Lois Weiss: Between the Bricks

We are releasing a white paper obliterating the notion that a loan workout is somebody making a call to a connection, like a reverse mortgage broker. Restructuring commercial real estate loans often requires the lender to accept a discount. Asking politely or going over an asset manager to a department head is not the path to them accepting reality. The borrower must show why doubling down on a failed borrower is reputationally sound for the asset manager and financially sound for the lender. Game theory studies decisions in which the result depends on what the other party decides, so neither side can choose well until it has worked out what the other will do. In a workout, the lender decides whether to modify or foreclose based on what it expects from the borrower, and the borrower’s proposal only works if it reads the lender correctly. Waiting impacts the two sides of a workout differently. The borrower’s equity is a call option on the property struck at the loan balance. If the market recovers, that payoff is convex, which is why a restructuring that costs the lender a little can be worth a great deal to the borrower. The lender holds the opposite position. Its payoff is capped at par plus interest however far the asset recovers, and its cost of funds accrues every month the loan is outstanding, so waiting is a negative carry on a non-performing loan. Economics alone isn’t enough. The Ultimatum Game is when one player holds $100 and proposes a split. If the second player accepts, both keep their shares. If the second player rejects, neither gets anything. A purely rational second player would accept $10, since $10 beats zero. In practice, people reject offers they consider unfair, giving up their own share to deny the other side its $90. While rejecting a borrower’s discount offer can be wrong economically, a bad borrower, especially under a modification, can be politically damaging to the individual and the firm. Commercial real estate usually measures success by closed deals. Loan workout aren’t deal and success is built to a crescendo. Each decision impacts the next one in the process, even several moves later. A borrower skilled in operations is unlikely to also be skilled in loan workout negotiations, and an operator skilled in loan workout negotiations won’t instills confidence in their lender. Out-of-court commercial real estate restructuring is a small and unusual corner of the industry, and its many moving parts are often underappreciated. Its perceived simplicity belies its complexity. In out-of-court commercial real estate loan workouts, the best way for the borrower to manufacture leverage is to share its institutional knowledge of the property, tenants, market and future potential. Any lender stepping in must start from scratch. Helping the lender with transparency helps frame the negotiation in realistic terms to produce better chances of borrower success. Buckle up, this is complicated. Stay tuned.