Workouts 101, Part 2: Borrowers’ Leverage

Last week’s post talked about some of the basic issues that often are overlooked by both sides in a problem real estate loan workout.   Many of us were in the market for the last boom & bust cycle, and simply need a quick refresher on our workout skills.  

For others,  including many property managers and even some investors and lenders, this is their first serious down market, and it may take some time to adjust to the fundamentally different issues and priorities of real estate workouts in a systemic recession.  

This post looks more closely at some of borrowers’ points of  leverage and opportunity in typical real estate loan workouts.

 Knowing the property.  Borrower/owners usually are in a far superior position to a lender in understanding what it takes to run, and profit from, the real estate and its related operating assets.  Normally, the lender looks to the owner, or his operator managers, to know how best to keep the property performing and adequately maintained. 

The bottom line here is that, in an early stage workout, property owners should try to continue to be the “experts” for themselves and lenders both, and anticipate problems.  In that role, owners can offer solutions or compromises on any problem areas, and keep the momentum, forestalling the lender from considering trying to take over and bring in someone else (like a receiver).

Cash flow considerations.  In a workout, cash is king.  A smart lender will look at these issues straightaway, so as a borrower, you want to be ahead of the game here as well. 

Obviously, a failure to keep up with required debt service on the loan will trigger payment defaults and is the common path to a tough workout.  But other cash issues must be kept in mind as well. 

It’s entirely reasonable in a early stage workout to try to reduce operating expenditures to utterly necessary minimums.  Troubled borrowers sometimes are counseled to slow pay or shut down some nonessential items, to build a cash kitty, which might be used to reduce the secured debt and forestall enforcement or foreclosure.  However, failure to pay necessary maintenance, utilities, insurance or similar costs could trigger waste or covenant defaults.  (Shut down utilities, for for example, and you may lose fire/life safety protection, or suffer mold due to HVAC being down.)    Shorting unsecured trade creditors also might alienate them, reducing the chance, in a later bankruptcy, that this class of creditors would be friendly to the borrower and support a reorganization plan that keeps current ownership in place.    

Distributions of cash to an owner or partner, even prior to default, can be problematic in a workout.  This is because bankruptcy law (and some other remedies) may give a lender, and other creditors, some rights to recall those funds later.  Any plans of a borrower/owner to make payments to owners or insiders should be carefully discussed with legal counsel once a workout or default approaches.

Intrinsic value of the property.  Again, this is something a sophisticated  borrower may understand much better than the lender (even though the lender will almost certainly order an appraisal).  Remember, the lender is not necessarily expert in what makes your specific property special.  The borrower needs to highlight for the lender the unique features of the property, as well as the reasons why the borrower is the best person to run the property in a way that makes the best out of those unique features in the long run, even if the property is having difficulty in the short run.

There are more borrower points of leverage to come.  Look for another post early next week to find them.

  A note to readers:  I really appreciate all of your comments, and like my fellow Globest.com bloggers, encourage you to participate, throw out ideas and arguments, and ask questions (just not specific questions about specific deals, as we can’t give legal advice here).  Hopefully we can get a good conversation going here about what’s going on in the market and in law.