Distressed Commercial Real Estate – Discounted Loan Payoffs
Some of these distressed loans were extended during the financial crisis of 2007/2008, offering modest pay downs and deferring their ultimate repayment. The focus of this article is on distressed commercial real estate with loans secured directly by mortgages and loans secured by an interest in an LLC or partnership or other entity whose assets are primarily real estate.
A discounted loan payoff (DPO) is the repayment of a loan for less than the outstanding balance. DPOs are typically reserved for distressed assets that have declined significantly in value. The write-off of any portion of the loan principal is an expensive proposition to the lender. Prior to accepting any such loss, the lender determines that the borrower is unable to infuse additional equity and the prospect of foreclosing upon and selling the asset will not recover the principal. The payoff amount with the lender should approximate the value that the lender expects to recover from the asset through the foreclosure process. DPOs allow the bank in clearing troubled debt and create capital for future lending.
DPOs can be financed with new debt or additional equity. A key consideration for any investor in a distressed debt transaction is identifying the cause of the distress. Pricing of distressed debt is driven primarily by loan resolution or exit strategies, loan terms, underlying cash flow and value, guarantees, capital needs and related risk and return factors. These variables are subject to due diligence. Targeted rates of return reflect the risk in the underlying property, market and loan resolution strategy. The underwriting of troubled debt typically involves cash flows for the loan resolution strategy. There are two general types of investors, namely yield or return investors and ownership driven investors. Investors who navigate these factors are presented with the opportunity to acquire interests in commercial properties at a discount. Borrowers are able to utilize any equity infusions to perform critical tenant improvements to retain and attract new tenants, thereby starting down the road of increasing the property’s value.
The distressed commercial real estate market is complex. Many of these loans are intricately structured. There are also more stringent bank loan underwriting criteria and rising interest rate uncertainties. Due to these complexities, investors should consult with advisors and financiers who are experienced in distressed debt resolutions. Loan restructurings may have significant tax consequences to both the lender and the borrower. Generally, the cancellation of indebtedness by the lender results in taxable ordinary income to the borrower and the lender would reflect a corresponding loss. Investors should consult their WS+B partner to discuss these tax and other implications.
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Stephen Tuffy, CPA, CIA 212-751-9100 [email protected]
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To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
