Before the economic recession, revenues were high and businesses were expanding. Part of that expansion resulted in many small business owners purchasing commercial real estate. This was seen as a smart way to invest excess capital and also served as tax planning because business owners experienced depreciation and maintenance write offs that would cancel out gains experienced from their operating business. However, for those who purchased commercial real estate just before or since the recent recession, they are facing a much different economy today. The once good investment is just another financial obligation that the business cannot support and the rental market does not provide enough rental income to support the obligations associated with the property. Additionally, many businesses are running at a cash loss or break even point in today’s economy so they do not need the additional tax benefits of owning real property.
The economy has changed and now the business is likely more suited for a rental relationship where costs are fixed and affordable. Rather than deal with large and sporadic maintenance costs on top of debt service, a rent rate for a smaller place in today’s rental market is much more affordable. Yet the business has established goodwill in its current location. The customers and clients know the business address, the building, or the store front and moving can often affect the overall performance of the business. This leaves business owner liquidating their personal assets in order to support their debt service in hopes that the commercial real estate market will improve, along with the rest of the economy. When those funds run out, they are faced with few options outside of foreclosure and auction.
There is another plan. An option that may allow the business to stay in it’s current location. It is known as a commercial short sale. With the value of commercial real estate still being lower than it was before the economic recession, investors are looking to purchase properties at today’s values, and rent them until the market improves. Properties with willing, paying tenants are more highly sought after. Rather than letting a commercial property go to auction, or relocating a business to a different space which could affect business performance, a short sale can allow all parties to be satisfied. The investor buys a property at a good value with a paying tenant in place, the bank gets to liquidate the property for appraised value without having to go to auction, and the business owners gets to maintain a rental agreement for the commercial space they are currently using to run their business.
There are certain aspects that must be achieved in order to get a short sale approved. They include:
1. Determining the liquidated value of the property – Banks will only accept values supported by third party appraisals
2. Determine any cross collateralization or owner occupancy requirements – Many business owners will have multiple loans outstanding with their businesses. These loans could have terms and conditions that would be violated by a short sale, which could cause defaults on multiple loans with multiple creditors.
3. Understand the local rental market – Not all rental markets are the same. In some areas renting may outweigh the cost of ownership and therefore a short sale would not create value for the business owner.
4. Agreed upon closing statement or HUD-1: A closing statement must be shown to the bank which shows all sales proceeds going to the bank, and none going to the seller. The nature of a shot sale is that the property is sold for less than what is owed and therefore the secured creditor has the rights to all sale proceeds.
If these conditions are met and satisfied, a short sale is an option that can provide relief to small business owners. It is important that you find the right investor for the property and that you and this investor share similar goals for the property, which include your right to lease and operate within the space. The solution not only will save the business, but it will greatly pay down the deficiency owed by the guarantor, and will satisfy the bank by giving them a cooperative solution with a quick closing.
If you are experiencing trouble with your commercial real estate, contact us to determine if a short sale is the best course of action for you.
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An SBA workout is like any other debt workout. The goal of the workout is to remove as much of the burden of the debt load and debt service as possible from both the business and the guarantor while preserving the business opportunity (when possible). Workouts take many forms and there is no cookie-cutter way to effectively conduct a workout. Workouts do require a level of risk and there are many things that need to be considered before entering into a workout. Some circumstances worth considering are:
– Liquidated value of business assets: What are the business asset worth and how much of the debt would be covered by liquidating them for the benefit of the SBA creditor?
– Current and projected business performance: How much cash flow can the business afford to service debt with? Can the owner afford any more cuts? Is revenue climbing or falling? Do projections show improvement in the short-term? Is loan modification possible given the financial capability of the business?
– Current industry trends: Is the industry expanding or is the market constricting? Are their external forces affecting business operations?
– Size of the SBA obligation: Is the loan so large and under collateralized that it scares away most potential buyers or investors? Is the loan so small that the debtor will be left personally responsibly for all shortfall liability?
– Personal net worth of guarantors: Does the guarantors show a large amount of equity in their home? Do they have other liquid and unprotected assets?
– Additional collateral for SBA loan: Did the guarantors pledge additional collateral for the loan? Is there a lien on real property? Is there cross-collateralization with another operating business?
Understanding these points of interest will help a defaulted borrower calculate the true costs of a SBA secured debt workout. The results from a successful debt workout are pretty incredible. Guarantors settle their outstanding obligations, businesses survive and are in some cases restructured in order to preserve jobs and opportunity, and the banks satisfy their SBA obligations and receive their SBA guaranty. However, workouts have costs and some businesses are not financially strong enough to support the requirements of a workout. A full assessment and valuation of all relevant business factors should be done before any small business owner enters into a workout with a SBA lending bank.
Because the bank has its SBA guaranty to protect, lenders do not often have the same level of flexibility when it comes to modifying or altering SBA loans. Therefore they follow a strict path of liquidation which is regulated by the SBA Standard Operating Procedures for loans in default. This path traditionally means litigation, foreclosure, and auction of the business followed by a pursuit of the guarantor to collect the deficiency. Workouts offer alternatives to both lenders and debtors that meet all of the SBA requirements but do not require litigation, foreclosure, or bankruptcy. Understanding how to satisfy the SBA requirements is what’s key to success.
Overall a SBA debt workout is a business strategy that is meant to preserve the business opportunity while removing debt from both the business operation and the guarantors. Defaulted SBA borrowers who do not qualify for loan modification are candidates for a workout. However the costs associated with a workout vastly vary based on the circumstances surrounding each loan, each business and each guarantor.
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The Small Business Administration (SBA) is a federal organization whose mission is, “…to aid, counsel, assist and protect the interests of small business concerns, to preserve free competitive enterprise and to maintain and strengthen the overall economy of our nation,” (http://www.sba.gov/about-sba/what_we_do/mission). The majority of their work is focused on providing loans and guarantees to small businesses in order to support their overall mission. Most loans are issued through participating SBA lending banks where the bank loans the business money and the SBA guarantees a large portion of the note (ranging from 50-90%). These guarantees vastly reduce the risk to the bank because even if the loan fails, the SBA guaranty will assure they do not experience large losses. This shift of risk away from the banks opens credit to small businesses that they would otherwise not qualify for, creating opportunities for small businesses to grow, hire, expand and succeed.
However, what happens when one of these businesses fails? Revenues are down since the beginning of the recession and have not fully recovered for many industries. Many feel when they cannot pay their SBA loan that bankruptcy is their only option. However, it is not. The SBA has a program in place that allows defaulted guarantors to settle their obligations for far short of what is owed on their loans. The process is called the Offer in Compromise program and is essentially a bankruptcy alternative. The SBA has a lot of information on their website and distributes the required forms for an Offer in Compromise (www.sba.gov).
However, after reading all information available and reviewing the required forms, many borrowers still don’t know how much to offer. Essentially the question that goes unanswered is: How much is the right amount to offer in or for the SBA to accept an Offer in Compromise?
The answer to that is somewhat addressed in the SBA Standard Operating Procedures, “The compromise amount must bear a reasonable relationship to the amount that could be recovered in a reasonable amount of time through enforced collection proceedings and must be sufficient to protect the integrity of the SBA loan program,” (http://www.sba.gov/about-sba/sba_performance/policy_regulations/standard_operating_procedures). Yet this answer leaves a lot open to interpretation and leave many still scratching their heads.
To answer the question, first a defaulted guarantor must understand the following things: an Offer in Compromise is a privilege, not a right, and, that any fraud or misrepresentation throughout any part of the loan process will result in disqualification from the Offer in Compromise program. This means that communication and cooperation are essential in maintaining your ability to settle. The bank must believe you are acting in good faith to put forth your best offer per the SBA guidelines for forced collection. Once this type of relationship is established, you must present an offer with all required supporting documentation that addresses the following points:
1. The forced liquidated value of the assets of the guarantor
A guarantor must present an offer equal to or greater than the liquidated value of their personal assets. To determine liquidated value, a guarantor must first examine their personal balance sheet and remove any assets that are protected from collection such as homesteaded properties or protected retirement assets (see post on State by State Protection for more information). From there any remaining assets must be appraised or valued at their liquidated value less any debt owed against the assets. For example if you own a rental property whose liquidated value is $300,000 and you owe a mortgage of $250,000 on that property, the forced liquidated value would be $50,000 for that asset ($300,000 liquidated value – $250,000 mortgage). Finding liquidated valuations often requires the assistance of certified appraiser.
2. Future earning potential of guarantor – ability to garnish wages
Above and beyond a guarantor’s liquidated asset base, an acceptable offer must compensate for the earning potential of the guarantor. The SBA will likely want to examine the current earning statements of a guarantor along with at least two years worth of tax returns in order to be able to calculate the guarantors ability to earn. The SBA and bank will then compare this to the state laws regarding wage garnishment to calculate the borrowers future ability to repay the loan (see post on State by State Protection for more information). Other factors are also included in this calculation, such as age and health conditions which may limit a person’s current or future ability to remain gainfully employed.
3. The size of the deficiency balance
While the validity of an offer is based more on the previous two points, the size of the deficiency does come in to play. The offer must not jeopardize the integrity of the program as dictated by the standard operating procedures. This means that certain offers may be considered too low simply because the balance is large. For example, a $15,000 Offer in Compromise may be a perfectly acceptable offer for a distressed borrower on a $200,000 deficiency. However, a similar borrower would likely not get a $15,000 offer accepted if the balance owed was $2,000,000.
4. Cost of collection and administrative costs
Assets held in trusts, other businesses, partnerships, or other asset protection vehicles often have higher cost of collection, meaning that the bank would have to spend more time and money litigating in order to have the legal right and access to liquidate those assets. The costs are considered by the bank when reviewing any offer. Likewise, any costs associated with accepting an offer are considered as well. For example, if a defaulted guarantor owns multiple real estate properties, each with a lien on them that would need to be released if an Offer in Compromise is accepted could mean that the bank has to incur thousands of dollars in legal fees releasing those liens. Those fees would be considered before accepting any offer.
These four points touch on how the bank and SBA will review and validate an offer. Each must be addressed and support by the appropriate documentation. If done correctly, the SBA will accept the offer and the guarantor can settle their obligation without having to file for bankruptcy protection.
In the end, determining the appropriate offer amount can be difficult. Dealing with the SBA can be a long process and proposing an inadequate offer can result is precious time wasted and your window of opportunity to settle closing. SBA loans that are not settled in a timely fashion are sent to the US Treasury Offset Program, where settlement becomes much more timely and expensive (for more information see post on Treasury Offset Program). Therefore if you find yourself behind on your SBA payments, contact your bank, be open and honest, seek the help of professional to assist you in calculating an adequate value for an offer in compromise, and present to the bank and the SBA as soon as possible.
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