R. Scott Elmore

Two years ago, I wrote an article that addressed the value of commercial real estate loan workouts. Since then, foreclosures and bankruptcies have outnumbered the workouts. Looking back, the “perfect storm” should have been evident.

In December 2006, the FDIC issued guidance to banks addressing over-concentration in CRE loans. When the guidance was issued, most banks exceeded the recommended concentration levels in their loan portfolios.

The regulators “meant business” and began to force banks to reduce their CRE concentrations. As we moved into the Great Recession of 2007, things only got worse. Banks sought to reduce CRE portfolios by refusing to make new loans and asking existing borrowers to pay down their loans to bring the banks’ loan to value ratios into compliance.

The philosophy of “kicking the can down the road” enabled banks and borrowers to survive for awhile. However, as the economy worsened, culminating with the fall 2008 financial crisis, the weight of the decline in property values began to bring down both banks and borrowers. As more banks faced enforcement orders, they had less ability to work with borrowers and many borrowers were cashless. Because properties could not be sold or leased, borrowers lacked good options to present to banks. Consequently, banks were forced to increasingly turn to foreclosure. In turn, borrowers, having exhausted all their options and liquidity, turned to bankruptcy for help.

Is there light at the end of the tunnel?

Recent reports by the National Association of Realtors find that vacancy rates for CRE have already peaked or will soon top-out.

While rents will remain low, it appears that the 2011 outlook for all segments is stabilization or slight growth with multi-family leading the way.

None of this says that we are totally out of the woods.

For example, now that prices have dropped and come close to bottoming out, buyers are purchasing substandard loans and devalued properties. The banks seem to be in a better position to take advantage of these opportunities since they have already identified and written-down their problem loans. However, many commercial borrowers are subject to underwater SWAPs (interest rate hedges) preventing them from selling their properties even if they have a buyer. In these situations, there are usually enough sale proceeds to satisfy the underlying loan on the property, but not enough to satisfy the additional SWAP liability.

In these circumstances, I still believe opportunities exist for workouts, loan discounts and forbearance agreements between banks and borrowers.

Ultimately, the banks’ ability to rid themselves of these loans and borrowers’ ability to liquidate or relieve themselves from CRE property liabilities will allow for a recovery of the market.

CRE is an important part of the United States’ gross domestic product. To the extent that banks and borrowers can work together to settle these loans, it will benefit the economy as a whole.

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R. Scott Elmore is a member of Elmore, Stone & Caffey PLLC, where his primary practice is business and commercial real estate oriented and encompasses the areas of banking law, corporate law, mergers and acquisitions, and real estate finance. This column is provided through the Knoxville Bar Association, a nonprofit corporation that offers continuing legal education and service to the community.

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