Before agreeing to provide capital to a property owner, investors should consider the following:
- Underwrite the asset’s cash flow to make sure that there will be sufficient income to repay the loan or preferred stake, and
Underwrite the borrower to ensure that they are capable of managing the property well.
- Underwriting entails analysis of the forecast cash flows, financial assumptions, market conditions and credit aspects of the discounted cash flow returns projected. Underwriting is not the same as due diligence, which is the review and inspection of the environmental, financial, legal, physical and regulatory aspects of the property.
However, when the investment do not go as planned (example: a tenant unexpectedly goes bankrupt), each capital provider must be prepared to make the best out of the situation. The complications that occur when problems arise are a big reason why it is critical for investors to be aligned with experienced capital providers who know how to navigate the process.
In commercial real estate, borrowers make payments using the cash flow from the property. The payments are made via a “waterfall.” In other words, senior portions of the capital stack are paid first and junior portions are paid in order of seniority until the cash runs out. Some waterfalls are simple payment priority waterfalls, while others are more complex and involve preferred returns. For example, if a preferred return hurdle is achieved, then a cash flow and/or sales proceeds promote (i.e., a greater percentage than the sponsor’s pro-rata split) is paid to the sponsor.
In the event of default, creditors that are not getting paid can file to foreclose on the owner.
- If there is enough cash flow to pay the senior debt and mezzanine debt lenders, but not the preferred equity, the preferred holder may make a legal claim to acquire ownership of the property.
- If the cash flow is limited to paying the senior lender but the mezzanine lender is not getting paid, the mezzanine lender can make a claim to acquire ownership of the property.
- If no lender is getting paid, the senior lender has priority in a foreclosure, but the mezzanine lender can still step up and take ownership of the property by by curing the defaulted senior loan and taking over the mortgage payments.
A key element in workouts is the value of the property relative to the position in the capital stack. Take the example of a property with a $6 million senior loan and $1 million apiece of mezzanine debt and preferred equity:
- If the market value of the property at the time of default is at least $7 million, the preferred equity holder would want to exercise its ownership rights so it can recoup some or all of its investment.
- If the value is less than $7 million, the preferred equity holder might decide against trying to take over the property in order to limit losses to the $1 million already paid out.
The same principal applies to the mezzanine lender, depending on whether the property is worth at least $6 million. The senior lender, on the other hand, will usually try to recoup whatever it can because its basis starts at the first dollar. If the mezzanine lender or preferred equity holder take control of a property, they assume the responsibility of making payments to the capital providers that are senior to their position.
As a result, if there are several layers of mezzanine debt and preferred equity, each provider must decide whether they want to take that responsibility of owning the property and how a change in ownership affects their interests. Because the foreclosure process involves legal action, it can be expensive and take a lengthy period of time. Consequently, the holders of the debt and preferred equity often will negotiate settlements with the equity holder.
Experience is crucial when dealing with defaults.
- For one thing, an experienced manager knows how to cut the best deal in a default negotiation.
- What’s more, if forced to take over a collateral property, an experienced manager has the know-how to operate properties and improve the cash flow in order to raise the value back to where it was, while in the hands of an inexperienced manager a property is likely to languish.