Real Estate Loan Workouts and Present Value Analysis
by Denise Evans
Any attorney who negotiates loan workouts or short sales needs to understand the Net Present Value (NPV) analysis used by virtually all lenders.
Simply put, the lender calculates the value of a foreclosure and compares it to the value of a workout or short sale. Because a foreclosure and a loan modification will yield future cash, the lender must discount them to today’s cash equivalent in order to compare them to the nearly-immediate cash obtained from a short sale. This is called calculating the present value (PV) of each scenario. The PVs are then “netted” against each other to see which is most valuable.
Discounting is a fairly simple concept. Suppose a foreclosed property (ORE, REO or OREO, all used interchangeably) could be sold for $100,000 in 24 months. Subtracting holding costs, disposition costs and sales commissions might yield only $89,000. If the discount rate were 12%, then what amount of money invested today at 12% interest would grow to $89,000 in two years? The answer is $70,093. Using a discount rate of 12%, the present value of the foreclosure option is $70,093. You can calculate it in Excel by clicking on “Formulas” and “Insert Function” and then typing PV, clicking GO, and following the instructions.
Sometimes, two alternatives will have substantially the same PV. In that case, the alternative with the fewest risky assumptions will win. Usually, a foreclosure has the largest number of risky assumptions because the lender must assume:
- Value of property now and in the future;
- Holding period until sale;
- Holding costs until sale;
- Risk of litigation or bankruptcy and
- Legal fees if there is litigation or bankruptcy.
If you want a lender to approve a short sale or loan modification, you must make sure it has accurate information regarding all risks and expenses of the alternatives. To determine the future value of the collateral, the lender will start with an appraisal, which might be supported by information regarding three or four comparable sales. You might want to obtain your own appraisal, supported by six to ten comparable sales, and offer it to the lender for consideration in addition to the one ordered by it. Bear in mind that traditional appraisals exclude foreclosure credit bid prices and ORE sales after foreclosure as duress sales not relevant to determining Fair Market Value. But, if that is the future your lender faces if it does not accept a short sale or workout, then those are exactly the comparables that should be used. When you obtain your own appraisal, you should request the footnote inclusion of lender foreclosure credit bids, and post-foreclosure sales prices. A lender’s credit bid is usually its assessment of the discounted present value of the collateral, and is strongly persuasive to another lender evaluating a loan workout secured by comparable real estate.
Property problems that could result in rapid loss of value—such as roof leaks—should be disclosed, along with a third party estimate of cost to repair. Anticipated HOA increases, assessments, and real estate tax increases should be revealed. For residential properties, it is sometimes necessary to point out that real estate taxes will double after a foreclosure because of the different assessment rate when a property is not owner-occupied. Finally, if you anticipate bankruptcy or litigation, make that fact known to the lender, along with your estimate of time to resolution and anticipated lender legal fees.
This purely analytical process breaks down if you encounter hidden agendas. One type is the community bank that sometimes takes an emotional stance regarding a defaulting borrower, and the desire to punish that borrower.The other type involves a desire by the lender to inflate its asset values. In the typical short sale, the lender receives cash in an amount less than the mortgage note balance, it releases the collateral, and it forgives the deficiency balance. The cash has a clearly defined value. With foreclosure, however, lenders can sometimes book the real estate at a value greater than its current fair market value.The first step for any workout or short sale attorney is to discover the presence of hidden agendas and plan accordingly.
Assuming the absence of hidden agendas, all negotiations and information exchanges should be conducted with the NPV in mind. When you do that, you will see dramatic improvement in your success rate.
About the Author: Denise Evans is a former banking litigation attorney from Texas. She currently resides in Alabama, where she is a commercial real estate broker and a distressed real estate consultant. She is the author of nine books and is much in demand as a seminar speaker.
Ms. Evans will be speaking at Landlord-Tenant Law seminars in Mobile, Alabama; Biloxi, Mississippi; and Montgomery, AL (March 2012).
