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Commercial/Multifamily Update: Workouts Can Deliver (Winter '03)

by Kathleen Hayes
Lerner, Sampson & Rothfuss — USFN Member (KY, OH)

Delinquencies on the Rise

Although it may appear that the economy is finding its feet for the first time since September 11, 2001, the economy’s standing remains shaky, leading to increasing mortgage delinquencies. In its CMBS Quarterly Insights, Standard & Poor’s forecasted that the average delinquency rate would reach 2 percent to 2.5 percent by the end of 2002. The highest delinquency rates were expected to occur in the lodging and healthcare sectors.

Workouts are a Necessary Option

Defaulting borrowers often are unable to avoid descending even further into delinquency — they neither have the cash to reinstate nor the credit to refinance. Even non-defaulting borrowers often are unable to secure refinancing due to factors such as lack of capital in the marketplace and poor consumer purchasing. Lenders attempting merely to foreclose will find that foreclosure battles with sophisticated commercial mortgagors are costly and unsatisfying. Yet, workouts can resolve such disputes. In many jurisdictions, mortgagors have the right to redeem their commercial property until the confirmation order is entered. As a result, workouts may be a possibility even after a foreclosure sale.

Workouts prevent or conclude litigation. The lender receives a steady stream of income. The mortgagor retains its commercial property and continues to operate. This period of time — without the pressure of litigation — may allow the mortgagor to adjust operations to make the payments needed to reinstate the debt and pay down the loan. The mortgagor also has a greater opportunity to secure refinancing. In any event, the lender will be owed less in the unfortunate event of a future default.

Forbearance Agreements

In the delinquent consumer loan context, a forbearance agreement is a workout option that suspends the foreclosure proceeding, often to the relief of the lender and the mortgagor. Generally, the lender requires a down payment to demonstrate the good faith of the mortgagor before entering into a forbearance agreement. A percentage of the delinquency is repaid each month together with the regular monthly payment. This percentage can vary. For example, a "fresh start" forbearance agreement requires payment only of the monthly amount, allowing the mortgagor an opportunity to build a better credit relationship with the lender and an opportunity to refinance or sell the property. Another type of forbearance agreement may require payment only of the monthly amount for a specified period and a balloon payment at the end of the forbearance period that fully reinstates or pays off the loan.

Forbearance agreements similarly may be applied in the delinquent commercial mortgage context with little expense and tremendous benefit to the lender. The expense of the preparation of the agreement is minimal as compared to foreclosure. The agreements are not required to be recorded in the public real estate records. As a result, neither title exams, often difficult and expensive due to the frequent complexity of commercial real estate titles, nor title insurance are necessary.

The benefit of a forbearance agreement to the lender is extremely high. Provisions can be included in the agreement where the mortgagor waives any and all claims and defenses it may have against the lender arising out of the subject loan transaction, the default and up to the date of the agreement. This waiver continues beyond the default or termination of the agreement and can be drafted to apply to any claim held by the mortgagor that might make the lender cautious of either commencing or proceeding with foreclosure. If the foreclosure proceeding has been initiated, and the parties have been properly served, the agreement can require the mortgagors to execute an agreed order of judgment and a decree of foreclosure where the lender waives execution on the judgment pending compliance with the terms of the agreement. In the event the mortgagor breaches the agreement, the lender may proceed to execute on the judgment having avoided much of the expense of litigation.

Deed-in-lieu of Foreclosure

A deed-in-lieu of foreclosure is an alternative to a foreclosure proceeding in which the mortgagor delivers title of the mortgaged premises to the lender in consideration for the cancellation of the mortgage debt. Many of the disadvantages associated with traditional foreclosure proceedings are not presented by a deed-in-lieu of foreclosure. In contrast to the high cost and adverse publicity often associated with foreclosure, a deed-in-lieu generally is inexpensive and nonpublic. Fewer documents become public record. There also is an opportunity for the lender to voluntarily secure not only title to the real estate but also to personalty and fixtures and to obtain, among other things, an assignment of rents, an agreement on the payment of real estate taxes, and a warranty as to the condition of title. The lender can acquire the property more quickly than it could by foreclosure and can take immediate remedial action, such as construction and renovation, and leasing or selling the space. However, a deed-in-lieu of foreclosure is not recommended in the event there are other liens on the real estate.

Short Payoff

A short payoff, sometimes referred to as a short sale, is a workout procedure in which the lender accepts less than the full balance due on the loan as part of an agreement in which the mortgagor cooperates with the lender to obtain a quick sale and avoid foreclosure. The mortgagor sells a property with a fair market value below the amount of the mortgage to a third party for less than the loan balance with the consent of the lender. The proceeds exceeding the sale costs are paid to the lender in return for release of liability of the mortgagor. Under this alternative, the mortgagor and lender benefit as a result of avoiding foreclosure and its associated costs.

Conclusion

Economic conditions suggest that creative workouts will be pivotal in minimizing the delinquency rate in these uncertain times. The exercise of one of the discussed options does not preclude the use of another. Foreclosure is always an option — but need not be the first or only one. Experience suggests that foreclosure may be the least desirable alternative and should be exercised as the final option.

Editor’s Note: The Commercial/Multifamily section of USFN is open to USFN member firms providing commercial and multifamily services. The author’s firm is a member of the section.

© Copyright 2003 USFN

(Originally printed in The USFN Report)