Understanding Your Borrower, The Market, and Collateral before a CRE Work-out

By Joseph Patterson, ECL Software

“Houston, we’ve had a problem here” may have as much meaning to the nation’s commercial real estate loans as it did for Apollo 13. With any problem, understanding it is the first step to solving it. So with commercial real estate, knowing your borrower, market and collateral, becomes mission critical in any type of workout. Whereas, at Mission Control, the goal was saving the crew, the ultimate goal here is to maximize the recovery of the debt.

The purpose of this article is to provide some of the questions that need to be answered about the default circumstances, before and/or during a workout strategy. In the end, the decision comes down to what the outstanding balance is verses foreclosure/collection values, compared with the current default verses the default of a failed workout.

Know Your Borrower

What Happened?
It is important to understand what factors and circumstances contributed to the borrower’s financial difficulties. Misuse of funds, gross mismanagement, fraudulent or illegal activities, will certainly demand immediate acceleration, as well as preservation or protection of what assets remain.

However, most likely other circumstances – such as:

1. Bankruptcy of key tenants or customers,

2. Downsizing or relocation of tenants and customers,

3. Rising costs reducing profits in fixed priced contracts,

4. Accounts receivable are increasingly slow pay, and

5. General adverse effects of market trends

What’s their financial condition?
It is material that a clear and accurate picture of the borrower’s financial condition and business operations are understood and documented. At a minimum obtain:

1. Current detailed information regarding the operation and financial condition of the borrower(s) and co-borrower(s);

2. The nature and amount of all outstanding secured and unsecured debt;

3. Any outstanding or unpaid taxes or assessments;

4. Any contingent obligations or commitments;

5. An updated title report, with an evaluation of any junior liens;

6. A current appraisal;

7. The status and location of other personal property, such as accounts receivable, securities and equipment; and

8. Any additionally secured debt, which could be mezzanine or other subordinate debt.

What, Exactly, is in the Contract?
Carefully review the file and the loan documents to determine the relative rights of all parties involved. Look for any documentation deficiencies (you may want to have outside council to help with this).

The review should determine:

1. If a non-recourse real estate loan, any “carve outs” to the non-recourse provisions;

2. The loan documents are fully and properly executed by all authorized individuals;

3. The borrowing resolutions and authority documents are complete and fully executed;

4. Exhibits, schedules and appendices referenced in the loan documents are attached and complete;

5. The mortgage, deed of trust or other security documents are appropriately recorded and filed, and

6. Any required post-closing items have been received, including any title insurance policy and endorsements.

During this review, exercise extreme care in all communications. Quick, unintended or informal “understandings,” or commitments, may be misconstrued or leveraged by the borrower. This can lead to unwanted repercussions to any successful workout.

Know the Market

Having an independent market and economic analyses as to the recovery potential for the borrower and the related industry is very important. This becomes valuable information that will allow for better negotiations and validation of the borrower’s claims. It should also answer the following questions.

What are the Surrounding Property Values?
Not only know the appraised value of the property in question, but also the values of similar properties in similar geographic locations. Get actual pictures, prices and statistics. Obtaining any history on these properties will help to spot trends and test theories.

What are current and past Lease Rates?
Knowing the current and the past 12- to 24-month trends on lease rates will substantiate any assumptions on workout plans. However, include a variety of occupancies, as well as specific occupancies appropriate to the property in question.

How many Vacancies are there?
Most reports provide this number as a percentage. Although this is very helpful, having the actual numbers that calculated these percentages can have more meaning.  In a 10-suite building, one vacancy would be only 10% vacancy; but if that one suite was 4,000 square feet of a 10,000 square foot building, that would be a 40% vacancy. Again, understanding the numbers behind the percentages provides for a realistic perspective of what truly is happening.

The Collateral

What’s the Current Value?
As mentioned earlier, it is critical to have a current appraisal of all collateral in question.  This is essential to support any decisions made for the workout.

What are the Current Leases and Use Agreements?
Obtain copies of all lease agreements, usage agreements, and in the case of construction loans, prime and sub contracts. Review these agreements for their statuses, specific terms, obligations, and potential liabilities and effect on cash flows.

What’s the Current Condition of the Property?
Inspect the property for the condition of improvements, as well as how the maintenance has been handled. Look specifically for any deferred maintenance, any issues concerning environmental contamination or liability. 

Summary

Having all the facts related to the borrower(s), market and various circumstances surrounding the property and its value creates a better position to draw a successful work-out plan.

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