, Assignment and Assumption Agreement executed by the first lender, lender and borrower.
Foreclosure can be accomplished by judicial (filing a lawsuit for foreclosure) or non-judicial (trustee sale) means. For the most immediate remedy, filing a judicial foreclosure in conjunction with an application for placement of a receiver on the property would be pragmatic. A receiver would manage the property under court authority, thereby ensuring that borrower will not abscond with the collected rent, that the property will be adequately maintained and managed, and that lender would receive debt service to slow the increasing outstanding balance. In addition to commencing a foreclosure lawsuit and seeking a receiver, lender should simultaneously start the non-judicial foreclosure process. In most instances, lender will opt to dismiss the judicial action and move forward with the trustee sale once it is required to make its election.
Lenders Have Options.
There are several tools at the disposal of lenders to address a borrower’s default. Each one can be effective at helping the lender achieve its goals, either individually or in various combinations, as long as one keeps an open mind.