Let’s face it: The days of historically low interest rates, strong real estate values and timely tenant payments have faded into the sunset. If inflation is a friend to landlords because prices and rents rise, then a recession is a foe because prices and rents usually fall — helping to create a challenging landscape for commercial mortgage lenders, brokers and borrowers.
It’s no secret that lenders are scrambling to manage late-paying and nonpaying borrowers. Delinquencies and foreclosures weaken portfolios and lower property values, which push loan-to-value ratios above their required thresholds. And as commercial real estate lending continues to slow and the number of distressed properties increases, mortgage originators are increasingly likely to broker distressed debt. The brokers who are agile enough to make this change need to understand how to manage distressed debt, which is poised to be an issue throughout the coming year.
Distressed debt overview
Distressed debt is defined as a loan that is not performing as originally anticipated, and it is frequently described as either nonperforming or subperforming. Nonperforming loans (NPLs) are those where the borrower is no longer able to meet their obligations, causing a default. This category can include borrowers who haven’t made payments for a period of time, as well as those with loans that have reached maturity and are unable to be refinanced. NPLs are a significant risk for lenders and often result in portfolio losses.
Subperforming loans (SPLs) are typically categorized as loans that may not officially be in default but are not performing up to the standards set in the loan agreement. Examples include those that are past due for more than 30 days, or those that are frequently paid late. While SPLs are generally considered to have less risk than NPLs, it is equally important for lenders to closely monitor whether the borrower’s financial situation improves in a timely manner.
Distressed debt is a heavy burden for lenders to bear. It often ties up significant time and money while draining precious resources. Veteran mortgage brokers who have made it through major economic recessions in the past know that it’s common for lenders and borrowers to painfully fight it out in court for years before resolutions are reached, causing turmoil for both parties.
Working through problems
To avoid such difficulties, brokers need to address troubled assets with their clients. The first option for a broker is to educate a lender on how to work with clients to restructure troubled loans. If a borrower cannot make the monthly payments due to a rise in interest rates or a temporary tenant vacancy, for example, the lender may consider lowering the payments or delaying select payments until the payoff date to give the borrower some breathing room.
Although creative restructuring attempts are common, if the loan has an upcoming maturity date and the borrower is having trouble refinancing, the lender may consider extending the loan term to give the borrower more time. If the lender is uncomfortable with the current value of the collateral, it can request for the borrower to provide an equity infusion (also called a cash-in refinance) to mitigate the risk. A broker can work with the client to complete the equity infusion or even source a second mortgage for them to make up the gap. This move may help the client get back on track with their payments and avoid default. Since it can take months or even years to work through a foreclosure process, time is of the essence.
Although the above option is the preferred method, sometimes working with a borrower is not feasible and more drastic efforts need to be taken to address impending risk. Managing a hostile borrower who is unwilling to collaborate on solutions can cause immense stress for brokers and lenders. This is especially true for commercial mortgage professionals who entered the business in the past 10 to 12 years, a period where they were most likely focused on origination efforts rather than workout strategies.
“Knowledgeable brokers can help lenders analyze the best options to manage portfolio risk exposure and emerge from the current market cycle as unscathed as possible.”
The result is an industry that is oversaturated with professionals ill-equipped to manage the nuances of working through subperforming and nonperforming loans. The good news is that there are niche companies that specialize in servicing distressed debt, marking a light at the end of a dark tunnel for lenders that need support in times of crisis.
Special loan servicers
A lender that is experiencing an increase in troubled assets should consider bringing on a special servicer. This party can implement strategies to manage a borrower in default, or even a foreclosure process down the road.
When looking for a special loan servicer, it’s important to find one that can meet the needs of a specific portfolio (i.e., different asset classes or deal types). There is no one-size-fits-all solution to debt management, so lenders that get a head start on interviewing multiple brokers and servicers will ultimately have greater levels of success. To start, experience and expertise in dealing with defaulted loans and foreclosure processes in the markets you are active in is a must.
It also is imperative to remember that each state has its own laws regarding defaults and foreclosures, so lenders often must tap multiple regional servicers if their real estate portfolio spans state borders. Of course, having a clear understanding of compensation strategies is key. Some special servicers charge a flat fee, while others will charge a percentage of any profits gained.
Seeking an exit
For lenders seeking an exit plan, brokers can facilitate the sale of loans, which can provide immediate liquidity and eliminate risk as the lender is no longer responsible for the performance of the loans being sold. When selling distressed debt, there are multiple options, and knowledgeable brokers can help lenders analyze the best options to manage portfolio risk exposure and emerge from the current market cycle as unscathed as possible.
One option is to sell the loan at par, meaning the buyer pays the face value of the loan. For example, if the outstanding loan balance is $500,000, the buyer would pay the current lender $500,000 for the loan. There are even times when a buyer may be willing to pay par, plus any interest owed, or reimburse the lender for items such as attorney fees.
Commercial mortgage brokers will have an easier time selling loans at par if the outstanding balance involves low leverage, the property is in a high-quality market or there’s a high likelihood that the borrower will eventually start performing on the loan. For lenders selling distressed debt, this is a solid option to recoup the principal balance and eliminate any further risk.
For riskier loans, lenders may be forced to sell below par, also known as a discounted sale. In these cases, the buyer pays less than the face value of the loan in exchange for taking on the risk of attempting to recover the full value of the remaining balance.
For example, if the outstanding loan balance is $500,000 but the market perceives it as being risky, a buyer may only be comfortable paying $400,000. The buyer may require a discount for many reasons, including a highly leveraged loan, a destabilized property with many vacancies, an asset that is in poor physical condition or one that is not in a prime location. While the seller of the loan will take a loss, it may be worthwhile if they need liquidity or believe the situation will get worse if they hold onto the loan.
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Many U.S. mortgage lenders and borrowers are facing possible financial trouble. An experienced broker can be invaluable to help both parties navigate choppy waters. There is much to evaluate when managing a loan portfolio amid an economic recession, but the winners are those who have mastered the art of swift and strategic decisionmaking. For inexperienced or unprepared lenders, now is the time to shed risk. ●