Debt Purchase Transactions: Beware of the Risks

Current market conditions may present unprecedented opportunities to purchase debt secured by distressed commercial real estate assets at potentially significant discounts. A record number of CRE secured loans are maturing at a time when owners are facing high interest rates, declining occupancy rates and correspondingly reduced cash flows and property valuations. CRE foreclosures are becoming more frequent.

For those looking for buying opportunities, it may seem reasonable to assume that purchasing a CRE secured loan at a discount is worthy of some consideration. However, buying CRE secured debt is very different than acquiring real estate itself. It presents unique risks and requirements and these differences can have an adverse impact on your investment returns.

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About the author:
Pamela V. Rothenberg

Transcript

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 The current financial climate is presenting an array of unprecedented opportunities for savvy commercial real estate investors. Specifically, the opportunity to purchase debt, secured by distressed commercial real estate assets, at potentially significant discounts. This market situation is a result of a record-high number of commercial real estate secured loans maturing, coupled with high interest rates, declining occupancy rates, reduced cash flows and property valuations, and an increase in commercial real estate foreclosures.

Given these less than favorable conditions for owners and investors, which show little sign of immediate improvement due to unlikelihood of interest rate reductions by the Federal Reserve, seeking buying opportunities might seem a sensible step. However, purchasing commercial real estate secured debt differs markedly from acquiring real estate, presenting unique risks and requirements that can impact investment returns adversely.

Whether as a direct strategic choice or an opportunity that presents itself, purchasing debt is a proposition that requires careful assessment. 

Before buying debt, take time to think through a few scenarios.

First, suppose everything goes according to plan; you purchase the debt and manage to service it in the typical lender fashion. You then wait until it's repaid at maturity or sooner refinanced by the borrower. The ideal scenario involves the borrower fulfilling their obligations, whether fully repaying or refinancing the debt. You might also choose to sell the performing or non-performing debt to another party, fetching an amount equivalent or higher than your initial investment.

However, if default occurs either at the outset or subsequently, you must revert to the available remedies under the loan documents. Provided that no bankruptcy petitions or other actions from the borrower are initiated, and that there are no claims from other secured or unsecured lenders or third parties, you should successfully obtain the title to the commercial real estate within the anticipated time frame and cost projections.

Of course, there are instances where things don't go as planned, but you still return your investment and achieve some profit. This can occur following a borrower default, leading you to exercise remedies that result in not obtaining the commercial real estate title. However, you still manage to obtain some targeted investment returns. This often happens when a competitive bidder outbids you at the foreclosure sale.

Alternatively, a bankruptcy petition could be filed voluntarily by the borrower or involuntarily by one of their creditors, where the plan of reorganization gets confirmed by the bankruptcy court. If the borrower can implement the said plan, they will likely refinance the debt, preventing foreclosure. Therefore, at the time of refinance, you get reimbursed for the outstanding principal, interest on the loan, and enforcement costs, resulting in a full recovery and potential return on your investment.

There are also times when you purchase the debt, exercise remedies, and acquire the commercial real estate title, but unfortunately, the process takes longer or costs more than anticipated. Such instances usually surface when you overpay for the debt, which is often the result of an inflated valuation of the commercial real estate asset securing the debt. It can also occur if bankruptcy petitions are initiated by the borrower or one of their creditors or unexpected claims by secured or unsecured creditors or other parties lead to delays and unexpected litigation and transaction costs.

And then there’s the Worst Case Scenario: Catastrophic Loss

Although rare, this is a possible outcome. There are instances where the selling lender does not own the loan, and when you buy it, you fail to get a good title to the debt. Similarly, when loan agreements are defective and unenforceable, it prevents the realization of any remedies in case of a borrower's default. In such instances, the investor fails to realize any returns on or of their investment.

Before making a decision, it’s imperative for investors to gather all pertinent facts about the debt to ensure the venture's success.

The first step involves conducting extensive due diligence on the debt. This includes examining the loan documents governing the debt, with special attention to whether the debt has been securitized. This step would also involve a comprehensive legal evaluation of the seller’s title to the debt, the enforceability of the loan documentation, and the specific remedies available to the investor under the loan documents.

Next, it’s crucial to understand its fair market value and to anticipate the impact a foreclosure sale might have on significant occupancy leases. The loan file should also be reviewed to uncover any potential claims the borrower might have raised against the lender or any other threats that could emerge during the debt's life cycle.

To ensure a seamless debt acquisition process, investors should also understand the laws of the jurisdiction governing the loan documents and occupancy leases. This understanding will equip the investor to anticipate any possible complications while exercising remedies.

Taking into account the specific circumstances surrounding the debt, it's necessary to evaluate the likelihood of the borrower contesting the investor's actions or even filing a bankruptcy petition. This should influence the strategy adopted when exercising remedies under the loan documents.

After establishing the borrower's likely position, the investor needs to map out the most likely path to follow when exercising their remedies under the loan documents. This includes creating a timeline for pursuing these remedies, factoring in local law and custom. 

Pricing the debt is a crucial aspect of the acquisition process. The price should be based on the lower of two factors: the estimated value of the property securing the loan and the maximum amount you are willing to pay to achieve an acceptable yield, assuming full performance and pay-off at maturity by the borrower. It's also critical to factor in any risk discounts associated with the specificities of the loan.

Finally, the debt acquisition should be painstakingly documented, ensuring a complete set of loan documents governing the debt and the necessary paperwork for debt transfer.

Remember to obtain an assignment of the selling lender’s mortgage title insurance policy. An updating endorsement should be added, changing the name of the insured to the debt purchaser and including the recorded assignment/transfer of the deed of trust or mortgage.

After you purchase debt, you become a lender. That means you must conduct yourself as a lender and that you assume risks of lender liability.

In regards to lender liability, it is essential to exercise discretion, act in good faith, and not exploit the borrower's predicament. Therefore, buying a loan with the sole goal of foreclosing on the real estate serving as collateral may pose a lender liability risk unless you're prepared to handle the potential fallout.

Following are some general do’s and don’t’s to help guide you through the process:

Where possible, seek distressed debt. This type of debt comes with a reduced risk of challenges to your rights to remedies.

Prioritize first-lien real estate secured debt with an attached mortgagee title insurance policy. This strategy minimizes the likelihood of bankruptcy filings by the debtor or its creditors.

Endeavor to acquire debt where the principal amount considerably surpasses the real estate’s value securing the debt. In such a scenario, a debtor's likelihood of successful reorganization under bankruptcy laws is reduced.

Acquire debt where you are the sole secured creditor with few other unsecured or mezzanine lenders, decreasing the risk of conflicting lender interests.

Now for the don’t’s:

Avoid debt possessing a lender participation feature or where the lender retains an equity position with the borrower.

Avoid scenarios where the court may transform the debt into equity through equitable subordination or debt recharacterization.

Avoid purchasing debt where the full principal amount hasn’t been advanced by the selling lender.

Avoid situations where contentious conduct exists between the selling lender and the borrower.

In conclusion, while purchasing CRE secured debt introduces a new breadth of risks and issues, these challenges can be managed with proper analysis and strategic decision-making. In doing so, you are more likely to realize your targeted investment returns. Nonetheless, remember that every debt acquisition is unique and calls for careful case-specific analysis.

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