Addressing Due Diligence Requirements in Distressed Real Estate Loan Acquisitions
October 5, 2022
Originally published on November 23, 2020 and updated on October 5, 2022.
One of the first things that must be done before purchasing a distressed real estate loan is a thorough review of all the existing lender’s documents. The terms of many commercial loans are negotiated when entered into and, consequently, the lender may have made concessions that will limit the lender’s ability to recover from the borrower or give other creditors priority against some or all of the borrower’s assets. One must also be aware of state laws that affect what the lender may do to recover the loan from the borrower, irrespective of the loan documents.
Due diligence for such deals is different from a typical real estate transaction because it must be done in a very short period of time and, oftentimes, with limited or dated information. Unfortunately, because of time constraints there often is no opportunity to do a thorough analysis of the property, including environmental and title review.
One must also assume that if the borrower is in trouble on their loan—beyond just missing a couple of loan payments—it is often likely that one or more of the following is also involved: taxes and/or insurance payments may not be current; there may be mechanic’s (or judgment) liens on the property; and the property is likely in need of repairs and maintenance.
It is very important to get this information before closing, since your client may end up being responsible for paying these items.
Some of the major considerations and questions that must be asked are the following:
- What is the physical condition of the property? What needs to be done to correct the situation?
- What is the status of existing leases? Has a tenant shut down or moved out? Are any leases—especially with credit tenants—about to expire? Is a tenant having financial difficulties, including the possibly of a bankruptcy filing?
- Are there any other sources of income for the property?
- Is the borrower keeping current on financial-reporting requirements?
- How much equity, if any, does the borrower have in the property? If the borrower has little or no equity, presumably the risk is greater since it has less to lose in foreclosure. If the borrower has some equity in the property, the borrower is likely to be more motivated to work out the loan, and you should become familiar with the relevant default provisions and remedies under the loan documents
- Is the loan recourse or non-recourse? The borrower is more likely to work with the lender when it risks personal liability for a deficiency.
- Copies of all property-related notices, including those received from borrower and/or borrower’s tenant(s).
Answers to these (and other related) questions are usually found in the due diligence material that is provided by the seller or intermediary. Typically, the buyer is provided with the original loan documents and the original lender’s subsequent documentation of the relevant loan. At the very least, the information should include the following:
- mortgage or deed of trust
- security agreement
- UCC financing statements
- personal/corporate guaranties
- assignment of rents and leases
- enforceability opinion as to original mortgage, forbearance agreements (if any); any additional security documentation (i.e., additional notes, mortgages, modifications, amendments, etc.)
- all relevant title policies and related documents, including underlying title documents and survey.
It is critical to review these items closely. One must confirm with the selling lender and through their own review of the due diligence documents that there is no defect in the original loan, such as lack of perfection. Even more critical is to ascertain the level of financial distress of the borrower, and carefully review the borrower’s and guarantors’ financial information—obtained from what is available in the due diligence documentation and what can be ascertained from independent verification and/or from public records. Preferably, an appraisal of the property as of the date of the original loan and, if available, as of the current date, should also be reviewed.
When purchasing a distressed real estate loan, it is also important to deal with issues associated with title coverage and representations and warranties. The Real Estate Group at Levenfeld Pearlstein can help guide you through these issues.