In this ongoing article series, the attorneys at Goulston & Storrs will keep you up to date on the current and emerging issues related to workouts and the Commercial Real Estate market.
Timothy Carter, Frank Ditta, Zev Gewurz, Jonathan Stein, and Jennifer Bisgaier
More than two years have passed since the Federal Reserve seismically shifted its fiscal policy and began hiking interest rates. With no signs that rates will go down any time soon, approximately $2.0 trillion of commercial real estate mortgages are scheduled to reach maturity from 2024 through the end of 2026. Banks with troubled loans on their balance sheets face increased regulatory and internal pressures to dispense with these bad loans, often at a discount and sometimes even with seller financing to a would-be note purchaser.
Into this landscape, commercial real estate investors seeking to capitalize on distressed opportunities increasingly are investigating discounted note purchases.
Distressed CRE Investing in Recent Downturns
Back in 1992, following more than a decade of repeated savings and loans failures, Congress established the Resolution Trust Corporation whose mission was to maximize value from the sale of assets from failed thrifts while minimizing the impact on real estate and financial markets. This led to an onslaught of loan sales. The RTC faced harsh criticism for its susceptibility to loopholes and workarounds as well as its costly rollout.
When the Great Recession came in 2008, Congress opted not to employ a similar mechanism in managing the crisis, and loan sales were anemic. Lenders largely coalesced around the strategy of “extend and pretend” – extending maturity dates and pretending that the values and cash flows of the properties they had financed still supported their underwriting.
In the wake of the most recent downturn, lenders with thin balance sheets and facing regulatory scrutiny (and in some cases facing direct intervention by the Feds) have been inclined once again to consider selling failing, distressed, and potentially distressed CRE loans and notes. The auction of Signature Bank’s $33 billion CRE loan portfolio in the fall of 2023 may be viewed as a starting point for the growing trend, and as note sale transaction volumes grow and market valuations become better established, more lenders may look to move additional underperforming paper.
Key Considerations for Note Purchasers
Investors looking for opportunities in the CRE distressed debt market will need to consider a variety of factors when contemplating note purchases:
- Local Law: Start by learning about the legal process to acquire distressed notes and, more importantly, foreclose on loans, in the jurisdiction where the property is located. Make sure you understand the timing, costs, and potential pitfalls relating to local laws and regulations.
- Legal Due Diligence: Review the loan documents and the status and condition of the loan and the property, including defaults and recourse/guaranty triggers. Note that loan agreements typically spell out the requirements for eligible assignees—prospective buyers should ensure that they qualify to purchase the note.
- Parties: Determine the status and financial and legal position of the borrower. Early in the diligence process, investors should try to be in direct discussion with the borrower as well as the lender. In addition, investors will want to understand if there is a guarantor and, if so, the wherewithal and possibility of recovery from any such guarantor.
- Title: As with all CRE investments, prospective debt investors will want to ensure proper title coverage is in place. In conjunction with counsel, investors should either confirm that they will be covered by the lender’s loan policy of title insurance and, if not, obtain their own policy. Further, title should be updated and reviewed to confirm that that no new encumbrances have been placed on title since the date of the existing loan policy. Note that buyers should also be aware of any other debt on the property, such as mezzanine loans, second mortgage loans, and/or liens. In distressed situations, liens and other encumbrances may be problematic, particularly in the context of construction and development.
- Property: Along the same lines as title and other customary legal diligence, any prospective investor should conduct thorough property due diligence. A careful review of all property documents and reports, including environmental, engineering, and zoning reports, should be undertaken. If the site is tenanted, leases and leasing agreements should be reviewed as part of this evaluation, as well as management development, brokerage, and any other agreements that may need to be terminated, replaced, or assumed.
- Tax: If investors purchase a note at a discount, they may face a tax event if they foreclose or ultimately accept a deed-in-lieu or assignment-in-lieu. The tax implications of any investment should be reviewed with accountants, tax counsel, and any other relevant advisors. It should be noted that under “market discount” rules, investors who acquire a note at a discount may be required to recharacterize gains on a later sale of the acquired note as ordinary income rather than capital gains, which can be a trap for the unwary. Tax advisors should be engaged at the outset to assist with structuring.
- Enforcement of Remedies: The challenges faced by distressed debt investors in exercising remedies under loan documents are heightened as borrowers may make claims that the note purchase and assignment was improper or deficient and is therefore unenforceable by the distressed investor. During the Great Recession, this strategy was employed by borrowers to delay or prevent enforcement of remedies under their loan documents. Prospective note purchasers should consult with litigation and bankruptcy counsel to analyze potential borrower defenses in advance.
- Bankruptcy: As with all distressed investments, the risk of bankruptcy is always looming. If a borrower files for bankruptcy, a note purchaser can no longer make collection attempts or exercise remedies such as commencing a foreclosure while the “automatic stay” under the Bankruptcy Code is in effect. A bankruptcy filing may result in a discounted sale of the property, or the note purchaser may be “crammed down,” a maneuver which allows a bankruptcy court to ignore the objections of a secured creditor and approve a debtor’s reorganization plan as long as it is “fair and equitable” and notwithstanding that it may alter contractually agreed economic terms in a manner unfavorable to the note purchaser. Given the complexities in each distressed CRE situation and in the bankruptcy process itself, potential CRE note purchasers should engage bankruptcy counsel to analyze these issues as well.
Prospective investors should not rush to step into a lender’s shoes without first understanding all the potential pitfalls of the transaction. A full diligence of the asset, the loan, and the borrower is required for an informed investment decision. Those willing to take the plunge – after, of course, performing comprehensive due diligence – may be handsomely rewarded with windfall profits.
The authors are attorneys at Goulston & Storrs where they are members of the firm’s Commercial Real Estate Workouts Group, which is a multi-disciplinary team of restructuring, real estate, litigation, and tax attorneys who guide clients through the complexities of commercial real estate loan workouts. In this ongoing article series, Goulston & Storrs will keep you up to date on the current and emerging issues related to workouts and the CRE market. For more information, email the team at DistressedREWorkingGroup@goulstonstorrs.com or click here.
