Lenders are in the business of giving performing loans which are repaid according to agreed terms by the borrowers. This is accomplished by establishing and adhering to a loan approval process which qualifies the property and the borrower against benchmarks and other variables that quantify the likelihood of repayment and the applicable risk premium, loan terms and repayment schedule required to mitigate loan default. However, regardless of the best efforts of the lender and the best intentions of the borrowers some loans on the books will become non-performing requiring steps to change their status. When a loan goes into default depending on the underlying reasons, the options available to correct the problem are varied. The status of a loan being in default inadvertently provides an opportunity to improve, correct or change the financial structure supporting the property or relinquishing ownership interest in the property which can be a viable option under certain conditions to rectify the delinquency. Some of the possible ways to address a non-performing loan and change its status are:-
Loan Modification – changes covenants in a mortgage instrument and accompanying note or trust deed which makes the terms of repayment more affordable to the borrower temporarily or permanently. This can include reduction of interest rate, extension of duration, adding delinquent amount to outstanding principal and reamortize the loan balance, etc. This modification can be all that is required to rectify the mortgage delinquency and allow the borrower to afford the mortgage payments going forward without further default. This allows the lender to keep the loan on the books provide the borrower with some financial relief and make the repayment more affordable based on the property’s cash flow.
Discounted payoff – represents the change implemented by a lender in which it accepts less than the outstanding amount due on a loan to satisfy the indebtedness from the debtor. This allows an owner whose property has correctable diminished performance to acquire third party funding in the form of debt or equity to satisfy the discounted payoff amount and remove the asset from the lender’s balance sheet. This is a positive resolution to the delinquency for all the parities; the lender receives payment of a percentage of the outstanding debt and only has to write off a small amount in contrast to the entire balance, the property owner has established a new loan possibly a bridge or hard money instrument providing time to maturity to correct or improve the property’s fundamentals for stabilization and future refinance, the bridge or hard money lender has added another loan to its books that meet its loan parameters, third party equity provider injects funds into the capital structure to payoff indebtedness to lender while diluting the sponsors’ equity for an attractive Return On Investment (ROI), etc.
Bringing in Outside Equity – an equity partner can sometimes be solicited to recapitalize the capital stack extinguishing the lender’s debt financing or strengthening the property’s fundamentals making it a more attractive candidate for alternative debt financing while maintaining an adequate equity/debt ratio for cash on cash yield purposes. However, this reduces the principals’ equity stake in the property and dilutes their ownership interest. This financial maneuver represents a viable option to address a property being in default and providing corrective measures to the problem while positively improving the position of the stakeholders in the property.
Refinance – a property owner who still has sufficient equity in the asset supported by property value and Loan to Value (LTV) ratio can possibly get a loan from another lender to pay the original lender the total amount due; if other variables in the property profile and borrower profile support the loan. This removes the asset from the original lender’s balance sheet while providing the property owner with a new loan instrument to service going forward. Executing this option makes a clean break from the original lender which may be beneficial especially if the relationship has become tumultuous during the loss mitigation process.
Sale – disposing of the property through sale offers an option of satisfying the delinquency associated with a non-performing loan if the property value and the equity to debt ratio are sufficient to net enough capital after sale to pay off the underlying debt on the property. This could be considered one of the least desired options as it eliminates future ownership interest in the property with its related financial benefits. However, depending on the circumstances surrounding the loan default it may offer a means to make the lender whole, possibly netting the principals cash from the sale in excess of loan satisfaction and associated fees and provide capital to be reinvested into other properties.
Deed in Lieu of Foreclosure – occurs when the mortgagor conveys ownership of the property to the mortgagee to alleviate the lender commencing foreclosure proceedings. The property owner in this circumstance relinquishes all rights in the property which are transferred to the lender via a deed to avoid the necessity of the lender going through the foreclosure process to gain ownership of the subject property. This action represents a more amicable resolution of the non performing loan status without the lender having to resort to litigation to gain title to the property to perfect their security interest. A deed in lieu of foreclosure is considered a friendly foreclosure and it less adversarial in nature than a foreclosure.
Foreclosure – usually represents the last option available to the lender to protect its interest in property and to assert its rights for repayment of indebtedness evidenced by the loan instrument on the realty. This course of action is applied by lenders generally when other options were not executed by the property’s owner, were executed but also went into default or market conditions diminished their relevancy as viable loss mitigation alternatives to address the mortgage status. In foreclosure the lender declares the loan instrument to be in default, notifies the borrower of its responsibility to cure the delinquency, and if not cured pursues litigation to gain ownership of the property for sale to a third party to get repayment of the loan balance from the proceeds of the sale of the property. This is contingent upon the net amount from the sale being enough to satisfy the outstanding loan amount. In the event of the net amount being inadequate to satisfy the outstanding balance this leads to a deficiency judgment against the property owner for a recourse loan. However, the frequency of lenders enforcing deficiency judgments against property owners is debatable in commercial real estate loans enforcement.
Loss Mitigation is used by lenders to work with borrowers experiencing problems with making mortgage payments which could result from a cash flow problem caused by high vacancy factor, tenants’ delinquency, rental rate below market, etc. Lenders are primarily concerned with the repayment of the loan incurred against the property and will try to work with the owners over rough spots during the ownership. The options available are usually specific to the individual property and the underlying reasons for delinquency and the viability of turning its financial picture around. The earlier in the stage of delinquency steps are taken may provide more options of resolution and offer the property owner with the possibility of protecting more equity from erosion.