The signs for commercial real estate are ominous. It is estimated that more than $800 billion of commercial mortgage debt will mature over the next three years. Multiple factors, including tight credit, declining property values and rising vacancy rates, suggest many borrowers will be unable to refinance or sell their projects for amounts sufficient to repay maturing loans.

Even loans that are not maturing may face distress as tenants fail and rental income declines. Some analysts expect the default rate for commercial loans to triple in 2009, with a 3.9% default rate by the end of the year. Estimated default rates for construction loans stood at more than 11% at the end of 2008.

Triage and diagnosis

Loan defaults typically are resolved by a consensual restructuring or with the lender acquiring the property. To reach a favorable resolution, borrowers should take inventory before default by asking:

  1. Can the project ultimately succeed?

  2. What loan modifications are necessary for a project turnaround?

  3. What is the financial exposure, such as potential personal liability?

  4. Can additional equity be committed and financial exposure increased?

  5. What lenders are in the capital stack?

  6. Is bankruptcy an option?

  7. How much is owed, what is the property worth and what is the tax basis?

The borrower's first choice typically is to restructure the loan with new terms that enable the project to succeed and that the lender finds preferable to foreclosure. The proposal should be tailored to the specific project and loan.

Sometimes the solution is easy. Assume the project is a stabilized office building that can pay its monthly debt service, but the loan is maturing and the borrower cannot satisfy extension conditions tied to debt coverage and loan-to-value ratios. The modification could be as simple as a 6- to 12-month extension.

Other situations are dire. Consider a 125,000 sq. ft. shopping center that was fully occupied and co-anchored by a Circuit City at loan closing. It now has a shuttered big box and a 50% vacancy rate, and the remaining anchor is paying reduced rent because of a co-tenancy clause tied to Circuit City.

The modification could involve converting the loan to a so-called cash flow mortgage, with payments capped at 100% of cash flow and excess interest accruing. Such an agreement could also include additional advances for project improvements and leasing costs as well as a principal write-down.

The borrower should demonstrate that the new terms enable ultimate repayment and are not delaying foreclosure. The borrower also should be prepared for demands such as a higher interest rate, a principal paydown and additional guaranties. Moreover, many projects have a complex capital stack, and the borrower must satisfy multiple lenders.

In the last major real estate downturn, some borrowers used bankruptcy to force the restructuring of loans. That result may now be unattainable. Many current loans are structured to make it more difficult for the borrower to file bankruptcy and include a powerful deterrent — a so-called springing guaranty whereby principals become liable for the loan upon bankruptcy. The project often is the borrower's only asset and may trigger rules that make it more difficult to block foreclosure efforts and emerge from bankruptcy.

Nasty side effects

Troubled loans, even if restructured, can have severe tax consequences. Restructurings can result in cancellation of indebtedness (COD) income. And foreclosures and deeds-in-lieu can result in COD income and gain, even though no cash was actually received.

The next few years will be rough for many borrowers. Advance planning may enable some owners to retain their projects. So, practice preventive medicine before the diagnosis becomes dire.

Edward C. Hagerott Jr. is a partner in the Real Estate & Real Estate Capital Markets Group of Goodwin Procter LLP and is based in its Los Angeles office. He can be reached at ehagerott@goodwinprocter.com.