Distressed Note Sales: A Strategy for Buyers and Sellers

In its efforts to tame inflation by increasing interest rates, the Federal Reserve continues to announce spikes in the federal funds rate–most recently, an increase of 75 basis points on November 2, 2022. The Federal Reserve has indicated that these rate increases will continue through the remainder of the year, but possibly at a slower rate. Nonetheless, a rising interest rate environment makes it more expensive for borrowers to refinance mortgage loans as they mature, leaving real estate collateral at risk of foreclosure for those borrowers who are priced out of replacement financing. In addition, the rising rate forces lenders to address increased capital reserve requirements in the face of mounting maturity defaults, among other business and regulatory pressures.

Real property is “distressed” when it is priced below historical or underwritten market value, sometimes at a loss to the property owner and even at a price less than the amount owed to the lender, when the property owner must liquidate the property quickly due to solvency or cash flow concerns. A “distressed loan” is a loan that the borrower does not have the financial capacity to pay according to its terms, resulting in a high probability of loss to the lender. A wave of distressed real estate and distressed loans will likely materialize as borrowers and lenders alike seek a quicker exit from loan default situations or are interested in reducing their overall risk exposure to real estate-related investments, creating opportunities for savvy investors seeking yield and/or opportunities to acquire valuable assets at less than historical market values and/or less than the cost to construct a new project.

A borrower facing a loan maturity default is more likely to consider a distressed sale of real estate when:

• Immediate liquidity will avoid insolvency or relieve other financial stress (i.e., foreclosure).
• Alternative sources of debt and equity financing, including mezzanine financing and preferred equity, are unavailable or otherwise inaccessible.
• The tax impact of a discounted payoff, or short sale, is more attractive to the borrower than the prospect of either protracted litigation with a lender threatening foreclosure following a maturity default or the assertion of a deficiency claim against loan guarantors.
• A bankruptcy reorganization is impractical, or too expensive, given the uncertainty of market conditions.

Rather than amend a loan in default, or extend or refinance a matured loan, a lender is more likely to sell a distressed loan at a discount to par when:

• The note is sub-performing or non-performing with a long-term maturity or low yield.
• The borrowers and guarantors are non-responsive, uncooperative, or litigious.
• The collateral securing the note is overleveraged and the borrower has limited financial resources.
• The collateral securing the note comes with a moderate to high risk of liability to the lender if the lender takes title (e.g., potential or confirmed environmental liabilities, public safety issues and/or operational exposure).
• The real estate collateral securing the note requires a significant investment to improve, stabilize, or protect.
• The collateral securing the note is valuable primarily in non-core industries or oversaturated markets.
• A foreclosure on collateral securing the note poses material and negative headline risk to the lender (e.g., real estate that is used by educational or religious institutions, non-profit organizations, or country clubs).
• The collateral securing the note has already been marketed unsuccessfully by the borrower, owner or sponsor (i.e., the only viable exit left is a note sale).

Ballard Spahr’s multidisciplinary Distressed Assets and Opportunities team leverages comprehensive experience in all aspects of distressed assets and distressed loans to help clients identify and leverage opportunities, maximize value, manage risk, and solve market-related business challenges. Ballard Spahr attorneys assist clients in identifying target distressed assets for acquisition or disposition. As it relates to bankruptcy, Ballard Spahr has decades of experience assisting buyers in navigating the acquisition process through the complex sale process under Section 363 of the Bankruptcy Code. Regardless of the distressed asset type or investment structure, Ballard Spahr has the team capable of mining accretive results for the client. Please contact us for more information.

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