When purchasing a “distressed” commercial real estate loan, it is essential to understand the nature of the defaults and the motivations of each party involved in the deal and transaction. Diligence is the key.

Start by extracting your sources. How did you find out about the availability of the loan? A broker ? A public record, like a foreclosure complaint? Sign a non-disclosure agreement and access the data room and get as much information as possible.

After confirming what you got, review and analyze all the latest loan and property information available.

To get started, get copies of:

  • Mortgage documentsincluding all warranties and endorsements.
  • Notice of Default and Dispute Documents (if a foreclosure has started).
  • Any pre-negotiation or forbearance agreement with the Borrower and any information provided to the Mortgage Lender pursuant to such agreements.
  • financial state for the borrower and the guarantors (diligence of the sponsor and the principals).
  • Budgets, list of rents, information concerning reserves, capex, etc.
  • Copies of all leases, rent register, any relevant information regarding tenant performance and tenancy status.
  • Management agreements and service contractsmaybe union contracts.
  • If there is ongoing construction work (including ongoing tenant improvement work), obtain copies of the construction contracts, architect contracts, claims for payment, lien waivers, construction inspection resultsetc
  • If there’s a mezzanine loan — so there’s a “debt pile” — getting a copy of intercreditors agreement (ICA) between the mortgage lender and the mezzanine lender and the mezzanine loan documents.
  • If the interest purchased is a mortgage note or equity, get the co-lender agreement or the participation agreement.
  • Are there preferred shares in the agreement? If so, get one copy of joint venture agreement (to determine the protections granted to the holder of preferred interests).
  • Obtain and Review all third party reports obtained at loan origination, such as environmental, engineering and zoning reports.
  • Order one new title report— new privileges could have been recorded!

So start to review and review loan documents. In this regard:

  • Carefully review all loan documents and any collateral agreements.
  • Understand the nature and importance of defects. Is the fault a technical fault? Is the borrower or guarantor able to remedy the default? Confirm default requirements and notices.
  • Are there defects in the loan documents/assignments/signatures/perfection of guarantees? Have loan documents been properly filed/recorded? Were they all signed and notarized?
  • Have they or can they be corrected via a pre-negotiation or forbearance agreement with the borrower?
  • Are there ceilings (or limits) on the guarantees obtained at closing? Diligence the guarantors.
  • Are there any restrictions on the assignment of debt?
  • If applicable, review the pre-negotiation agreement and pay attention to what the selling lender may have discussed with the borrower.
  • If applicable, review the forbearance agreement.
    • Typically, a forbearance agreement obligates the lender to defer corrective action in exchange for changes to the underlying loan documents or other benefits to the lender.
    • For example, in return for agreeing to forbear (and granting a covenant and other relief), a lender may obtain fees, institute cash management, increase the interest rate payable on the loan, obtain additional guarantees or additional guarantees. It can also fix “flaws” in the loan documents at this stage.

At the same time, pay attention to ownership and warranty – ask questions!

  • Analyze environmental, engineering and zoning reports. Are property taxes up to date?
  • Diligence of rents and role of rents, leases and other income.
  • If construction is underway, obtain and review all construction-related documents (requisitions, liens and lien waivers, reports provided by the construction consultant, etc.).
  • If loan is a construction loan, review construction agreements and “serve” letters with/from general contractor or construction manager, architect, material subcontractors.
  • Inspect the property, if possible.
  • Get an updated title report and review the title (and any exceptions underlying the title) and investigation. Are there mechanic privileges on the title? Judgment or other privileges?
  • Does the loan come with cross collateral so there are multiple properties in a portfolio?
  • Is the cash “managed” by the lender? Are there any reserves maintained under the loan?
  • If the property is a hotel, review the management agreement and franchise agreement, as well as comfort letters or SNDAs with hotel managers and franchisors.
  • Are there any privileges attached to the property and have these changed since the origination of the loan?

Who are you dealing with? Diligence the borrower, the guarantor and the sponsor.

  • Review financial information of borrower/principals/guarantors.
  • Review existing financial clauses; consider caps on guarantees.
  • How much equity is left in the project?
  • Do the borrower’s organizational documents provide for an independent director to vote in bankruptcy?

Who are you dealing with? Diligence the loan seller.

  • The purchase and sale agreement may include surviving representations – can the loan seller fulfill them?
  • There may be environmental issues/liabilities that are the responsibility of the seller of the loan that impact the analysis of the seller’s financial condition.

Who are you dealing with? Is there a mezzanine loan and a mezzanine lender?

  • If there is a mezzanine loan, what protections have been given to the mezzanine lender in the ICA? (We discuss some of these protections in The Role of ICAs Between Mortgage and Mezzanine Lenders and Mezzanine and Construction Lending – ICA Considerations and Provisions.)
  • Does the mezzanine lender have healing rights? A possibility of purchase?
  • What if the mortgage lender is considering a deed in lieu? Does the mezzanine lender have certain protections in this case?
  • What approval rights does the mezzanine lender have on changes to mortgage documents?
  • What notices will need to be sent to the mezzanine lender in connection with acquiring the mortgage loan?
  • And who is the mezzanine lender? What is his ability (or appetite) to heal or step in and acquire the mortgage?

When it comes to acquiring distressed commercial mortgages, it bears repeating – diligence is key.

This is the first in a series of articles exploring key considerations for acquiring distressed real estate debt. In our next article, we look specifically at distressed mezzanine loans.

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