Distressed Property: Chronology of a Defaulted Loan

As uncertainty about the economy continues, lenders and investors are well-advised to review the warning signals of a distressed property so that preventive action can be taken. These warning signals frequently appear in some variation of the following pattern:

• Deferred maintenance

• Over-financing

• Rising vacancies and declining rent receipts

• Tax delinquencies

• Default in debt service payments

Deferred Maintenance
The failure to keep an income property in sound operating condition often is the earliest sign of trouble. The best protection is to have the property inspected at regular intervals by a person trained to spot signs of deterioration (e.g., leaky ceilings on a top floor showing defective roof, cracks in bearing walls, rusted metal, etc.). In addition, periodic operating statements from the owner should be scrutinized to identify (and verify, if necessary) repair and maintenance expenses.

Over-Financed Property
An over-financed property is one lacking a "cushion" to protect the lender, i.e., little or no cash remains for the owner after operating expenses and debt service have been paid. In this situation, even a small increase in expenses or decrease in rentals will mean negative cash flow and the risk of default. A property may be over-financed when the loan is made (often reflecting poor underwriting) or may become over-financed as a result of a declining spread between expense and income. Periodic balance sheets listing all debt, together with operating statements, often will signal a potential problem. Calls to the first mortgagee by a junior lender inquiring if debt service is current is a tip-off that payments may be late on junior loans. Another sign not to be overlooked is payment of debt service by checks drawn on unknown or distant banking institutions.

Rising Vacancies and Declining Income
Any indication from operating statements or otherwise that vacancies are rising or that rental income is not keeping pace with rising expenses is cause for concern. This is likely to be due to causes beyond the owner's control. But rising vacancies may be the result of poor tenant selection or physical deterioration, which in turn may reflect deferred maintenance. Such problems may be curable. And if a squeeze on cash flow is due to temporary factors, a lender may be more willing to work out a forbearance program with the owner if debt service cannot be maintained.

Tax Delinquencies
A major sign of trouble is failure to pay real estate taxes on time, particularly when a substantial penalty can be imposed. A lender should never be in the dark about failure to pay taxes; the mortgage should require copies of receipts from the owner 30 days after the due date. Since property assessments often are too high, a lender should seek to be aware of possible tax overcharges and require owners to apply for reassessments in appropriate cases.

Default in Debt Service Payments
A default in a mortgage payment is usually the end of the line. At this point, a lender that ignored earlier warning signals or that sought unsuccessfully to help the owner solve his problems is faced with the question of workout or foreclosure.

Worst Case Scenario
The "worst case" of a problem loan involves a not-overly scrupulous owner of an income property who comes under extreme cash pressure for any one of a number of reasons. Having only small cash equity in the property, the owner decides the time has come for drastic action. The object is to abandon the property after recouping any remaining equity. This goal is achieved by stalling on mortgage payments for three or four months through a number of devices, including late payments, mistakenly "unsigned" checks and one or more meetings with the lender that fail to achieve any results. During this period, few or no operating expenses are paid while the owner accumulates the gross rentals, often enough to reimburse equity, at which point the owner walks away from the property. Prompt action by a lender when signs of distress appear can prevent this scenario from occurring.