The long recession from which we are emerging has caused numerous borrowers to default on the loans for their commercial projects including loans for residential developments, shopping centers, office buildings and industrial/warehouse/flex space. Many residential developers have seen their sales of completed units or lots stop or slow to a trickle over the past few years, while the interest on their loans continue to accrue. This may result in the debt on the projects being significantly greater than the value of the projects. Many developers of commercial projects have either been unable to lease space or have had to lease it at rates that are significantly lower than anticipated rental rates. Compounding the problems of commercial developers, many tenants have defaulted on their leases as their revenues have declined, leaving such space unoccupied or re-let at greatly reduced rental rates. Meanwhile interest has continued accruing on the developers’ loans.
Although these projects have been disappointments for the original developers and lenders financing the projects, financially troubled projects can present excellent investment opportunities for new investors/developers provided they have the capital to acquire the projects based on current market valuations and the project lender is willing to discount the existing loan balance to make the purchase and completion of the project feasible.
The least complex of the three types of transactions is the purchase of property from the lender after the lender has obtained title to the property through a foreclosure sale. The second transaction type is often referenced as a “commercial short sale.” Similar to a residential short sale, a commercial short sale involves a buyer contracting to purchase commercial property from an owner who is in default on a loan on the property, with the contract being contingent upon the lender’s agreement to reduce the principal balance due in satisfaction of the loan. These transactions are complicated due to the requirement for simultaneous negotiations with and the agreement of both the seller and the seller’s lender.
A third transaction structure involves a buyer purchasing a loan from a lender at a significant discount from the outstanding loan balance. This transaction can occur without the consent of the owner of the real property, requiring negotiation and agreement with only the buyer and lender. In addition to many of the same issues as involved in the prior transaction types, these transactions involve additional complexities. The buyer must review existing loan documents and other various amendments and forbearance agreements to confirm that the loan documents will be enforceable upon the completion of the purchase and assignment of the loan to the buyer.
These transactions may be further complicated if the lender has commenced foreclosure proceedings requiring the review of all pleadings in the foreclosure litigation. Following the purchase of the loan, the buyer may negotiate with the property owner for a payoff of the loan in excess of what the buyer paid for the loan, a restructure of the loan on terms beneficial to the buyer or a deed in lieu of foreclosure conveying title to the property to the buyer without necessity of pursuing a foreclosure judgment. If the buyer does not reach agreement with the owner, the buyer will proceed to foreclose the mortgage.
Prior to closing on any of these types of transactions, considerable investigation regarding the property must be done, including not only typical transactional due diligence such as obtaining and reviewing title, survey, zoning, and environmental conditions, but also investigation into potential legal liabilities that may accrue to a buyer or successor developer for work performed by a prior developer of a partially completed project and expired permits and development obligations. Due to the changed economic conditions the previously planned and permitted buildout of a project may no longer be feasible requiring changes to approved development orders. Given the overbuilding of residential units and depending on the location of the property, some buyers are modifying previously planned residential projects to mixed use or commercial developments. As the price of raw land has declined significantly, some buyers and developers are looking at density reductions resulting in smaller developable areas thereby reducing their environmental mitigation costs.
As the realities of changed economic conditions are accepted by property owners and lenders, investors with capital are finding potentially lucrative investment opportunities in the acquisition of financially troubled projects provided they have the expertise and guidance to understand and address the complexities involved with these transactions.