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Common Borrower Mistakes In Commercial Loan Workouts


The strategies for commercial real estate loan workouts tend to be dramatically different than the considerations for most homeowners who are considering walking away from their home. Conventional wisdom gleaned from residential walk-aways does not cleanly apply to commercial defaults.

While each case is different, homeowners tend to walk away from their home only as a last resort. They have depleted their assets trying to hang on to their house longer than they should. Bankruptcy laws often provide powerful protection against the lenders’ potential deficiency claims. The crushing volume of residential foreclosures tends to provide a certain “safety in numbers” protection for residential walk-aways. Defaults on commercial real estate loans tend to be different.

Consider a borrower who owns one parcel of commercial real estate that is “upside down” (the property is worth less than its mortgage debt) and the lender has no practical recourse against the borrower. (The lender may have no practical recourse either because the lender gave up the ability to sue the borrower in the loan documentation, or because the debtor has no assets and no income to pursue.) The borrower takes no pride in ownership of the property and doesn’t mind taking the hit to the borrower’s creditworthiness that will come from a foreclosure. The borrower has not owned the property long enough for his post depreciation adjusted basis to be less than the depressed value of the property. This type of commercial borrower is much like a homeowner who walks away from his home and does not have much to lose by defaulting on the loan.

Many commercial borrowers, however, have something to lose in their workout negotiations. Among the common mistakes borrowers make in their commercial workout negotiations are:

1. Assuming that the lender will draw first blood through a foreclosure.

Often the real estate is owned by a syndicate with multiple personal guarantors on the note. Often at least one of those guarantors has “deep pockets” (i.e. assets or income that the lender can pursue for its losses). Sometimes lenders who perceive that they have recourse against persons with deep pockets first sue the guarantors, without first bothering to foreclose.

A pre-foreclosure law suit is especially likely when the collateral for the loan is a challenging asset to hold or resell, such as a property with environmental or structural challenges. A lender is more likely to sue first when the value of the collateral depends upon the ability of the owner to operate a successful business on the property. For example, all other things being equal, a lender would be less likely to foreclose on an owner operated assisted living facility than a platted vacant parcel. Often, instead of foreclosing on a challenging asset, the lender has a court appoint a receiver to manage the asset, depriving the owner of the rents on the property during a foreclosure or law suit.

2. Assuming that the Lender Can’t Sue the Borrower After a Foreclosure

So far, it is rare for first mortgage lenders to sue homeowners on post foreclosure deficiency law suits. Not all commercial property owners are aware that after most foreclosures, the lender can sue the borrower and guarantor’s for the lender’s deficiency claims. Lenders seem more likely to sue commercial borrowers after a foreclosure.

3. Neglecting Tax Consequences.

Generally, owners who lose their commercial properties through a short sale, deed-in-lieu of foreclosure, or foreclosure do not receive money from the title transfer. Any of these three title transfers, however, is a sale for tax purposes. Because of cash out refinances, tax depreciation or other reasons, it is not uncommon for property to be worth less than the debt against it, while the property is worth more than the owner’s adjusted basis in the property. This is especially likely when the owner has owned the commercial property for many years. The closing on the workout or foreclosure may force the owner to recognize capital gains and may create a tax liability that is not easily dischargeable in bankruptcy.

In residential and commercial workouts, the lender may forgive all or some portion of the debt to the borrower. There are some protections against the recognition of forgiveness of indebtedness income for homeowners that do not apply to commercial borrowers.

4. Ignoring Conflicts of interest among partners.

When property is owned by syndication, there are often conflicts of perspective between the partners who are financially stronger and the partners who are financially weaker. Typically the stronger partners have more of an inclination to hang on to the project to avoid being sued. Typically the weaker partners are more willing to abandon the asset.

Often there is a conflict between the younger and the older partners. For example, the older partners may not anticipate ever needing to borrow more money again. The younger partners may have more of an interest in protecting their creditworthiness.

Each commercial workout is different. The strategy in commercial workouts tends to be more complex than in residential workouts. Owners should work with their tax advisors and attorneys before embarking on the process.

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