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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   December 2009

How to Save a Sinking Loan

With delinquencies up, brokers can help lenders determine how and when to salvage projects

Construction-loan delinquencies areincreasing at an unprecedented pace. According to a Deutsche Bank AG analyst this past July, more than $140 billion in losses could hit regional and local banks as a result of delinquent construction loans in the next few years.

As such, many construction lenders and brokers likely will face a prolonged period of acute decisionmaking -- especially if they are constructing commercial properties -- before the commercial real estate market sees any improvement.

For mortgage brokers, this dilemma has broad implications as they look to arrange construction and/or takeout financing for clients in the near future. In fact, brokers can play a key role in assisting lenders, as well as their clients, in resolving complex issues surrounding construction loans that are underwater or headed there.

Defining 'underwater'

An underwater loan generally has a market value that is less than its book value. It often is nonperforming because of late or uncertain payments. It could also be underwater because the collateral's market value has decreased to less than the outstanding loan balance.

In some cases, a loan may be underwater because the collateral source is no longer the principal source of a loan's payment.

For construction lenders and borrowers, as well as mortgage brokers, the main problem is that delinquency rates on loans backed by existing properties also are increasing rapidly. This past March, Deutsche Bank AG research showed that the delinquency rate on about $700 billion of commercial mortgage-backed securities had more than doubled to 1.8 percent in the prior six months. Although this delinquency rate is less than that for residential mortgages, it is near levels seen in the previous recession in 2002 to '03. 

In addition, according to Foresight Analytics, more than a quarter of the $524.5 billion of mortgages on banks' books due to mature in the next four years are backed by real estate that is worth less than the mortgage.

The overall impact of this increasing delinquency trend among permanent loans is to depress values throughout the market, thereby destroying the fundamental economic basis on which those commercial construction projects were predicated. Developments that "penciled" when the first shovel went into the ground and construction draws began now often don't make economic sense.

Brokers, lenders and borrowers wonder what they can do to minimize project losses. There is no easy answer. The decision to continue or to curtail construction is a complex, delicate balance. It requires achieving the maximum revenue from a project while minimizing the costs -- all without negatively affecting future attempts to restart or complete the project, when and if that opportunity arises. 

Mortgage brokers can play a critical role by helping lenders and borrowers reach that critical decision. After all, any loan restructuring or modification is a delicate negotiation that requires give-and-take on both sides.

The broker's traditional role as intermediary between these parties provides an opportunity to facilitate a successful resolution that will endear the broker to the lender and the borrower, strengthening relationships for the future.

Assessing the situation

One way brokers can help in these situations is by helping their clients who have at-risk construction loans know what steps their lenders might take to assess the situation. Some steps that construction lenders and their intermediaries can take to determine the right strategic decisions for underwater construction loans include the following.

  • Performing a construction cost-validation assessment. Construction projects are notorious for their propensity to run over budget, even in good times. Only by determining and validating actual project costs incurred to date can a lender accurately calculate the cost to complete the project. Once an independent assessment of the numbers is delivered, the lender can weigh the additional cost of completing the project against the cost of shutting it down until market values revive and make construction viable again.
  • Conducting a detailed income analysis. Lenders also can benefit from analysis of projected revenues associated with the project's various components to determine the property's highest and best use. This analysis could point to an alternative development scenario that would motivate the lender to complete construction. 
    For example, a stalled condo project in a market with declining home prices and a large amount of unsold inventory may make sense to complete as a rental apartment property. This analysis also might include an assessment of what the overall time and budget costs might be for the project scope to be adapted.
  • Seeking project suspension and/or termination support. Construction projects are complex, and deciding to shut down a project prematurely often carries wide-ranging implications for the lender. Lenders should closely evaluate costs and other implications associated with suspending or terminating the project or identifying alternative development scenarios before executing this decision.
  • Stepping up -- or initiating -- construction-management oversight. If construction continues, lenders should maintain ongoing monitoring of the construction process to ensure that the project is delivered on time, on budget and in compliance with all construction-quality standards.

There is no clear-cut guide as to when these steps should occur. Some might not occur until a loan is officially underwater.

Given the current market uncertainty, however, lenders may want to consider checking all or some of their construction loans periodically to keep their fingers on the pulse of where major loans and portfolios are headed. Mortgage brokers, with their detailed local-market knowledge, can be valuable resources to lenders in this regard, as well as valuable information sources for their clients.


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