Ask the Workout Window: From Multifamily to Multiproblems—Handling a Troubled Loan

In each issue of The RMA Journal, veteran workout leader Jason Alpert gives advice on thorny workout challenges. Have a challenge you would like Jason to address? Send your question to WorkoutWindow@rmahq.org. 

QUESTION: My bank provided a loan to cover the purchase, minor construction, and refurbishment of a multifamily property for $15.885 million. The property is a 60-unit, four-building, two-story garden-style apartment complex that was built 20 years ago. The borrower purchased the property for $14.3 million, with the pro forma rents of $2,000 per month per unit and a net operating income (NOI) of $885,000, which was underwritten at a 4.15% cap rate ($21.330 million or loan-to-value (LTV) of 74.5% as complete). The loan originated three years ago (2022) and is approaching renewal/maturity. The $1.5 million refurbishment and construction loan was delayed a few months, and the property wasn’t formally stabilized until mid-2023. For fiscal year-end 2023, the borrower missed debt service coverage ratio (DSCR) of 1.25x due to lower rents and higher insurance costs. However, we formally waived the DSCR covenant because of the delays in construction and stabilization.  

We recently received interim financials for 2024, and the property is still underperforming the pro forma. We are concerned about another DSCR default when we formally test in early 2025 and whether the borrower will be able to right-size the loan in preparation for the maturity event in early 2025. Annualized fiscal year-end 2024 statements show rents are currently less than expected ($1,840 per unit per month), and NOI is down 28% from the pro forma, estimated at $635,000. Our internal appraisal group estimated a current cap rate of 5.25% for the market, resulting in a property value of only $12.1 million (current loan balance is $14.4 million, indicating an LTV of 120%). The loan is being paid as agreed, even though it has a 0.80x DSCR (we believe the $160,000 shortfall is being covered by guarantors, who had combined liquidity of $2 million at closing in 2022). How should we start approaching this credit?  

JASON: Given the sub-1x DSCR, the overleveraged nature of the credit, and the pending maturity, I strongly recommend downgrading this credit to watchlist or criticized and transferring it to your workout group. Based on the facts above, it doesn’t appear that you have an active default to declare (because you’ve already waived the previous DSCR covenant), but early intervention with your customer is critical to achieving a win-win solution. To that end, I suggest scheduling a meeting with the customer to discuss the bank’s concerns and the upcoming maturity. Consider bringing another banker or credit representative as a second witness, as this conversation may be difficult for the customer. Be sure to take thorough notes, ask thoughtful questions, and listen carefully to the customer’s plan for remedying the property’s issues. After the meeting, follow up with an email to all attendees, including the minutes of the meeting and action items to be provided to the bank (such as financials, marketing or sale plans, and cooperation on appraisals or other inspections). 

Assuming collateral is perfected, and the borrowers or guarantors are cooperative and transparent, the bank may want to retain this customer, especially if they have other assets or services besides this one sub-performing loan. In that case, an A/B/C note restructure may be appropriate, where you bifurcate the loan into two or three separate facilities. The A-note is right-sized to cash flow (with a DSCR of 1.25x) and an LTV that within policy. The B-note and C-note are charged off (all three loans are moved to nonperforming, where interest income is no longer recognized and any payments received are used to pay down the book balance of the loan). After 12 months of performance, the bank may consider upgrading the A-note of the loan to a pass rating and accrual status. The B-note, also known as the “hope note,” can be repaid with any excess cash flows or restructured to incentivize the borrower with loan forgiveness. Payments on the B-note accrue interest at a higher percentage, which will be forgiven if the principal is repaid over definite period, and the C-note is fully forgiven if the A- or B-notes are paid off. There are various ways to handle the B- and C-notes.  

For illustrative purposes, based on the fact pattern above and assuming the current NOI is stabilized (double-check via third-party appraisal), the A-note may be right-sized to support a 1.25x DSCR at a 6% rate and 25-year amortization, assuming these terms should be as close to market as possible. This would result in an A-note balance of roughly $6.6 million, leaving a $7.8 million balance allocated between the B- and C-notes. I recommend the B-note be right-sized to the value of the collateral, or $5.5 million—the total value of the collateral is $12.1 million, less the A-note of $6.6 million. The remaining $2.3 million is the balance of the C-note.  

This scenario may seem dire for the bank, but given the tremendous changes in the market over the last three years, both shrinking NOI and the rise in interest and cap rates have crushed value. The goal is to incentivize the borrower or guarantor to retire the A-note and the majority of the B-note, allowing the bank to recover in the next year or so. This is why a net present value (NPV) analysis should be conducted on various restructuring scenarios, based on facts and information from the borrower. Perhaps the A/B/C note restructure is too risky or infeasible, in which case a note sale or discounted payoff may be the best result for the bank. It’s important to note that this type of restructure and loan redocumentation is complicated and not suitable for internal documentation.  Outside counsel should always be engaged for this type of deal. 

Jason Alpert is managing partner at Castlebar Holdings, a distressed debt fund and financial institution advisor. Jason led and managed workout and special asset teams at major financial institutions for two decades. He is on the editorial advisory board of The RMA Journal and is an adjunct professor at the University of Tampa. Email Jason at jason@castlebarholdings.com or reach out to him at 813-293-5766.    

Disclaimer: The Workout Window is not intended nor is it to be considered legal advice. As The Workout Window stresses, consult with legal counsel and your institution’s management to be sure you are acting within the parameters of your institution’s policies and banking law.  

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