How Commercial Real Estate Workouts Can Help Banks and Borrowers

We partnered with our friends Mark King, President of Edgefield Holdings, Keith Maruska, Senior Vice President and ORE officer at Comerica Bank, and J.T. Ennis, Managing Partner of consulting firm REStructure and Manager of its investment arm Sundance Capital, to learn about commercial loan workouts in today's markets and how lenders can resolve defaults for both parties.

Economic challenges are impacting just about every industry, and many with commercial mortgages are feeling the pressure. That means their banks are, too.

Rising interest rates post-COVID-19, the continuation of work-from-home policies and preferences, bank stresses leading to tightening credit, and other variables are increasing risks in commercial real estate, particularly for office space. The Mortgage Bankers Association reported that roughly a quarter of mortgages on office buildings were due for a refinance in 2023. Unsurprisingly, defaults on commercial real estate loans are on the rise.

For these reasons and others, it's important for commercial borrowers to understand the realities of a commercial real estate workout, and for lenders to know how to best perform them.

Let’s outline some of the major components of commercial real estate workout plans and how they can serve a company and its bank.

What is a commercial loan workout?

A workout in the banking world is when a borrower and a lender come to a new agreement on a loan. The lender should, in good faith, come to an agreement with the borrower that resolves the issue without increasing costs and creating bigger problems. For lenders, it can be a good idea to first give borrowers some time for things to fall into place, but the lender must also do their due diligence and understand the full picture of the borrower's circumstances before agreeing to a new plan.

When should a lender consider performing a commercial loan workout?

In the most traditional sense, a commercial real estate workout is triggered when a borrower has defaulted on payments toward their loan. Most of the workouts happening today have come from catastrophic events coming out of the downturn. But there are several other lesser-known defaults that lenders can be on the lookout for. For instance, banks always have the right to enforce covenant agreements in the loan documents if they are not met by the borrower. Workouts can also take place when there are governance issues within a company and simply when a loan matures and borrowers and lenders must decide if they wish to renew the loan at the current market rate. Workouts can also arise from any combination of these issues, or even smaller issues that lead lenders to dig deeper into a borrower’s history. Lenders should always seek to get ahead of the curve and aim to initiate a workout before a borrower is unwilling or unable to pay, providing the borrower with as many options as reasonable, which serves both parties.

What are the benefits of a workout?

A workout is an alternative to what those in the industry call nuclear options, like costly litigation, bankruptcy or foreclosure. They do require a great deal of probing, digging and question-asking, but in the end, workouts can help lenders turn a non-performing loan into a performing one. On the borrower’s side, they can afford a company more time to get to the root issues that are causing their defaults.

What should the process of the workout look like?

A workout should start with an in-person meeting with the borrower at their offices, whenever possible. It's important to take a deep dive to understand the full scope of the borrower's position and how their company runs. For a family-run business, this could even include understanding family dynamics. Additionally, it's important to back up what the borrower is telling or showing you with public records and important documents, like the original loan documents, tax returns, court records, etc. When everyone at the table understands and is clear about the borrower's position, this leads to less risk of hiccups or new discoveries down the road.

In this phase, it's imperative for banks not to make too many promises early on. It's important for banks to express that this is a business transaction and to avoid getting emotional. On the borrower's side, it might be difficult for a borrower not to get emotional when their livelihood is at stake. Banks can recognize this, but it's key not to overpromise. Often, a borrower can grasp onto these ideas, and this can potentially turn the relationship sour down the road, risking the chance of a resolution. Instead, explain your limitations as a lender, share what can be achieved in each meeting and document the results. Always be fair, but do not give false hope. In these situations, under promising and over performing are best practices to keep the relationship positive and to serve both parties well.

What solutions can a commercial real estate workout bring?

Commercial real estate workouts are typically resolved with a forbearance agreement. This details the new agreement between the borrower and the lender in which the lender agrees not to foreclose on the loan as long as the borrower meets the revised terms. The document will acknowledge how much the borrower owes, how they will repay the funds and when, and provide a release provision for the borrower. Other options for a resolution include a loan extension or a loan modification. Many lenders favor a forbearance agreement, however, because they identify the default and get the borrower to admit fault while also providing protective language for banks. It protects both parties and, if done right, creates a new starting point.

For questions, guidance and more information on best practices, please reach out to Danielle Mashburn-Myrick or any member of Phelps' Bankruptcy and Reorganization team.