Commercial Development News - Appraisal Development International

Strategy of Last Resort: To Default or Not To Default?
Although It May Get a Lender's Attention, Defaulting Is Considered a Risky Debt Strategy

By Mark Heschmeyer
CoStar Group
Published: Jun 2, 2010

As the volume and number of underperforming commercial real estate loans mounts, so has the number of owners who have or have considered turning to loan defaults as a strategy for forcing a refinancing or to get out from a loan that is underwater altogether. However, experts say this is a high-risk strategy for managing troubled debt at a time when access to money has become tight and as regulators pressure lender away from workouts.

John B. Levy & Co. drew attention to the issue this past week in a podcast called "To Default or Not Default? That Is the Question."

"What we're seeing is that some borrowers are being advised to stop paying on their loans if they want to get a discount . . . to default," said Andrew Little, principal at John B. Levy & Co. "And that is really bad advice. Borrowers who are experiencing problems with their debt need to take a more measured approach when working with lenders."

Even as some borrowers are facing the prospect of default, lenders are holding onto a substantial amount of capital. In fact, Little suggested that there is more capital available these days than there are good deals to fund. The total disarray of the global market over the past couple weeks has resulted in a run on hard assets, and investors are vigorously pursuing real estate in the U.S.

"What we're seeing is a 'Tale of Two Cities' scenario," Little said. "There's a lot of capital available in gateway cities, and then there's everyone else - the secondary and tertiary markets. And as for the lending world, investors are ready to make loans on the premium properties, but they're turning away from properties that aren't at the top of the A-list."

CoStar Group put the question of whether a loan default should be considered a viable strategy to a number of other industry professionals. Their answers, for the most part, suggest the strategy can be viable, but only after other options have been exhausted and all that is left is bankruptcy, a short sale or a deed-in-lieu.

"I would not advise clients to walk away. I don't think it's worth ruining a professional lending relationship that may have taken years to develop," said Charles G. Argianas, president of Argianas & Associates in Downers Grove, IL. "Unless the borrower absolutely cannot make debt service, I would not advise clients to walk away from their responsibilities, I just wouldn't."

"We have seen CMBS borrowers defaulting on loans prematurely as a tool in order to get more attention from their lenders and special servicers," said David Goldfisher, principal of The Henley Group Inc. in Natick, MA. "Typically, well thought out and detailed plans for resolving a troubled loan in advance of a default is a much more effective way of communicating with your lender and will provide them the right incentive to negotiate in good faith."

"Default is always an option for owners and always has been, but it should be the last strategy after previous attempts to contact the lender or special servicer," said Mark J. Chapman, senior vice president of PM Realty Group in Hudson, MA. "It may be an effective strategy if the lender/special servicer is too busy to focus on a particular owner's issue. However, it is only effective if a borrower/owner has several viable options to put in front of the lender that address both property issues and the lender's regulatory constraints."

But while the consensus recommendation may be to avoid defaults, the reality is: it is happening, and happening successfully in some cases.

"We recently sold a multifamily asset in Mesquite, TX, in which the owner defaulted and was 60-days delinquent," said William C. Jarnagin, an associate with Marcus & Millichap in Dallas. "During the process of closing, we stepped in to assist the borrower with negotiations with the lender and the lender actually reduced the interest payments on the loan by half for one year and gave a conditional agreement to extend for another year. We are working several assets where the borrower has considered this currently."

"This is only an effective strategy for distressed debt that will undoubtedly need a significant write down to clear the market if the lender does end up owning the asset," Jarnagin added. "There has to be a significant level of distress. Physical deficiencies and code issues are likely to weaken the lenders desire to take possession of the asset. Properties that are nearly covering debt service and do not need significant capital injections are not likely candidates."

Todd A. Carlson, a senior associate with Marcus & Millichap in Houston said the strategy has been used more successfully with CMBS-type debt because of the ability for special servicers to modify loans that are in default or non-payment status.

"I think it is used in situations where the debt is non-recourse so the lender/special servicer must just rely on the asset to recoup any losses," Carlson said. "If a borrower can prove that they weren't the reason for the default, and they are a quality owner/operator, the lender might consider them the best option with the fewest costs and liabilities."

Dan Colton, principal of Colton Commercial in Tempe, AZ, said the strategy of pursuing a loan default is also sometimes used in cases in which there are multiple loans on the property.

"The borrower defaults on loans in second and third position while keeping the first current. Drawing the secondary lender(s) to the table appears to be a viable option that is starting to occur in the market place," Colton said. "Other conditions to obtaining potential discounts are strengths associated with loan guarantees, if the lender can absorb the discount or if the notes have been sold."

Marty Busekrus, an investment sales associate with NAI Rauch Weaver Norfleet Kurtz & Co. in Fort Lauderdale, FL, sees this used as a strategy more commonly on the CMBS side where the special servicers are not inclined to deal with the sponsor until the borrower has defaulted.

"Once the loan goes in to the 30 days past due case, the bankers are all over it and that's when the special asset managers and attorneys get involved," Busekrus said. "That could go either way for a borrower. It's true, you will get the attention of the bank, but probably not the good kind of attention. Depending on who the special assets manager is, they may be very experienced and been around the block a few times, in which case the strategic default may not work out in the borrowers favor."