When Commercial Real Estate Loans Go Bad

[NOTE:  This post originally appeared on The Vanilla Shell on September 4, 2010]

Comparing  the options available to lender and borrower between residential loan defaults and commercial loan defaults  is like comparing apples and oranges.   When a commercial real estate loan goes into default, the borrower and lender have far more options available to resolve the default and a greater chance at success compared to residential short sales and modifications. 

Why the higher success rate?  First off, commercial loans oftentimes involve larger sums of money than residential.  Hence, the lender’s motivation to reach an agreement with the borrower is greater since the consequences of not reaching an agreement and taking the property back via foreclosure will result in a larger charge-off to the lender.  On the borrower side, given that many commercial loans are guaranteed by individuals who have other assets available to the lender in the event that a judgment is obtained, protection of these other assets is justification to do something more than just walk away from the property.

Most often, the borrower and/or the guarantors do not have sufficient funds to bring the loan back into conforming status.  If that were the case, why the default in the first place, right?  Instead, typically workout agreements can involve a deed-in-lieu of foreclosure (where the borrower simply deeds the mortgaged property back to the lender who then markets and sells the property), a pledge of additional collateral by one or more guarantors (such as other real estate that has equity, ownership interests in other businesses or maybe even life insurance proceeds) or, if neither of those options are available, a voluntary foreclosure agreement (which shortens the borrower’s redemption period in exchange for a waiver of any deficiency judgment against the borrower.

If no deal can be reached, then the lender typically forecloses on the property through a process called “foreclosure by action.”  This process is different than what we typically think of where notice of the foreclosure is published, then a sheriff’s sale takes place and the property is sold subject to redemption rights of the owner and junior lienholders.  In a foreclosure by action, the lender files a lawsuit against the borrower and any guarantors.  At the end of the day, the lender gets a court order allowing a sale to take place just like in a foreclosure by advertisement, and once the sale is held, the lender goes back to court to approve the sale (and then the redemption period starts running).  The major difference, however, between these two types of foreclosure is that in a foreclosure by action the lender preserves the right to a deficiency judgment against the borrower and the guarantors that allows the lender to seize assets other than just the mortgaged property.