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Debt Purchase Transactions: Beware of the Risks
Friday, March 29, 2024

CRE Secured Debt Purchase Transactions present unique risks that should be understood and carefully managed. 

Current market conditions may present unprecedented opportunities to purchase debt secured by distressed commercial real estate assets at potentially significant discounts. A record number of CRE secured loans are maturing at a time when owners are facing high interest rates, declining occupancy rates and correspondingly reduced cash flows and property valuations. CRE foreclosures are becoming more frequent.

And, there seems to be no end of these distressed conditions in sight for CRE owners and investors. Interest rate reductions by the Federal Reserve, which could provide some much needed relief, are unlikely to occur in the near term given, among other factors, the continued risks to the banking system presented by the distressed state of the commercial real estate industry.

If you are looking for buying opportunities, it may seem reasonable to assume that purchasing a CRE secured loan at a discount (that can later be foreclosed so you become the owner of that real estate), is worthy of some consideration. However, buying CRE secured debt is very different than acquiring real estate itself. It presents unique risks and requirements and these differences can have an adverse impact on your investment returns. 

Buying CRE secured debt is very different than acquiring real estate itself. It presents unique risks and requirements and these differences can have an adverse impact on your investment returns.

Here are some guidelines that can help you understand these differences and better manage the associated risks. 

1. Before buying debt, evaluate how things can go right (and wrong). 

Here are some examples of the possible outcomes of a debt purchase transaction – ranging from the “best case” scenario to one involving a catastrophic loss:

Outcome #1 – Things go according to plan: you achieve your targeted investment returns:

  • After purchasing the debt, you service it in a customary manner (as a lender) until it is repaid at maturity or sooner refinanced by the borrower (i.e., the borrower performs its obligations and fully repays or refinances the debt) or you sell the performing or non-performing debt to someone else either at or above your total price you paid for it.
  • Alternatively, if the debt is in default or if the borrower subsequently defaults under the debt:
    • You exercise available remedies under the loan documents; 
    • No bankruptcy petition or other borrower actions are filed;
    • No claims by other secured or unsecured lenders or third parties are initiated; and
    • You obtain title to the CRE (or achieve any other remedy you pursue) within the time frame you anticipated and for the costs you projected.

Outcome #2 – Things do not go according to plan but you achieve some return on and a full return of your investment:

  • Following a borrower default, you exercise remedies and either:
    • You do not obtain title to the CRE securing the purchased debt, but you do receive some of your targeted investment returns. This can occur where competitive bidder outbids you at the foreclosure sale; or
    • The borrower files a voluntary bankruptcy petition (or a creditor of the borrower files an involuntary bankruptcy petition) and the plan of reorganization is confirmed by the bankruptcy court. If the borrower is able to implement the plan, it will likely refinance out the debt that you purchased at some later point, preventing you from foreclosing and ending up with title to the CRE. In this scenario, at the time of the refinance, you would be reimbursed for the full amount of the outstanding principal and interest on the loan and your enforcement costs, so you would receive a return of (and possibly some return on) your investment.

Outcome #3 – You achieve an impaired ROI on your investment:

  • You buy the debt, exercise remedies under the loan documents, and obtain title to the CRE, but the process takes longer and/or costs more than anticipated.
    • This can occur if you overpay for the debt based on an inflated valuation of the CRE asset securing the debt, where bankruptcy petitions are filed by the borrower or one of its creditors or if unanticipated claims are initiated by secured or unsecured creditors or other third parties that are not extinguished by a foreclosure sale resulting in unanticipated delays and litigation and transaction costs.

Outcome #4 – You suffer a catastrophic loss and fail to realize any return of or on your investment.

  • This can happen when the selling lender does not own the loan and you do not get good title to the debt when you buy it or when the loan documents governing the loan are defective and unenforceable, in either case, precluding you from exercising any remedies in the face of a borrower default.

2. Before Purchasing Debt – Do your homework. 

Gather all pertinent facts about the debt, the selling lender, loan servicers (and any other interested parties, in particular if the debt has been securitized), junior secured and unsecured creditors, ground lessors, third party claimants, the borrower, any guarantors and the property. Then, follow this due diligence checklist:

  • Conduct comprehensive due diligence on the debt, including the loan documents governing the debt, focusing, in particular, on whether the debt has been securitized. This should include a legal evaluation of the seller’s title to the debt, the enforceability of the loan documentation and the specific remedies available to you under the loan documents.
  • Conduct customary due diligence on the CRE securing the debt to get a clear understanding of its fair market value and the impact a foreclosure sale will have on any major occupancy leases. 
  • Review the loan file to determine whether the borrower has asserted claims against the lender or any facts that could form the basis of a borrower claim.
  • Obtain a clear understanding of the laws of the jurisdiction governing the loan documents and occupancy leases and how they might impact your efforts to exercise remedies.
  • Based on the specific facts and circumstances surrounding the debt, evaluate the likelihood of whether the borrower would contest your exercise of remedies and whether a bankruptcy petition might be filed by or against the borrower.
  • Map out the path you would most likely follow in exercising your remedies under the loan documents in light of applicable law and local custom and practice, and develop a timeline for the pursuit of these remedies (i.e., would you exercise the assignment of leases and rents, seek a receivership, proceed immediately to a foreclosure or pursue a deed in lieu, and how long might it take in the specific jurisdiction to successfully pursue the remedies you elect). 
  • Carefully determine the price you will pay for the debt, based on the lower of the estimated value of the property securing the loan and the maximum amount you would pay for the loan to achieve the minimum acceptable yield, assuming the borrower fully performs and pays off the loan at its scheduled maturity, and factoring in discounts for the risks presented by the specific facts surrounding the loan.
  • Carefully document the acquisition of the debt, both in terms of obtaining a complete set of loan documents governing the debt and in requiring proper documents to transfer the debt.
  • Obtain an assignment of the selling lender’s mortgagee title insurance policy and purchase an updating endorsement to that title policy changing the name of the insured to the debt purchaser and adding the recorded assignment/transfer of deed of trust or mortgage as part of the description of the “insured mortgage.”

3. After You Purchase Debt: 

After you purchase debt, you become a lender. That means you must conduct yourself as a lender and that you assume risks of lender liability.

  • Borrowers can make claims of lender liability for on a number of bases (including breach of contract, negligence, fraud, and breach of fiduciary duty). One of the more common claims of lender liability arises based on the implied covenant of good faith and fair dealing that applies to every party to the loan documents.
  • This implied covenant requires a lender to exercise its discretion under the loan documents reasonably (and not arbitrarily). To avoid liability, a lender's actions must be based on well-documented and commercially reasonable grounds. A lender must also act in good faith and not to take opportunistic advantage of a borrower in a way that could not have been contemplated at the time the agreement was made.
  • Bottom Line: Do not buy a loan solely with the intention of foreclosing on the real estate serving as its collateral unless you are willing to take the risk of a lender liability claim.

4. General Do’s and Don’ts: 

  • When possible, only acquire distressed debt, since this might present a reduced likelihood of a challenge to your election to exercise of remedies.
  • Only buy first lien real estate secured debt that has an associated mortgagee title insurance policy and that would constitute “Single Asset Real Estate” under the Bankruptcy Code, reducing the likelihood of any bankruptcy filings by the borrower or its creditors.
  • Since a debtor will have a better chance of successfully reorganizing under the bankruptcy laws where its property’s value exceeds the debt, endeavor to buy debt whose principal amount materially exceeds the value of the real estate securing the debt.
  • Where possible acquire debt where you are the sole secured creditor and there are few other unsecured or mezzanine lenders.
  • Avoid Buying Debt:
    • That includes a lender participation feature or where the lender (or its affiliate) holds an equity position with the borrower (or insist on buying all lender “equity” positions in addition to the debt).
    • Where the facts and circumstances may allow a court to reform the debt into equity, either through equitable subordination, debt recharacterization or otherwise.
    • Where the full principal amount of the loan has not previously been advanced by the selling lender.
    • That involves an identifiable and contentious course of conduct between the selling lender and the borrower.
    • Where due diligence reveals that the borrower may have any basis to assert lender liability claims.
    • Where the facts and circumstances indicate the likelihood of third party claims.

The issues and risks associated with CRE secured debt purchase transactions can be managed to achieve your targeted investment returns. However, the facts and circumstances for each debt acquisition vary considerably and must be carefully analyzed on a case-by-case basis. 

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