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What is a commercial loan modification?

It has been said that there is nothing new under the Sun and as far as Commercial Loan Modifications go that is true. For years, since the invention of Commercial Mortgages, there have been Commercial Loan Modifications. In the good old days “modifications” were called workouts and addressed the same issues that a modification does.

Commercial loan modifications can be crafted in a number of guises and could include; a reduction of the face rate of the mortgage, it could include changing the index, fixing the rate, or changing the margin used in the loan.

A commercial modification could also include a change in the term of the loan more specifically the amortization period of the loan. Lenders learned a valuable and expensive lesson in the 1970’s and early 1980’s about long term lending specifically sometimes it doesn’t work. In the 1960’s and 1970’s lenders were given to lending on a long term basis typically for 30 years. The problem that arose is if you have money out at say 5% for 30 years and the interest rate environment changes to 21% the Lender is upside down.

In that scenario the Lender is borrowing money at 105, 15% or even as high as 20% but collecting at 5% that creates a problem. Banks are in the business of borrowing money (via CD’s, Annuities, and Savings Accounts) and lending it a profit. That profit is the “margin” or the spread between what they pay on the CD’s and what they can charge the consumer of capital (Borrower).

In the 1970’s the banks got caught with long term low interest loans in a rapidly rising interest rate environment turning each of those long term loans into a losing proposition for the Lender. Enter the “Balloon Mortgage” it’s the best of both worlds, lower payments based on long term amortization with a Balloon payment due in 5, 7, or 10 years typically.

The problem today is that there is no capital market for commercial loans. Anyone with a Balloon coming due in the near future will have an extremely difficult time refinancing. The fact that there is little in the way of lending going on, and a nearly 40% decline in values since 2007 Lenders have drastically lowered their LTV’s and the problem becomes evident.

Another possibility is to lengthen the term of the loan, making the amortization period longer thereby lower the payment granting some relief to the borrower. In some cases loans that were cast using a 20 year amortization are being modified to a 25, 30 or in some cases 42 year amortization schedules.
This may reduce the payment just enough to make it manageable for the borrower and to return the loan to a performing status.

Frequently, lenders are given to charging fees for late payments, events of default, impounds, force placed insurance, and Lender ordered appraisals and more. Think of the wisdom in that practice, the Borrower, already cash strapped is struggling to make his or her payment they may even be severely in arrears. The Lender compounds the situation by adding additional “junk” fees that constitute additional profit to the Lender but increase the amount of the default and could raise the debt service substantially.
These are Borrowers who are having difficulty enough meeting the monthly obligation so the Lender makes a bad situation worse.

Here is a “dirty little secret” the Lenders don’t want anybody to know, they may be illegally (fraudulently) charging those fees when not legally entitled to them. There are instances, particularly here in Florida, where the Servicer isn’t even empowered to collect the payments let alone additional fees.

An additional step in modification process could involve some level of “Forbearance” where the principal and interest payments are halted for a period of time; this is usually tied to a specific event like reaching a certain number of tenants or a specific income goal. In this scenario the unpaid payments could be forgiven but will most likely be “tacked” onto the back of the loan.

During the period of typical forbearance the Borrower is usually plowing all the cash flow back into the property in the form of tenant improvements or lease concessions. The idea being once the property performance improves the Borrower will resume making some level of payments.

The Lender and Borrower could also agree to an interest only payment in which the Borrower pays a minimum payment based on a stipulated interest rate and the principal balance remains unchanged. The Borrower again gets the benefit of a lower payment which could make all the difference between hangings on or a messy foreclosure.

In closing the Borrower and the Lender could agree to just about anything from forbearance to a participation mortgage from a principal reduction to a recasting of the entire loan. The bottom line is that any change of the terms of the original note and mortgage is a “modification”.

Why now?

There is an enormous crisis brewing in America and the World in the Commercial Mortgage business, this crisis is twice the size of the United States’ annual Federal Budget, four times the size of the Residential crisis. According to a recent Business Week article total outstanding debt totals $6.4 TRILLION that’s $21,333.33 for every man, woman, and child in the United States of American.

By most estimates the Commercial Investment Market has lost 40% of its overall value since the peak in 2007. That loss is an average and is an “across the board” number. Since real estate is a local phenomenon that loss can be and is greater in some areas of the country and less in others. Some property types have been hit hardest while others have escaped unscathed.

The challenge for Borrowers and Lenders alike is establishing a value for a particular piece of property in the context of today’s market. There are many factors to be considered including income; occupancy, expenses, location, future prospects, employment, and the overall economy.

There are major differences between the values of an office building in the Washington DC area versus an office building located in Detroit Michigan. Apartment values in New York and Manhattan have not suffered as much as Miami Beach Florida.

Add to that the fact that between 2010 and 2012 there are estimated to be $1.4 Trillion dollars worth of Commercial Mortgages scheduled to Balloon, in a market that has seen the biggest retreat in capital in the history of the country. Put simply lenders aren’t willing to lend, and if they are it is at levels and prices that make no sense in the face of the capital requirements of most Borrowers.

As an example a Borrower bought a $10,000,000 office building, put $2,500,000 down and mortgaged the balance of $7,500,000. The building has since lost 40% of its original value so it’s worth about $6,000,000 the original Lender is owed $7,500,000. The Borrower tries to find a replacement Lender and the only offers they can get are at a 50% LTV based on today’s value or roughly $3,000,000 with personal guarantees and hefty fees and costs.

There is more news according to the Urban Land Institute’s Emerging Trends Report for 2010 the markets aren’t expected to recover until 2020. That means that prices, capital, and property will all converge nearly 10 years from today. That’s quite a while for a recovery no matter how you view it.

The Federal Government recognizes there is a crisis looming in the Commercial Mortgage Market in fact there is no paucity of Politico’s willing to weigh in on the subject. In fact it’s probably easier to name who has not weighed in on it Christopher Dodd, Sheila Bair, Ben Bernanke, our president most of the cabinet, congress, and senate have all opined on the state of the commercial mortgage and real estate markets.

The FED has stated that probably the only way to stabilize the market is to engage in some form of modifications and workouts. The FDIC even issued a white paper that set forth at least 12 different scenarios under which a bank could modify a loan and still has it pass the Examiners intent gaze.

The consensus across the board is “Extend and Pretend” keep the loans in place, in the field, and off the Lenders books. Remember to the Lenders, particularly Banks a foreclosure and possession is a liability and not an asset. Banks have to “reserve” cash for an anticipated loss as a result of taking back a property. If a bank takes enough properties back the bank itself becomes illiquid and is subject to seizure by the FDIC and liquidation.

Benefits to the borrower.

Obviously, the Buyer would love to stay in possession of the property and continue to own and operate the building. The Buyer/Borrower has spent good time, money, energy, and effort to manage and maintain the property the and last thing they want is to be dispossessed.

Because the loan modification process takes place outside the court system there are no Judgments or Law Suits filed. The modification process is a process of offer and compromise by and between the Borrower and the Lender usually with a facilitator (consultant) acting as a neutral third party whose task it is to bridge the gap between the two. The Consultants job is to care…but not that much about the outcome so as to remain neutral and objective.

The Borrower remains in possession and gets to enjoy the benefit of continued cash flow, albeit at a reduced rate. This is particularly important to a Borrower who derives the majority of their personal income from the operations of the property.

If a Borrower uses the property as his or her primary business address it could be quite costly to relocate especially if the property has been extensively adapted for the Borrowers use. Adding to those costs are the costs associated with moving, relocating machinery, utilities, upgrading basic systems (i.e. electric, water, sewer, gas) the removal or installation of docks, roll-up doors not to mention all the downtime associated with the act of moving itself.

There is also the prospect of business interruption and the defection of employees who get wind of the foreclosure or if they object to the move.

Traditionally, real estate markets tend to double in value every 7-10 years. If we are not presently at the bottom of a real estate cycle we sure are close that means that ultimately the markets will recover and start to trend upwards. The ULI report suggested stability in 2020 that means a recovery sometime will begin between now and 2020’s stabilized market.

If the Borrower can somehow manage to hold on through the current crisis he or she may eventually be made whole. In plain English they may be able to sell for more than they have in the property generating a profit. By staying in title the Borrower can still take advantage of the favorable tax treatment available through cost recovery (depreciation) capital gains treatment, and possibly a 1031 Tax Deferred exchange.
The other surprise avoided is the taxation associated with “debt forgiveness” what most people don’t understand is when a property is surrendered via a “deed in lieu of foreclosure” that is not the end of the story. Depending on the amount of “forgiveness” there could be drastic, adverse tax consequences. The Borrower ends up owing taxes on money they never received or benefited from.

Another issue that is probably the most problematic is the “Deficiency Judgment”. The deficiency judgment arises when the proceeds of the foreclosure sale are not sufficient to liquidate (payoff) all or a portion of the mortgage, fees, penalties, court costs, taxes and any special assessments. The Lender will then seek a deficiency judgment and attempt to enforce those rights by seizing and selling any and all assets of the Borrower they can find including personal property, bank accounts, retirement accounts, and other real estate owned by the Borrower.

Benefits to the Lender.

The Lender can benefit from a modification in a number of ways. First, since it is a non-judicial process the Lender does not incur the huge fees associated with a foreclosure. There is no need for discovery, depositions, court reporters, filing fees, and the all important billable hour. Since it is a relatively simple process the Lender can bring counsel in at the end of the process saving time and money.

Because a modification is an “offer and compromise” the process is not subject to the vagaries of the court system. There is no need to get on the docket since there is no hearing process. The wait to get your “day in court” could be measured in years depending on your jurisdiction whereas a typical proposal is presented within weeks.

Since the process is a non-judicial process there are no court costs, no waiting to file responses, no complaints, and no lost pleadings the Consultant produces the proposal, gets the Borrowers approval to present it and the Lender is provided a copy.

As mentioned above in the Buyer/Borrower benefits section the Lender could be made whole as well. If the Lender elects to foreclose and sell in today’s market they are guaranteed at least a 40% loss. The loss severity discussed earlier coupled with the fact that capital is not available means that the Lender is looking for a “cash” buyer, and cash commands a deep discount.

The income will probably have dropped due to increase vacancy (the problem that precipitated the foreclosure and the mass exodus after the tenants become aware of the suit) a possible rent strike by the tenants that stay, and the need for concessions to attract new tenants. The Lenders loss could substantially higher (60%, 70% or more).

If the Lender and Borrower can come to some kind of agreement and prevent that loss when the market does return to normal the Borrower and Lender could agree to sell and or refinance and both are made whole.

Lenders and Banks are in the business of lending money not managing commercial real estate. They are not equipped to manage real estate and despite the brave face they put on they have to hire local management, often it’s not who they want it’s who they can get and of course results vary greatly.

Lenders aren’t equipped to make or manage repairs, tenant improvements, or day to day maintenance of a property. These items can be the difference between success and foreclosure sale. In a recent case a Borrower who owns a building directly adjacent to a building that a lender has taken back. The Lender’s building is 100% vacant and has been that way for 3 years since the shell was completed. The Lender has instructed its broker to “poach” as many tenants as possible from the adjacent fully tenanted building as he can.

One reason that hasn’t worked is the Lender is unwilling or unable to do the tenant requested build out. The Lender is also unwilling to sign a lease for longer than one year pending a presumed sale.
By keeping the Borrower in place the Lender has one point of contact to deal with especially when it comes to collections. Imagine the difficulty of collecting rent from 300 apartment dwellers from across the country.

Keep in mind that as soon as the Tenants become aware of the foreclosure 50% or more will go on a rent strike further depressing the income stream and causing even greater collection problems.
Examiners like performing loans, whether a bank is Federally Chartered or State Chartered Examiners like to see piles of performing loans. The Examiners don’t care at what rate or level just so long as they are performing in some form or fashion.

In that White Paper I mentioned earlier the FDIC offered 12 or so different ways to make a non-performing loan a performing loan. The most creative was to split the loan into two pieces one that works and one that doesn’t the Lender only has to recognize the smaller non-performing portion for regulatory purposes despite the fact it is part of a much bigger loan, creative eh?

Because there is no loss the Lender doesn’t have to post a Loan Loss reserve thereby preserving the Lenders capital and possibly a few jobs in the bargain. If the Lender has cash they remain solvent and as long as they don’t reach a level that panics regulators the Lender stays open and everybody keeps their jobs.

By modifying a loan the Lender eliminates the uncertainty associated with a protracted marketing campaign. In today’s market how long could it take to identify a potential buyer or buyers? Then once you have some suspects you need to qualify them to make them prospect. Not everyone will have the cash necessary to buy, and most certainly will not have the credit and credibility.

The prospects will make the usual low-ball offers and it may take months to bridge the gap between the Lenders aspirations and the Buyers expectations. Many transactions will unravel in due diligence and the Lender can expect be re-traded at least once or twice. The broker should expect a fee haircut. That whole process is eliminated by keeping the Borrower in place.

By remaining out of the chain of Title the Lender avoids all the “what if’s” associated with ownership. What if we get hit by a Hurricane, earth quake, Tornado, Tsunami? What if the area is down zoned, the major employer closes shop and leaves town (GM). What if the market worsens, changes, or just goes away. What if there is a fire, flood, civil unrest, all of these can and have happened just think about California, Hawaii or most recently Chile, China, Haiti.

Lenders and Banks are very cautious and protective of their image in the community. They don’t want to be seen as an evil empire wiping out the small guy. Locally, there is a Lender that made it a point to lend to houses of worship…imagine foreclosing on one of those. Imagine the Ill will that would create in the community especially among the members of the congregation.

Bottom line, Lenders don’t want the property they want the money the further into this crisis we get the more reality apparent that will become.