S.E.C. Real Estate Observer

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As we all know, it’s hard to fly like Superman not only when your cape is on fire, but when you have a portfolio filled with Debt laden properties that are ready to hit the proverbial lender graveyard. Historically, Debt has undermined many great fortunes. Among our founding fathers, Jefferson, Adams and Franklin, (and most of the other founding fathers) experienced the continual and unrelenting anxiety associated with maddening Debt. More pertinent perhaps, today we are witnessing many of the same people problems and issues. Large and small developers and investment owners are struggling to make payments, doing their best to recast Debt or are literally walking away from projects. It is certainly not a time for the meek and mild.

The recent Carefree, Arizona S.E.C. meeting was an historically typical “downturn” marketing session as evidenced by the presentation of many properties burdened with a Debt problem that a year or two ago would have been considered “just fine.” The market deterioration and unquenchable lender resolve to get capital back into their coffers has repositioned values and has ultimately reduced equity to areas often much lower than ever anticipated. Some are below Debt amounts. The single family housing issue is a good example of this phenomenon. Reverse values are rampant when Debt is more than the value of the home or property.

Debt becomes sinister in some cases and casts the relationship between borrower and lender into an awkward and often time’s litigious position as both scramble to gain positions to protect themselves. Adversarial situations pop up, friendly relationships are jeopardized, and things often get personal. Debt is a mean adversary when antagonized and puts us in positions not wanted and not often experienced. It has a nasty habit of becoming not only a financial problem, but a people problem.

With eight years in the banking business before starting my real estate career, I got a good taste of the philosophical viewpoint of lenders. I euphemistically refer to lenders and their institutions as “The Thieves Temple.” Okay, I don’t presume all lenders are bad as I continue to deal with some great lender personalities who maintain the right balance between relationships and business. They generally don’t lose their head in times of difficulty and are mindful of the future relationships they hope to salvage. However, in some cases the old adage of “If you need a heart transplant, ask a lender for his cause it has never been used,” is pertinent. Some of the tougher lenders, who purported to be your “relationship banker” in the past, are your pal in the good times and generally turn the file over to Guido, the in house work out guy, if your value and property deteriorate causing a loan problem.

I have also realized that Debt is not separate from real estate, but is part of real estate. Sounds kind of obvious I know, but it is important to reaffirm that both are joined at the hip. Therefore if it is part of real estate and we are practitioners of real estate then we must accept the fact that Debt, in its myriad forms, must be understood as a tool in developing equity and leveraging acquisitions.

If your new property needs to have the parking lot paved you research the various paving alternatives, asses cost, quality and quantity. Seldom do we think of debt in the same terms. It is a part of the entire property. It should not be divorced from consideration or be an afterthought. Colby Sandlian, S.E.C., and a mentor to many of us, stressed the importance of a ¼ point difference in a loan by measuring the dollar effect over many years. The details of your Debt are important.

Don’t overpromise. This is a big one that we should guard against when considering the initial loan and before signing documents. Most often, the problem of debt starts when you negotiate the Debt terms and responsibilities without due consideration to the long term effect. In our haste to “pay off” another loan or “get the deal done,” we may sacrifice our perspective and pay little attention to details. This may be a collision course for a future and possibly bigger problems.

Okay, so what about this Debt issue? How can we deal with it? Well the first thing is we can’t get too emotional about it. As noted previously, Debt is part of the property. You wouldn’t get emotional about a parking lot problem would you? Compartmentalize the Debt problem. As with most of you, this is a hard one for me because I take my obligations very seriously. We all must strive to honor our obligations. If, however, a realignment or modification ensues, I take it personally, (flying like Superman eh?) as my honor is at stake. Fortunately, I have avoided a lot of these issues over the years, but none the less we are all affected from time to time in varying degrees. The economic turmoil of today’s market brings this closer to home. Certainly our clients are often times in OZ when it comes to dealing with problems like this. That is why they need us.

As noted, the inability to fulfill the obligation of a Debt is one area where even the most skilled of us have had to swallow our pride and forage for a solution that would appease the appetite of the Lender before it engulfs any remaining equity. If the value of the asset falls below the Debt, the Lender may thirst for and pursue a personal deficiency (guarantee) if the Lender falls short of its goal to achieve full recovery of the obligation. This is often devastating emotional baggage for most borrowers. I call it “Borrower Purgatory.” (I have written a separate article on “guarantees” which may be of interest).

Depending upon the circumstances it may be best to personally sit down with the lender and discuss the options, or in the alternative, again depending on circumstances, sit down and map out all the possible conceptual ideas for solving the problem. Sometimes a brainstorming session with one or two S.E.C.’s or others can add additional insights. I use a program called “MindJet Manager” which is a great tool to use when you have an issue or process you want to develop, but need a place to gather your wildest creative thoughts and freely organize them. Define the problem, decide on all the solutions available and then proceed and pursue till the problem is solved.

If the relationship is contentious, find an arbitrator or surrogate to meet with the lender. This often provides a buffer as the surrogate has no dog in the fight and can be more objective. A good attorney, CPA, other S.E.C.’s (this has been used many times in the Society) and other confidants are good sources. If the lender remains hostile, it means that the likelihood of an amenable resolution may not be in the cards….not yet anyway. What I mean by this is that lenders in a difficult loan must assess their position and it seems they always take time to get educated about the true nature of the problem. Sometimes they soften up when the realization of what they have hits them or the problem moves up the hierarchical food change (larger banks primarily) to someone who can address it more rationally. Understand that a lender has timing, protocol, and procedure issues which take time to develop. Use this time wisely. A caveat here. I would not pursue an adversarial posture even if the lender is pounding his shoe on the table. This is really a renegotiation of a business agreement in which all parties have a stakeholder position. Nothing more. The lender does not want to own your property generally, he just wants to insure that in one form or another he has proper security and has a reasonable expectation of being repaid.

Read the loan documents. This seems like an easy recommendation, but is routinely overlooked by all of us when working through a Debt situation. The lender often makes a mistake which can allow us an opportunity to defer the lenders position a bit and get him to sit down and talk through the issue once you get a foothold. Several SEC’s have pursued this avenue first and found issues which may cast a cloud on the lender position, which will allow you to at least get their attention.

Some Debt solutions and formulas are:

1. Convert all or a portion of the Debt to Equity & a First Mortgage. If a lender has a $100,000 mortgage on a property worth $100,000 and the loan is tenuous, ask the lender to create a new $80,000 hard loan which meets all his lending criteria (and the Feds). The remaining $20,000 is a contribution in the form of equity in the property and comes out first when the property is sold. If there is cash flow the $20,000 gets a priority.
2. Convert all or a portion of the Debt to a First Mortgage & Second Mortgage. Again, same example, if a lender has a $100,000 loan on a property valued at $100,000, ask the lender to create a new $80,000 First Mortgage (again, acceptable in standards for all loans) and a very soft second mortgage for $20,000. By doing this the lender has a fully saleable first and a frumpy second. The Second can be discounted and sold (rather than discounting the entire $100,000 mortgage as most lenders generally do).
3. Partially Walk the Debt and Add Cash. Again, our example, a property with a value of $100,000 and a mortgage of $100,000. Give the lender a first Mortgage for the $80,000. Take the remaining $20,000 and add it to say, $50,000 cash added by the lender and make a new loan on another property. Let’s say the other property is an F&C $100,000 land parcel you own. You end up with two mortgages, but if the land is F&C you got financing where none was available and walked away from the deal with $50,000 in your pocket to serve the Debt on both properties and expenses.
4. Who has the problem? Is it the lender or the borrower? This obviously depends on value, equity (if any) and Debt. Let’s use our example once more. You own what was at one time an appraised $100,000 parcel of land. The mortgage was $80,000 at inception. Fast forward to today and the property is now worth say, $80,000 or is effectively 100% financed. Who has the problem theoretically? Of course, the lender does. The lender (conventional generally) is trying to avoid the possibility of getting the property back as he will have to declare it effectively an REO on his books, write it down further, and allocate other funding to offset this problem on its balance sheet. This predicament is the source of an opportunity. The solution becomes one of benefit seeking.

Okay, the reality of Debt in our dealings goes without saying as an integral part of our business. Be cautious, about what you sign and what you are agreeing to. Do your homework up front. William Zeckendorf, one of the first big real estate developers of skyscrapers and big deals in the 50’s and 60’s starts his book by describing the circumstances relating to his experience as a big time borrower, and how one small passage in one of his many mortgages caused his entire empire to fall. This lesson is repeated time and again. Debt is a partner that can get ugly or it can be a healthy adjunct to your wealth building model. Use it improperly and you will be like Superman with his cape on fire. Use it wisely and you will continue to soar. Remember, Kryptonite can’t kill it, so handle it with respect, honesty and reverence.

Stephen D. Barker, S.E.C., Chairman of the Board and Chief Executive Officer of Catellus Group, LLC, a Michigan and North Carolina based corporation, has specialized in all facets of commercial investment real estate including development, rehabilitation, management and finance.