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Since the onset of our current economic downturn, many opportunity funds and other investors have been actively seeking to acquire distressed real estate properties and loans. However, during the past year, there have not been as many buying opportunities as would have been expected, as many sellers have been reticent to readjust their expectations to the new economy and have held onto their properties and loans. As the recession is now affecting commercial real estate, this apparent standoff between sellers and purchasers may be loosening, particularly in the area of distressed debt. Pressure on commercial real estate in 2008 was driven primarily by maturing loans that could not be refinanced because of the lack of liquidity in the credit markets. Lenders that did not have to clean up their balance sheets generally responded by negotiating extensions of these loans in exchange for some concessions by the borrowers, and continued to hold onto the debt. However, many of the loans that matured in 2008 were originated between 1998 and 2003, before the dramatic drop in capitalization rates and aggressive underwriting that followed between 2004 and 2007. Beginning in 2009, pressure on commercial real estate is now coming from the collision between the economic realities of the depressed market and the exuberant pro-formas of the 2004–2007 vintage deals. The current surge of tenant bankruptcies, lower rental rates, higher vacancy rates and increasing capitalization rates were not taken into account in the acquisitions and financings of those halcyon days. This reality is causing an increasing number of defaults as these loans mature or interest reserves that were on LIBOR (London InterBank Offered Rate) life support run dry and the projected cash flows are not achieved. 1 As a consequence of these rising defaults, many commercial lenders will be faced with the option of having to either take properties back or restructure debt, and may instead choose to sell the debt at its then current market price. Therefore, there are likely to be more and more opportunities to acquire defaulted commercial loans at discounted levels. Acquiring a defaulted or “non-performing” loan presents the purchaser with different issues and challenges than the acquisition of a “performing” loan. 2 This article will discuss and analyze the issues and challenges that are particular to acquiring non-performing loans and provide recommendations and insights for resolving them. The first and perhaps most obvious distinction between acquiring a non-performing loan and a performing loan involves the pricing of that debt.

Pricing A prudent purchaser in both cases will re-underwrite the underlying property in order to confirm whether it supports the debt level. However, the purchase price for a performing loan is much more closely tied into the actual outstanding balance of the loan, because there is a reasonable expectation that it will be repaid in full, and the anticipated return to the purchaser is based upon the underlying interest rate of the loan and the amount of the discount, if any, off of the outstanding amount of the loan. With respect to the acquisition of a non-performing loan, however, it can be argued that in calculating the purchase price, the amount of the loan is wholly irrelevant for two reasons. First, a non-performing loan is most likely in default because the underlying cash flow does not support the debt, and therefore whatever amount theholder of the debt had originally advanced to the borrower some time ago (and in a completely different economy) has little or no correlation to the value of the property and the amount of debt the property can service today. Second, unlike a performing loan, there is little expectation that the debt will be repaid in full, and therefore the anticipated return to the purchaser of a non-performing loan is wholly linked to the value of the underlying property, not the debt amount. For example, the purchaser of a non-performing loan will expect to recover its investment by either foreclosing upon the property and re-selling it, restructuring the loan with the borrower at new (and sustainable) loan terms, or accepting a discounted pay-off when and if the non-performing loan is refinanced. All three exits are driven solely by the then underlying value of the property and have nothing to do with then outstanding balance of the loan. Therefore, the fact that a non-performing loan is acquired at a 50 percent discount does not in and of itself reflect a good deal for a purchaser, whereas a 50 percent discount off of the outstanding balance of a performing loan that is expected to pay off in full is certainly more meaningful.

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