Read Carefully Before You Sign on the Line
I've got a problem coming up with the bank. It goes back to the $7.65 million loan that we took out in August 2007 to purchase a new building for our business. We managed to avoid foreclosure last year by agreeing to turn the deed over to the bank, which gave us a five-year lease on the property in return. Our monthly payments (including rent and taxes) would start at about $35,000 for the first year and then rise annually to about $80,000 in the fifth year. At the time, I was relieved. I mean, we were eight months behind on our payments, and the bank had personal guarantees from me, my two brothers, my two cousins, my mom, and my uncle. We could have lost everything. The problem is, our monthly payment is due to go up to about $62,000 in September, and I don't know if we can cover it. Business is better, but not that much better. Any advice?
President, West End Express
Dayton, New Jersey
During the recent financial crisis, banks came up with a clever policy that quickly became all the rage. It's called pretend and extend, and it's exactly what the name implies. Instead of foreclosing on bad mortgages and having to take write-downs, banks would pretend that the loans weren't really in default and extend the terms, thereby giving the market more time to recover and improving their chances of getting their money back. Borrowers didn't mind, because the policy allowed them to get out from under the threat of foreclosure, at least temporarily. The government didn't mind, either, because it wanted to minimize foreclosures. But mainly, the policy was good for the lenders, because -- as the saying in commercial real estate goes -- "a rolling loan gathers no loss." What happened to Mike Baicher isn't exactly the same, but it is similar.
If you're a longtime reader of this column, you might recognize his name. I've written about him several times, most recently in the June 2009 issue, when it looked as though the bank might foreclose on his building. (See "You're Sure You Know What the Other Side Is Thinking.") Instead, the bank proposed doing a so-called deed in lieu of foreclosure, taking over ownership of the building and then giving Mike's company a five-year lease on it. Mike and his family were so worried about being sued under their personal guarantees that they jumped at the offer without paying much attention to the terms of the lease. If they had, they might have been a bit more cautious.
They had bought the building at the height of the real estate bubble for $8.5 million, putting up $850,000 of their own money. The monthly payments back then were $70,000, including taxes. Their company, a trucking and warehousing business, could afford that expense when the economy was booming, but sales crashed as soon as the recession hit, and survival became the name of the game. To conserve cash, Mike stopped making mortgage payments. By the time the bank sent in its workout team to propose the new arrangement, he figured he could pay no more than $40,000 per month, which comes out to about $3.70 per square foot.
In fact, that's more or less in line with what Mike's neighbors are paying. Then again, a large number of buildings are empty, and the bank needed a tenant. Without one, it would have to determine the value of the asset by comparing it with the current value of other properties in the area, which were worth much less in 2009 than in 2007. The bank would thus be forced to write down the value on its balance sheet. If there was a tenant, however, the valuation of the property could be based on the amount of rent being paid rather than on comparables. Provided the rent increased enough over the period of the lease, the bank could keep the asset on its books at the original value. That was important, given that write-downs hurt a bank's ability to make loans and earn profits. Enough of them can even put the bank in peril.
The problem in Mike's case is that the increases in the later years of the agreement would push the monthly payment well beyond his company's ability to pay, not to mention beyond market rates. Mike did tell me that his agreement with the bank included a provision not to raise the rent in the second year if business hadn't improved enough to make the scheduled increase affordable. But even then, he'd still be facing a jump to almost $70,000 in September 2011.
So, this time around, I advised Mike to immediately start trying to work out a new deal with the bank. If he waits, he runs the risk of winding up in the same situation he was in before. Because the bank insisted that he and his relatives sign personal guarantees on the lease, they would again have the threat of eviction and personal losses hanging over their heads, and they might not be as lucky as they were the first time. They no longer have the deed as a bargaining chip. Consequently, the bank might be more inclined to throw them out and go after their personal assets. What's more, the bank probably isn't as averse to taking a write-down now as it was in the spring of 2009. For one thing, property values have risen a bit, and so the write-down wouldn't be as great. Moreover, if Mike's bank has benefited as much as other banks from the Fed's easy-money policy, it has substantial earnings and cash reserves that it lacked a year ago, and so it could absorb the loss without creating other problems for itself.
That said, Mike's position is in one way stronger now than it was then. Had the bank done its homework, it would have realized that his business could not handle the levels of rent it is obligated to pay in the last three years of the lease. What's more, those rents are way out of line with the market. You could make a strong case that the bank took advantage of Mike and his family's situation by ramming through a deal that was good for its shareholders but bad for West End Express.
I generally don't favor settling disputes by going to court, but if I were still practicing law, this would be one case I'd be happy to take. I suspect that the bank knows it may be on shaky ground as well. For that reason, I'm hopeful that Mike will be able to work out a new deal with his lender without recourse to legal action. The sooner he does, the better off he will be.
Please send all questions to AskNorm@inc.com. Norm Brodsky is a veteran entrepreneur. His co-author is editor-at-large Bo Burlingham. Their book, The Knack, is now available in paperback under the title Street Smarts: An All-Purpose Tool Kit for Entrepreneurs.
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