Refinancing: Properties Under Pressure
Real estate markets continue to struggle in the current recession, with weakness primarily due to lower demand rather than large new supply coming to market. As a result, many owners' income properties may be experiencing significantly lower operating income and be close to the point of distress, where current rental income is insufficient to pay operating expenses and debt service. A property owner in this position should consider whether to seek a restructuring of existing mortgage loans that carry interest rates significantly higher than current levels. How should an owner proceed in this situation?
The first point to remember is that a lender will agree to restructure a loan only if convinced this is the best (or least distasteful) alternative in dealing with a loan under pressure. The lender must also have confidence in the borrower’s ability to manage the property in harmony with the lender.
Restructuring the Debt
The borrower wants the lender to restructure the debt in one form or another. Possible formats include:
- Reducing the debt service constant
- Accruing interest
- Using a cash flow mortgage
- Providing additional financing
- Creating good/bad loans
- Creating a third-party agreement
If the property is now in a negative cash flow position, one approach is to cut the monthly constant by one or two percentage points. For example, a loan of $750,000 might have been secured by property worth $1 million that was generating net operating income (NOI) of $100,000 annually. If the loan carried a 9% interest rate and a 10% constant, debt service would be $75,000, leaving a $25,000 cushion. If high vacancies and increased operating expenses cut NOI to $60,000, the property would have a negative cash flow of $15,000. Reducing the constant to 8% would put the property at a break-even point. A lender might agree to this for a specified time, after which the constant would return to its former (higher) rate.
Another approach to the same end is to reduce the payment rate of interest while accruing the difference between it and the contract rate. For example, the rate could continue at 10% but only 8% might be payable currently, with the remaining 2% accrued for a period of years or until loan maturity. (One issue is whether the accrued interest will itself accrue interest.) A possible advantage of using this approach over a straight interest reduction is that it is more likely to be deemed a modification of the existing debt rather than an exchange of old debt for a new debt. The latter can have tax disadvantages for the borrower.
Cash Flow Mortgage
In a cash flow mortgage, the lender receives all cash generated by the property except that required to meet operating expenses. The lender may require that its consent be a condition to any capital improvements or cash distributions to owners. This type of mortgage, in effect, makes the lender and the borrower partners in the property, so the lender will want to closely monitor its management. One risk with the cash flow mortgage is that if the property is subject to other loans, the cash flow lender risks being held liable to them or becoming subordinate to their liens if the lender’s actions are deemed prejudicial to them.
If the lender is optimistic about the recovery possibilities, it may agree to advance additional money to finance current operating expenses and to make capital improvements. The new money can be secured by a junior mortgage on the property or by other collateral, such as personal assets of the borrower. If the property already is subject to junior financing, the junior mortgagee may be willing to subordinate his loan to the new loan, since it is in his interest to avoid a foreclosure.
If the current value of the property is substantially below its book value, the existing loan may be separated into a good loan and a bad loan. The good loan, calculated as a percentage of current market value, might carry a market interest rate. The bad loan, calculated as a percentage of the difference between market value and book value, might pay a reduced or deferred rate or it might be structured as a cash flow mortgage.
Participation by Lender
In return for any of the relief measures described above, the lender may ask for some form of participation in future cash flow or refinancing/sale proceeds. Alternatively, the original loan may be divided into a conventional mortgage and a participating mortgage. Initially, no return may be received by the lender on the participation loan since all cash flow available for debt service will go to the conventional first mortgage. However, if and when the property turns around and cash flow increases, the lender can anticipate receiving a participating share.
This article was written by Brian Bader and originally appeared in BDO USA, LLP's "Real Estate Monitor" newsletter (Fall 2011). Copyright 2011 BDO USA, LLP. All rights reserved. www.bdo.com. Somerset is a member of the BDO Seidman Alliance, a nationwide association of independently owned accounting and consulting firms.
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Somerset CPAs, P.C.
3925 River Crossing Pkwy.
Indianapolis, IN 46240