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How Commercial Real Estate Borrowers Should Approach Their Lender: What to Do Before Defaulting (Part 1)

This blog is aimed at the lending community – so why are we giving hints to commercial real estate borrowers as to how to approach their lenders? There is, of course, a simple answer.

The goal here is to get the bank paid as quickly and inexpensively as possible. It is easiest to accomplish the goal while working with a motivated and cooperative borrower. One of the telltale signs of an experienced workout professional is the ability to help the borrower past the “denial stage” to face the stark reality of a troubled loan so that a thoughtful strategic workout plan can be formulated and implemented. Many borrowers are poorly counseled to take a combative approach with their lender. Others are not counseled at all and come totally unprepared to their first meeting with the workout team. Still others have no idea what has happened to them and even less grasp as to what is going to happen next.

Recently, at the request of Urban Land magazine, I wrote an article (with the assistance of two attorneys who were then associates here at JMBM) addressed to commercial real estate borrowers who are on the brink of defaulting. Entitled “What to Do Before Defaulting,” workout professionals will find this article helpful in making it clear to their troubled borrowers exactly what they need to do. We’ve segmented the article into five separate posts, the first of which follows.

What to Do Before Defaulting

Copyright © Urban Land Institute’s Urban Land Magazine 2010. Reprinted with permission.

Profitable commercial office space depends on healthy numbers of employees in order to keep companies initiating and renewing leases. As office vacancies increase due to the recession and downsized office staffs, many building owners find themselves heading toward foreclosure, struggling to service mortgages on office buildings that are declining in value. In 2009, commercial office vacancies nationwide jumped to a 15-year high of 17 percent from 14.5
percent a year earlier, according to commercial real estate research firm Reis Inc. Commercial rents plunged by nearly 9 percent in 2009, the largest drop since Reis began tracking commercial occupancy in the 1980s.

Commercial mortgage-backed securities (CMBS) became one of the top sources of real estate finance early in the 2000s, providing sizable liquidity to both investors and commercial lenders. Many financial institutions met the increased demand for CMBS during the real estate bubble of 2005 to 2007 by lowering their underwriting standards. Then the bubble burst, rents and occupancies in commercial properties fell, and borrowers found themselves with insufficient revenue to make regular principal and interest payments to meet current debt service. There is now more than $600 billion of commercial real estate loans in the CMBS structure. According to Deutsche Bank’s April 2009 report, The Future Refinancing Crisis in Commercial Real Estate, at least two-thirds of loans maturing between 2009 and 2018, totaling $410 billion, likely will not qualify for refinancing at maturity. To refinance all $600 billion in loans, borrowers would need to put up at least an additional $100 billion of equity.

While CMBS loans were not the only source of investment during the real estate bubble, these numbers paint a picture of the dire situation property owners are facing and help explain why commercial real estate will not see a recovery in the near future. Owners facing the numerous problems in the commercial real estate market have several options to consider before foreclosure or bankruptcy.

When Cash Flow Becomes a Problem
When a property begins to experience cash-flow problems, owners are often placed in the unenviable position of meeting monthly debt-service payments that can far exceed the amount of monthly cash flow generated by the property. Even those who can still meet monthly payments might find themselves in default of their loan if the property can no longer generate enough money to meet the prescribed debt coverage or loan-to-value ratios
imposed by the loan documents.

In the world of commercial real estate, properties are measured by the amount of cash they produce. When cash flow drops, owners are forced to think creatively in order to maximize their investments.

One option is simply to sell the underperforming property and move on to the next deal. However, this may not be feasible for most owners of cash-strapped properties. Because the value of a commercial property is primarily derived using some measure of the holding’s annual cash flow, a property with reduced cash flow will garner a reduced price on the open market and often will be valued at less than the total debt on the property.

For the owner, the only option may be a short sale, but lenders are not always willing to take a huge hit if they think there are better roads to recovery. Short sales also do not necessarily protect a personal guarantor from liability. In some cases, requesting a short sale from a lender may actually increase the potential liability of the guarantor. This is the case when lenders include in their documents “badboy” carve-outs–stipulations that allow the lender to convert a limited guaranty to a full guaranty when one in a list of prohibited actions is taken.

Owners may also want to consider restructuring their leases in order to continue generating income. Reducing rents or granting deferrals to tenants who are having difficulty paying rent is an option if there is a possibility that the owner can maintain ownership by taking a slight hit now to keep the property successful in the future.

A tenant whose lease is due to expire soon is in a good position. A credit tenant may be sought out by other landlords dangling enticing offers, including “free” rent and generous improvement allowances to encourage that tenant to disrupt its operations and move across town. They may hide fees and costs and hope that the tenant–attracted by a
teaser lease rate and an appealing package of tenant improvements–will bite.

Tenants are often willing to extend the term of the lease or make a small payment toward a past-due amount if the owner is willing to reduce the rent. An owner may be able to increase cash flow in the long term and lock in longer leases by thinking creatively and working with tenants who may also be struggling financially.

Another option for owners is to seek a capital infusion from additional investors–either in the form of equity or debt–though this approach is easier to consider than to execute. But if a property is generating cash flow–or has the potential to maintain or even increase cash flow–obtaining additional short- or long-term equity investment
or financing may be possible.

Equity investors are looking for bargains, so an owner should be prepared to part with a sizable stake in the property. One of the most successful examples of an equity investment occurred several years ago when Bank of America–then, as now, a troubled institution–sold a 50 percent interest in its San Francisco headquarters to a major developer, which also obtained an option to sell its stake back to the bank when times improved. Several years later, the bank was able to buy out the developer, which pocketed a tidy profit while Bank of America preserved its complex, as well as its dignity.

Much-needed cash can also come in the form of debt from private, mezzanine, or hard money lenders. Success will depend on the cost of the additional capital, but refinancing is often the easiest way for a property owner to inject new cash into a troubled property.

This is Dick Rogan, bank lawyer and author of, signing off for now. Join us again soon to check out what’s new in the World of Workouts.

Year after year, day after day, workout professionals in the know rely on JMBM’s Special Assets Team™ to handle problem commercial and real estate loans. Whatever problem loans you have, chances are, we’ve seen it. Give us a call.


Our Perspective. JMBM represents commercial banks, special servicers, private lenders, asset-based lenders, hard money lenders and factors. We help lender clients throughout the United States craft business and legal solutions to their commercial and real estate troubled loans. For more information, please contact Dick Rogan at, or (415) 398-8080.

Richard A. Rogan is Chair of the JMBM Special Assets Team™. He also serves as the co-managing partner of JMBM’s San Francisco office and co-chair of its Bankruptcy Practice Group.

JMBM’s Special Assets Team™ has represented hundreds of lenders in California and throughout the United States. We regularly appear in bankruptcy courts, district courts and superior courts. We are proud to serve as trusted counsel and advisors who look for a business solution and try to help lenders find the best possible resolution for each troubled loan. Whether a loan is being newly documented, restructured or litigated, JMBM’s Special Assets Team™ has the skill, know-how and experience to solve your problem in a practical no-nonsense way.

NOTE TO CONSUMERS: As a matter of Firm policy, JMBM does not represent individual consumers who have disputes with their lenders. Many lenders have specialized consumer workout professionals who have the time to help consumer borrowers. There are many fine attorneys who specialize in representing consumers. Individuals with consumer lending problems should contact a lawyer or law firm who specializes in consumer insolvency and bankruptcy in their local area. When in doubt, we suggest you contact your local bar association’s Lawyer Referral Service. [For example, see Bar Association of SF or LA County Bar Association Lawyer Referral Services]

JMBM does not provide legal advice to consumers, and cannot respond to consumer inquiries.