Real Estate Workouts: Cash Flow Mortgages

Thankfully, not all commercial properties are underwater or over-leveraged; however, even properties with relatively low loan-to-value ratios may experience extended bouts of cash shortfalls. A borrower failing to meet its debt-service obligations under existing commercial mortgage terms may negotiate with the lender to modify the loan to a cash flow mortgage. With a cash flow mortgage, the borrower’s debt service obligation at any point during the loan term is measured by the availability of cash flow at that time. The scenario that most often calls for a cash flow mortgage is a property temporarily in distress such as a property with a large tenant vacating space and there are reasonable expectations to re-lease the space for comparable or higher rents. In this situation, a lender with an outstanding mortgage loan likely to be defaulted may be willing to convert to a cash flow mortgage rather than foreclose or take a deed in lieu of foreclosure. Alternatively, the owner of a distressed property may be able to sell it for a price somewhat above the amount of the existing mortgage, with the seller taking back a purchase money cash flow mortgage in lieu of cash.

Commonly, loan agreements permit a lender to control the property’s cash receipts and disbursements if minimum debt service coverage ratios or other financial covenants are not met. The priority of payment varies between making operating expenditures, paying debt service, paying subordinate debt or funding reserve accounts based on terms of the loan agreement. In some cases, operating expenditures are subordinate to debt service payments, resulting in inability to pay operating expenses, thereby adversely affecting the property’s upkeep and tenants. A lengthy postponement of repairs or replacements solely in order to meet current debt service is detrimental to the property, its tenants and possibly its neighbors. Formal loan modifications can reset the priority of the property and servicing of the tenants for awhile. Still, the required debt service payments would then fall short under an unmodified loan. Changing over to a cash flow mortgage results in a compliant loan.

A bank approving a loan modification will have one less non-performing loan or REO property on its balance sheet. The lender also avoids time and costs associated with the foreclosure process. This keeps the risks of ownership with the borrower, and the lender or servicer avoids the need to monitor costs to ensure borrower is not deferring maintenance. Renegotiating the terms also provides opportunities for the lender to increase the interest rate and seek a partial loan pay-down and for the borrower to obtain advances for tenant improvement or releasing costs. A cash flow mortgage acts like a bridge loan without the borrower incurring the costs and inconvenience of seeking short-term financing. It also provides time for the borrower to stabilize the property and seek alternate longer-term financing. A revised loan also mitigates a borrower’s going-concern issues. It also allows the underlying borrower to maintain its reputation, relationship with the lender and credit history.

A CMBS note has multiple noteholders compared to a bank-held note. Therefore, a special servicer of a securitized note may be less inclined to modify a loan for fear of lawsuits from different tranche holders. Similarly, the senior CMBS tranche holders may push for foreclosing and liquidating the property to ensure their return of capital and potentially squeezing out the junior tranche holders. A modified loan may yield a lower return to the lender or noteholder even if the cash flow mortgage is satisfied at maturity because the delayed interest and principal received adversely affect the rate of return. Net cash flow available for debt service under a cash flow mortgage may be lower than owning the property outright because of special expenses. Before both parties agree to the loan modification, they should also consider whether accounting issues in the transaction would result in the recognition of cancellation of indebtedness for income tax purposes.

Lenders also have to consider the recent Financial Accounting Standard Board’s proposal to require banks to mark-to-market notes held on its balance sheet. These notes are recorded at amortized cost under current pronouncements. Borrowers should consider alternate financing, including hard-money lenders, as the credit markets have gained traction in the first quarter of 2010, and rates may be lower than that being offered for changing over to a cash flow mortgage.

This type of modification should not be mistaken for the widespread practice of “extend and pretend” wherein the lender or servicer extends a cash-flowing property’s maturing loan that cannot be refinanced in the current state market. In such cases, the lender may only be delaying the inevitable, and losses will eventually need to be recognized upon price discovery if commercial real estate prices, loan-to-values and occupancy levels do not return to their pre-recession levels in the near-term.

Some finer points with respect to structuring a cash flow mortgage include how to calculate cash flow. The negotiations will involve what constitutes revenue and deductions from revenues to arrive at cash flow. Revenues should include rents and other operating income on a cash basis rather than accrual. If capital proceeds are taken into account, revenues should be limited to net proceeds such as insurance proceeds reduced by casualty-repair charges. Some lenders may require that revenues be increased to reflect market rents when space in the building has been leased at below-market rates, particularly to the borrower’s related entities. Expenditures in connection with the ownership, operation, repair and maintenance and use of the property should be deducted from revenue in the cash flow calculation. However, the difference in legalese between “necessary and customary” and “reasonable” could result in drastically different deductions. Further, the borrower will want to deduct the cost of certain maintenance and capital expenditures, such as tenant improvements and replacements and commissions.

To the extent cash flow is insufficient to pay the entire interest due, the unpaid interest is deferred. If cash flow at any point is above current-due interest, the excess is typically applied to past-due interest. Some items to consider when structuring the mortgage include whether deferred interest will itself accrue interest. Also, is deferred interest treated as an addition to principal? If so, interest will increase at each future installment based on higher principal balances. The lender may desire to limit the deferral period or permit deferral of interest until the maturity of the loan.

Delinquencies continue to burgeon. The CMBS delinquency rate was 8.42 percent in May, up 40 basis points from the previous month and 565 basis points from a year ago, with lodging and multifamily sectors leading the way at 18.45 percent and 13.34 percent, respectively, according to Trepp LLC, a real estate research firm. Similarly, Foresight Analytics, a division of Trepp, estimates first quarter 2010 delinquency rate for U.S. bank and thrift-held commercial mortgages at 5.5 percent, up from 5.1 percent for the previous quarter. As such, the most difficult part for a borrower attempting to modify a note may actually be getting the attention of an already swamped lender or special servicer.