FINANCE & INVESTMENT: How a Real Estate Workout Works

By Stuart M. Saft Dewey & LeBoeuf LLPReports on the softening residential real estate market continued unabated through the first half of the year, as thousands of homes in Florida, Arizona, Las Vegas and nearly every other market sit partially-built and unsold.  In addition, most regions are now also experiencing a weakening in office leasing and investment sales activity.  As a result, we are seeing more defaults in the market both in the residential and commercial real estate arenas.  In the event the borrower defaults, the lender basically has five alternatives:  take no action and hope the problem resolves itself; foreclose the mortgage and sell the property; restructure the indebtedness; accept a discounted payoff of the indebtedness; or provide the borrower with temporary assistance by agreeing to a forbearance from making debt service payments.  A workout is a joint attempt by the borrower and lender to salvage a valuable property, prevent the delays and expense generated in a foreclosure or a bankruptcy proceeding and avoid any damage to a project’s reputation resulting from these actions. However, in order for a workout to be effective and successful, both the borrower and the lender must take reasonable steps to protect the value of the collateral and maximize its ultimate worth.  There is no standard form for a workout since each is the invention of the parties to a particular transaction and their reaction to a dramatic change in the fortunes of a project. The common thread running through all workouts is the parties’ shared belief that under the correct set of circumstances the asset can once again become successful and the indebtedness repaid.The most critical decisions for the lender to make are whether to foreclose its mortgage; exercise the power of sale contained in a deed of trust; have a receiver appointed; or take control of the property and replace the owner.  These decisions are never taken without a detailed consideration of the advantages and disadvantages of each and the overall risk to the lender.  Nevertheless, if the lender has no confidence in the owner’s ability to rescue the property, it may have little choice except to replace the owner.  In the event the borrower and lender determine a workout is in fact appropriate, it is imperative to act as expeditiously as possible to identify and remediate the problems that caused the default in the first place.  If the borrower stalls, the lender can end negotiations and foreclose or sue on the borrower’s guaranty, if any.  The initial step in determining whether to participate in a loan workout rather than foreclose the mortgage is finding the cause of the property’s problems and whether it can be turned into a viable asset. In order to achieve this, the lender must perform a thorough due diligence review. The pre-workout due diligence review requires the analysis of a number of vital documents including loan; leases and ground lease, if any; and construction financing; as well as the title, survey, environmental, engineering, and demographic reports on the property.  The lender must also obtain an updated appraisal of the property.  Although these documents and reports are already in the lender’s possession from the initial loan process, they should nevertheless be updated and reviewed again.  It is very likely the lender will uncover aspects about the property that should have been recognized when the loan was originally made, but in the haste in which the initial financing closed, were not.  The lender must deal with the reality of the current situation and, under the cloud of a potential default, decide the best manner of proceeding.  In addition, structuring and executing a successful workout also depends on the lender’s relationship with the borrower and the manner in which the lender learned about the property’s problems.  Every workout is distinctive to each loan and the challenges the property is facing. In many cases, adjacent properties can require various solutions only because they are constructed differently, have diverse tenant mixes, or attract another kind of user or purchaser. Since there are dozens of factors that can come into play in determining a property’s success or failure, there are obviously as many possible workout formulations – undoubtedly several that would be successful. It is therefore incumbent upon the parties to determine which workout formulation would be the most beneficial to both the borrower and the lender.   There is only one cardinal rule that MUST be followed, particularly by the lender: Preserve the Asset.  Since the primary security on the loan is the value of the property and not the borrower’s guaranty, which may be negligible, a lender will make sure that whatever decision is made pertaining to the workout, the asset is always protected. Stuart M. Saft is partner at the law firm of Dewey & LeBoeuf LLP, a full-service law firm, providing legal counsel throughout the U.S., Europe, Russia/the CIS, the Middle East, Asia and Africa.  With over 1,400 attorneys in virtually all major financial and commercial centers, the firm represents national and international corporations, financial institutions and government agencies in their most complex legal matters.  For more information, visit its Web site at www.dl.com