Modifications Made to Commercial Loans: What Are They and Why Now?

commercial loan

When it comes to commercial loan modifications, the old adage that there is nothing new under the sun is shown to be accurate. Since the beginning of the existence of commercial mortgages, a process known as commercial loan modification has been in place. Back in the good old days, what we now refer to as “modifications” were actually called workouts, and they addressed the same concerns that a modification addresses. Read more about the commercial loan truerate services

Modifications to commercial loans can take on a variety of forms. One of these forms is a reduction in the interest rate that is displayed on the mortgage. Other forms of modification include modifying the index, fixing the interest rate, or adjusting the margin that is applied to the loan.

A change in the duration of the loan, or more precisely the amortization period of the loan, is another possibility that could be included in a commercial modification. During the 1970s and the early 1980s, financial institutions were taught a priceless and painful lesson about long-term lending, specifically that there are periods when it is unsuccessful. The 1960s and 1970s were a time when lenders were more open to making loans over extended periods of time, generally for 30 years. The issue that has arisen is that the lender is in an unfavorable position if they have money out at a rate of, for example, 5% for 30 years and then the interest rate environment shifts to 21%.

The fact that the Lender is borrowing money at a rate of 105, 15%, or even as high as 20%, but only collecting at a rate of 5% causes a dilemma in this circumstance. Banks make their money by taking deposits from customers (via certificates of deposit, annuities, and savings accounts), then lending that money out to customers at a profit. This profit is referred to as the “margin,” which is the difference between what they pay for the CDs and what they are able to charge the consumer of capital (Borrower).

In the 1970s, several banks made the mistake of offering long-term loans with low interest rates during a period in which interest rates were climbing fast. As a result, each of these long-term loans became a losing proposition for the lender. Enter the “Balloon Mortgage.” This mortgage offers cheaper monthly payments based on long-term amortization, in addition to a “Balloon payment” that is normally due in 5, 7, or 10 years from the start of the loan.

The fact that there is now no capital market for commercial loans is the source of the problem. The process of refinancing will be particularly challenging for anyone who has a balloon payment coming due in the near future. The fact that there is very little in the way of financing going on, in addition to a roughly forty percent decrease in prices since 2007, has led lenders to significantly cut their loan-to-value ratios (LTVs), which brings the situation into clearer focus.

Lengthening the duration of the loan is another option. This would extend the period over which the principal is paid off, which would result in a reduced monthly payment and provide the borrower with some respite. In some instances, loan repayment plans that were originally calculated based on an amortization period of 20 years are being adjusted to reflect repayment over periods of 25, 30, or even 42 years in some instances.

It’s possible that this will bring the monthly payment down by exactly the right amount to make it more bearable for the borrower and get the loan back into a performing state.

The practice of charging fees for late payments, events of default, impounds, force imposed insurance, lender ordered appraisals, and other services is common among lenders. Consider the wisdom inherent in that practice: the borrower, who is already short for cash, is battling to make his or her payment, and they may even be well behind in their payments. The lender makes matters even worse by charging additional “junk” costs. These fees generate additional profit for the lender, but they also boost the total amount of the default and potentially the amount that needs to be paid each month toward the debt.

These are the Borrowers who are already having a hard enough time meeting their monthly requirement without the Lender making things even more difficult for them.

It is possible that the Lenders are illegally (fraudulently) charging those fees when they are not legally entitled to them. This is a “dirty little secret” that the Lenders do not want anybody else to know. There are some cases, notably in this state of Florida, in which the Servicer is not even authorized to collect the payments, much less any additional costs that may be incurred.

An additional step in the modification process could involve some level of “forbearance,” in which the principal and interest payments are halted for a period of time; this is typically tied to a specific event such as reaching a certain number of tenants or a specific income goal. Forbearance could be an option if the borrower is able to meet the requirements. In this particular circumstance, the outstanding instalments might be forgiven, but more than likely they will be “tacked” onto the back of the loan instead.

During the customary time of forbearance, the borrower will typically reinvest all of the cash flow generated by the property in some capacity, such as by making tenant improvements or negotiating lease discounts. The assumption is that the borrower will restart making payments of some kind once there is an improvement in the performance of the property.

It is also possible for the Lender and the Borrower to come to an agreement about an interest only payment. Under this arrangement, the Borrower makes a minimum payment determined by a predetermined interest rate, but the principal balance does not change. The borrower once again enjoys the benefit of a lower payment, which may be the deciding factor in whether or not the borrower hangs on to their home or faces a messy foreclosure.

At the end of the loan process, the borrower and the lender may come to an agreement on virtually any topic, ranging from forbearance and participation mortgages through principal reduction and recasting of the entire loan. In the final analysis, a “modification” is understood to refer to any situation in which the conditions of the original note and mortgage are altered in any way.

Why now?

The commercial mortgage industry is on the verge of a massive disaster in the United States of America and around the world. This crisis is twice as large as the yearly budget for the federal government of the United States, and it is four times as large as the residential mortgage crisis. According to a recent story published in Business Week, the total outstanding debt in the United States of America amounts to $6.4 TRILLION. This equates to $21,333.33 for each and every man, woman, and kid in the country.

Since its all-time high in 2007, the Commercial Investment Market is generally estimated to have lost forty percent of its overall worth. This loss is an average, and it is a value that applies “across the board.” Due to the fact that real estate is a local phenomenon, the extent of the loss may be and often is greater in certain regions of the country while it is lower in others. While some kinds of real estate have been severely impacted, others have been spared any significant damage.

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Establishing a value for a specific piece of property in the context of the current market presents a difficulty for Lenders and Borrowers alike. There are a great number of aspects that must be taken into account, such as income; occupancy; expenses; location; future prospects; employment; and the economy as a whole.

There is a significant gap between the market value of an office building in the metropolitan region of Washington, District of Columbia, and that of an office building in the city of Detroit, Michigan. The prices of apartments in New York and Manhattan have not been hit as hard as they have been in Miami Beach, Florida.

Add to that the fact that between 2010 and 2012, it is predicted that there will be $1.4 trillion dollars’ worth of Commercial Mortgages due to Balloon, and you have a market that has suffered the greatest reduction in capital in the history of the country. Simply said, lenders are not prepared to lend, and even if they are, they do so at levels and prices that are illogical in light of the fact that the majority of borrowers need substantial amounts of capital.

As an illustration, a borrower purchased an office building for the price of $10,000,000, put down a deposit of $2,500,000, and mortgaged the remaining $7,500,000. Since then, the building has experienced a decline of forty percent in value, bringing it down to approximately six million dollars; the original lender is currently due seven and a half million dollars. The Borrower makes an effort to locate a new Lender, but the only offers they can get are at an LTV of 50% based on the current valuation of the property, which is equivalent to approximately $3,000,000, with personal guarantees and substantial fees and costs.

There is other news to report. According to the Emerging Trends Report for 2010 published by the Urban Land Institute, it is not anticipated that the markets will begin to recover until the year 2020. What this indicates is that prices, capital, and property will all converge approximately ten years from now. No matter how you look at it, that is a significant amount of time for a recovery.

The United States Federal Government is aware that a problem is developing in the Commercial Mortgage Market; in point of fact, there is no shortage of Politicos who are prepared to weigh in on the topic. In point of fact, it is perhaps simpler to mention those who have not expressed an opinion on it. On the current condition of the commercial mortgage and real estate markets, numerous people, including Christopher Dodd, Sheila Bair, Ben Bernanke, our president, and the majority of the cabinet, house, and senate, have expressed their opinions.

The Federal Open Market Committee (FED) has remarked that engaging in some type of market modifications and exercises is probably the only approach to stabilize the market. Even further, the FDIC published a white paper that outlined at least twelve distinct circumstances under which a bank may change a loan and still have it pass the Examiners’ intent gaze. In this study, the FDIC also provided examples of how each of these circumstances could play out.

The general understanding among all parties is that “Extend and Pretend” should be used to continue keeping the loans in place, in the field, and off the books of the Lenders. Keep in mind that a foreclosure and possession are not assets but rather liabilities in the eyes of the Lenders, notably the Banks. When a bank “receives” a property back from a borrower, the bank is required to “reserve” cash to cover any potential losses. If a bank buys back enough properties, the bank itself can become illiquid, which makes it susceptible to seizure by the FDIC and ultimately leads to the bank’s closure.

Gains for the person who took out the loan

Obviously, the Buyer’s ideal scenario is one in which they retain possession of the property, continue to own the facility, and continue to run it. The Buyer/Borrower has invested a significant amount of time, money, energy, and effort into the management and maintenance of the property, and the last thing that they want is to be dispossessed of it.

Because the process of loan modification occurs outside of the court system, there are no judgments and no legal suits that are filed at this time. The modification process is a process of offer and compromise by and between the Borrower and the Lender. Typically, a facilitator (consultant) acts as a neutral third party whose role it is to bridge the gap between the two parties involved in the modification process. It is the responsibility of the consultant to show some concern…but not a great deal…about the final result in order to maintain their impartiality and objectivity.

The borrower keeps custody of the asset and is able to reap the benefits of continuous cash flow, although at a lower rate of interest. This is of utmost significance for a borrower who obtains the vast majority of their own income from the activities of the property in question.

It could be highly expensive to relocate a Borrower who uses the property as his or her primary business location, especially if the property has been extensively modified for the Borrower’s purpose before the Borrower took possession of it. The costs of moving, relocating machinery, utilities, upgrading essential infrastructure (such as power, water, sewer, gas), the removal or installation of docks, roll-up doors, and not to mention all of the downtime that is connected with the process of moving itself are added to these expenditures.

There is also the possibility that business may be disrupted, as well as the departure of staff if they become aware of the impending foreclosure and protest to the relocation of the company.

Historically speaking, real estate markets often see a doubling in value every seven to ten years. If we are not currently at the bottom of a real estate cycle, we are certainly close to reaching that point, which indicates that in the long run, the markets will eventually rebound and begin to trend upwards. The ULI research predicted that the market will settle in 2020, which suggests that a recovery will start at some point between now and when the market stabilizes in 2020.

If the borrower can survive the current predicament in some way, there is a chance that they will be repaid in full at some point in the future. To put it another way, they could be able to generate a profit by selling the property for more money than they have invested in it. By maintaining ownership of the property, the borrower will be able to continue to benefit from the advantageous tax treatment that is offered through cost recovery (depreciation), treatment of capital gains, and maybe even a 1031 tax-deferred exchange.

The taxation that is associated with “debt forgiveness” can also be avoided, which is another pleasant surprise. The majority of people are under the impression that the tale is over when a property is “surrendered” through the use of a “deed in lieu of foreclosure,” but this is not the case. The amount of “forgiveness” may determine whether or not there will be significant and unfavorable tax repercussions. The borrower winds up being responsible for paying taxes on money that they never actually got their hands on or benefited from in any way.

The “Deficiency Judgment” is an additional issue that is possibly the most serious of all of them. In the event that the proceeds from the foreclosure auction are insufficient to liquidate (pay off) all or a portion of the mortgage, fines, penalties, court expenses, taxes, and any special assessments, a deficiency judgement will be issued. The Lender will then pursue a deficiency judgement and attempt to enforce those rights by seizing and selling any and all assets of the Borrower that they can uncover. These assets may include personal property, bank accounts, retirement accounts, and other real estate properties owned by the Borrower.

Gains for the Borrower/Lender

The Lender stands to gain in a variety of ways if the adjustment is implemented. To begin, because it is an administrative process rather than a judicial one, the Lender does not have to pay the enormous expenses that are normally connected with a foreclosure. There is no requirement for the taking of discovery or depositions, the hiring of court reporters, the payment of filing costs, or the billable hour. The Lender can save both time and money by delaying the involvement of lawyers until the very end of the procedure because it is reasonably straightforward.

The process of modifying a contract does not fall under the purview of the court system because it involves making a “offer and compromise.” Due to the absence of a hearing process, there is no requirement that you get on the docket. The time it takes to acquire your “day in court” could be measured in years depending on the jurisdiction, yet it takes an average of only a few weeks to present a conventional proposal.

Because this is a non-judicial process, there are no court expenses, no waiting to submit responses, no complaints, and no lost pleadings. The Consultant is the one who generates the proposal, obtains the Borrower’s approval to present it, and then provides a copy to the Lender.

As was discussed in the part that addressed the benefits to the Buyer and Borrower, the Lender could also be made whole. If the lender goes through with the foreclosure and sells the property in the current market, they are certain to take a loss of at least 40 percent. The severity of the loss, which was covered earlier, combined with the fact that there is no accessible capital means that the Lender is seeking for a “cash” buyer, and cash buyers are entitled to a significant discount.

It is likely that the income will have decreased as a result of an increase in vacancy (the issue that led to the foreclosure and the mass exodus after the tenants became aware of the suit), a possible rent strike by the tenants that remain, and the requirement to make concessions in order to attract new tenants. The loss sustained by the lender can be substantially higher (60–70% or even higher).

When the market did return to normal, the borrower and the lender could come to an agreement to sell or refinance the property, which would result in both parties being made whole. This would be possible if the borrower and the lender could reach some form of compromise that would avert the loss.

Lenders and banks are not in the business of managing commercial real estate; rather, lending money is their primary focus. They are not suited to handle real estate, and despite the brave front they put on, they have to engage local management. Often, it is not who they want, but who they can get, and the outcomes naturally vary widely. Despite their brave face, they have no choice but to hire local management.

Repairs, tenant improvements, and day-to-day property upkeep are not within the scope of services that can be performed or managed by lenders. These things can determine whether or not a transaction is successful or results in foreclosure. In a recent instance, a borrower who owns a building that is located adjacent to a building that has been repossessed by a lender faced legal action. Since the shell of the building was finished three years ago, the Lender’s building has been completely empty ever since it was finished. The Lender has given its broker the instruction to “poach” as many tenants as he can from the adjacent building, which is already completely occupied by tenants.

One of the reasons why this hasn’t succeeded is because the lender is either reluctant or unable to perform the build out that the tenant asked. In the event that a sale is not yet finalized, the Lender will not execute a lease agreement for any longer than one year.

The Lender just has to deal with one point of contact while the Borrower remains in place, which is especially helpful when it comes to the collection of payments. Imagine the challenge of collecting rent from three hundred people who live in different apartments around the country.

Remember that as soon as the tenants find out about the foreclosure, at least half of them will go on a rent strike, significantly lowering the cash stream and causing even more trouble collecting the rent.

Examiners enjoy seeing large quantities of performing loans, regardless of whether a bank is federally or state-chartered. Examiners enjoy seeing large quantities of performing loans. The Examiners are not concerned with the rate or level of performance provided as it is taking place in some form or way.

In the White Paper that I referred to earlier, the FDIC outlined around twelve distinct strategies for transforming a credit that was not performing well into a loan that was doing well. The most ingenious solution was to divide the loan into two parts, one of which was performing well and the other of which was not. The lender only needs to identify the smaller non-performing portion for regulatory purposes, despite the fact that it is a part of a significantly larger credit.

As a result of there being no loss, the lender is exempt from having to post a Loan Loss reserve. This helps the lender keep their capital, and it may even save a few jobs in the process. If the Lender has cash on hand, they are able to maintain their financial stability; provided that they do not reach a level that causes panic among the regulators, the Lender is able to remain in business, and everyone is able to keep their jobs.

Through the process of loan modification, the Lender can remove the element of uncertainty that is associated with an extended marketing campaign. How long do you think it might take, given the current state of the market, to find a suitable buyer or buyers? After you have gathered some potential suspects, the next step is to qualify them so that they can become prospects. There will be some people who are unable to buy because they do not have the necessary cash on hand, and there will also be those who lack the credit and credibility.

The prospective purchasers will, as is their custom, present extremely lowball offers, and it may take several months before the Lenders’ goals and the Buyers’ anticipations can be aligned. As a result of the due diligence process, many transactions will fail, and the Lender should anticipate being re-traded at least once or twice. A fee haircut is something that the broker should be prepared for. The Borrower can be kept in place, which eliminates the need for that entire process.

The lender is able to avoid all of the “what if’s” connected with ownership since they have kept themselves out of the chain of title. What will happen if a hurricane, earthquake, tornado, or tsunami strikes our area? What would happen if the neighborhood was downzoned, the major employer decided to pack up and leave town? (GM). What if the market becomes worse, if it changes, or if it completely disappears? Consider the examples of California and Hawaii, as well as more recent examples such as China, Haiti, and Chile. What if there is a fire, a flood, or civil unrest? All of these things are possible and have occurred in the past.

The lending industry and banking institutions are extremely careful and protective of their reputations in the community. They do not want to give the impression that they are an evil empire intent on eradicating the underdog. Imagine if a local lender that made it a point to lend to places of worship had to go through the process of foreclosure on one of those buildings. Think of the ill will that would spread across the community, and in particular among the members of the congregation if something like that happened.

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