Friday, June 12, 2009

Loan Paydowns from the Borrower’s Perspective

I previously posted comparing CRE underwriting in 2006 and today (bottom line, even if your project income is unchanged, loans are 15-20% smaller, mostly because cap rates have increased). Suppose you have one of those 2006 loans and it’s maturing. What should you do? A look at the numbers reveals borrowers are much better off if they can negotiate an extension.

Here’s an example drawn from an actual deal done in 2006. The original underwriting and today’s underwriting is summarized in the table below:


Key points to note:

  • The value of the property is a little less than the current loan as a result of the NOI decrease and the higher cap rate. In other words, the original $2.2M cash invested is gone.
  • The property now supports a loan of only $4.5M. In other words, to refinance the current loan, the borrower will have to put in an additional $1,551,328. The new debt and borrower cash investment total $8.2M on a property worth $6M.

Now, there are whole sets of cognitive biases which predispose people to overvalue what they own (endowment effect, post-purchase rationalization), continue to do what they've done in the past (status quo bias, sunk cost effects, loss aversion), and expect a positive outcome to their choices (optimism bias, and valence effects). We know these biases exist, and their existence helps explain why borrowers continue to perform on loans when it makes economic sense to walk away. However, when it comes to writing seven figure checks, people get rational in a hurry. We are not going to see many people contributing large amounts of money to refinance properties which do not have equity.

So, what are the borrower’s options? One is to walk away from the original $2.2M investment and default on the loan. That would make sense if the borrower sees no possibility of a value recovery on the horizon. However, almost all borrowers do foresee a recovery, want to stay in the game, and will request an extension of the loan. The most common requests are an extension at the existing contract rate, or an extension at the current market rate. The table below summarizes the economics of those scenarios, plus a third option:


Note that although nothing solves the value problem (it takes higher NOI and/or lower cap rates to do that), there is cash flow under each scenario which is a reason for the borrower to stay with the game. To make an extension more attractive to the lender, the borrower could offer to apply some or all of that cash flow to pay down the loan, or sweep it into a reserve account as a hedge against further declines in NOI.

The third scenario (Till) represents how the loan could be restructured in a bankruptcy (for more on Till, Lee, et ux. v. SCS Credit Corp, see my post Getting Tilled: How a $6,425 Truck Loan May Decide the Fate of General Growth Properties). Since this is clearly the worst case for the lender, you might think lenders would avoid the risk and extend loans without a lot of argument. I identify some of the reasons lenders may fight it out in the post What Should Lenders Do With Maturing CRE Loans?