You have a class B office building in a Class A location that just lost its anchor tenant. Interest rates are on the rise and remote work is on the march. You are contemplating just giving the keys back to the lender.
But the tax implications would not be pretty and besides, you feel the building has potential and that the office class in general will right itself in the long run.
Another option might be to dust off a structure seen only occasionally in the last ten years ever since the commercial real estate markets became frothy and property values kept on rising. Namely, considering restructuring the debt into a performing A note and a subordinate B note.
This route, though, requires careful analysis to make sure the math works, Cynthia Nelson, senior managing director in the Real Estate Solutions Practice at FTI Consulting tells GlobeSt.com.
“You have to ask yourself what level of debt can the building support given the expected cash flow and occupancy and potentially at risk tenants? Could there be challenges in leasing up? Can you determine the operating income that can support a certain level of debt service at current interest rates, which are now higher than the last number of years,” she says.
Once you have determined that, it can be structured into a performing loan that can be refinanced at maturity. Then, the balance of the debt that is owed is structured into a so-called hope note that would carry a higher interest rate that may or may not be paid back. The bet here is that when the property stabilizes there will be enough cash flow or it can be paid off at maturity. This note would be subordinate to the senior note.
This structure might give the borrower some breathing room to reposition the property or lease up the vacant space or just navigate some of the uncertainty associated with the office markets right now, Nelson says.
Much, though, depends on the lender’s regulatory regime and whether it has the flexibility to do this. A CLO or Opportunity Fund might be difficult to deal with, she says, while CMBS has its own restraints. Commercial banks have their own set of regulators to contend with but Nelson said they have the bandwidth to do such a deal. If a lender has the ability to do this structure it could well be amenable to it. Not only will it avoid having to take back a struggling property but it could get repaid an amount that potentially even exceeds what it would have realized if it had foreclosed and sold the property, Nelson says. “This wouldn’t be a lender’s first choice but it is something that a practical lender that has some flexibility would consider.”
And if it doesn’t you can always threaten to return the keys.