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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   August 2010

Buying Debt to Save a Project

Brokers should know developers’ legal responsibilities when purchasing debt

Many developers are finding that their debt exceeds their property’s current value or their lender’s permitted loan-to-value ratio. Because of this, some banks and lenders want to get the underperforming loans off their books.

One way lenders are doing so is by selling these loans to third-party investors -- or even to the property-owner -- at a discount to the loan’s principal balance

If their lender wants to sell the debt, what choices do borrowers have, apart from defending the foreclosure, filing bankruptcy or giving the lender a deed in lieu of foreclosure? Generally, they must find another investor or lender to finance the acquisition. Most often, borrowers also must invest additional money as part of the buyback.

Commercial mortgage brokers who understand their clients’ legal responsibilities can help them negotiate buyback transactions with their original lenders and any new debt-buyers. There are some key issues of which you and your clients should be aware in these situations.

First, if property-developers wish to buy back their own debt, a transparent transaction is key. For instance, if there is a deal in the works that will add value to the property -- such as a signed tenant lease or a contract to sell the property at a profit -- borrowers must disclose it to the lender. Otherwise, they may be committing bank fraud.

Example Scenarios

Developer borrowers may be interested in purchasing their own debt for numerous reasons. Here are two such scenarios:

  1. Change of plans: A developer originally planned to build condominiums but changed its plans to develop an assisted-living facility. The developer had some presales with deposits, but the condo market disappeared. The bank ceased funding after determining it would lose more money if it continued to fund the project. The bank negotiated with the developer to sell the debt for 45 percent of the original face value and agreed to release the borrower’s guarantee. The problem in many similar situations has been finding a buyer for the loan when there is no construction lending available except from the U.S. Department of Housing and Urban Development.
  2. Change of bank: A development’s business plan still works, and the bank refinanced the $6 million land loan to extend it for one year. But the Federal Deposit Insurance Corp. closed the original bank, and another bank bought it and its debt. A third-party buyer entered a contract to acquire the property, but the borrower -- without an attorney -- wanted to buy the debt at a discount without telling the bank about the contract. He was advised that this was potentially criminal, however, and disclosed the contract to the bank. The bank agreed to take a 20-percent discount and released the developer of the personal guarantee.

On the other hand, if they have a nonbinding letter of intent that is subject to due diligence or a verbal agreement and don’t disclose it, it will most likely not cause a legal action.

Also, if borrowers inform the lender that they have a third-party buyer for the property but they really are the buyer, then that is bank fraud. A fair-value agreement between the bank and borrower to sell and purchase the debt is a clean transaction as long as there are no hidden added-value commitments of which the lender has not been informed.

If developers have a revised business plan for the property that requires them to buy down the debt, it likely is a sound transaction. For example, say the original business plan reflects a to-be-built condominium project. The borrower owes $40 million and under the new business plan, the land must be in the project for no more than $20 million. This will help negotiations with the lender. For instance, if the salability of condos is nonexistent but the apartment market is strong, the land cost must be reduced for the project to pencil out as an apartment project. If the bank questions clients, they must state the truth. But this discounted sale may proceed without such risk.

If someone else has purchased the debt from the original lender, and you and your client are negotiating with the new debt-owner, make certain that the release of the borrower’s guarantee is part of the transaction. If the debt is recourse, banks may choose not to cut a deal with borrowers who have a valuable personal guarantee, believing that the borrower should not profit while they take a loss. Therefore, they may not be willing to release the guarantee.

If it is a nonrecourse loan without a personal guarantee, however, the lender may be more likely to deal with the client without hesitation.

If a lender won’t work with your clients and the clients want to change the project’s business plan and get their guarantee released, they should continue to try to purchase the debt with a disclosed partner. Although a borrower’s personal guarantee is in place, some banks feel that this kind of purchaser may pay more than a true third party.

Also, investors may agree to pay more with the original borrower on their team. This is because as the developer, the borrower knows more about the property than any other prospective purchaser will.

Brokers who help their clients through the buyback process can gain their trust and solidify their positions as trusted advisers.

Note: This article was written for educational and informational purposes only and should not be construed as legal advice. Advise your clients to consult an attorney to determine what is legal and appropriate for their specific situation.


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