In cases when a real estate mortgage is nearing maturity or is in default, many property owners are faced with properties that are worth less than the amount of the debt securing their property (this is commonly referred to as property being “underwater” or “upside down”). This is an especially big problem because owners cannot simply sell the property to cover the amount owed on the mortgage and clearly there are no refinancing options for underwater properties.
This dilemma may be resolved if a deal can be established with the existing lender, whereby the lender and owner agree to a payoff amount that is less than the existing mortgage balance that is owed. This is known as a discount to the existing mortgage, or a “discounted payoff (DPO)”, also called a discounted note payoff.”
When lenders are faced with many non-performing loans (also know as non-accrual loans) on their balance sheet (for example during the S&L crisis from 1988 to 1992 and the recent subprime mortgage crisis starting in 2008), it is prudent for lenders to accept the highest and best price for a troubled mortgage payoff, note sale and/or the real estate it has taken title to via foreclosure. These properties are commonly known as “Real Estate Owned” or “REO”.
Typically, the party willing to pay the most for these assets is the existing owner, because the owner knows the property better than anyone else and the owner, who is underwater and about to lose all of his original equity in the asset, now has an opportunity to restructure the property and its balance sheet while continuing to own and manage the asset with the chance of realizing future cashflow and equity appreciation. Therefore, DPO’s are a viable tool for lenders looking to monetize troubled loans in a fast and efficient manner. Discounted payoffs are possible because lenders agree to give borrowers a discount on their current mortgage, allowing the borrower to either raise equity and/or turn to a bridge or hard-money lender for a loan that will facilitate the discounted payoff of the standing mortgage.
It works like this: Imagine a company owns a large strip mall in Ohio worth a total of $10 million with rent revenues from full occupancy at $100,000 a month. The company has an underlying mortgage with a monthly payment of $50,000 and a balloon payment of $7 million.
Let’s assume that, because of an economic downturn, occupancy falls to low levels, yielding less rent than is needed to pay the underlying mortgage and save up for the balloon payment. As a result, when the mortgage comes to maturity and the balloon payment is due, the borrower is short and cannot pay the $7 million owed. Let’s also assume that, because of the lower property occupancy and lower rents, the value of the property has gone down to $5 million.
At this point, the borrower can explain the situation to the bank (and the bank will usually perform its own market analysis for the property) and the parties may agree on a discounted payoff amount. If the bank agrees, the borrower can then turn to a hard money lender or bridge lender as a financing source for proceeds needed to facilitate the DPO, or in this case, to pay off the $7 million mortgage at a discount of $5 million. If the bank, borrower, and lender agree to this arrangement, the bank will get immediate liquidity, the borrower will no longer be underwater on the property, and the hard money lender will get a reasonable, fully secured, risk-adjusted return on their investment. Everyone wins.
There are a few restrictions to DPOs. As with most hard money scenarios, lenders will usually offer up to 75% loan-to-value ratio (LTV) because of the risk involved (in many cases the LTV may be more in the 50% to 65% range), although this can vary depending on the type of the asset, its location, the situation of the property, and recent developments in the local market. Usually these loans are offered for a 12-36 month period, which gives the borrower plenty of time to restructure or reposition the property including, attracting new tenants, property upgrades, restructure their balance sheet, and even borrow again on the property.