Financing

In an earlier article, we examined certain equitable defenses that borrowers may avail themselves of when fighting a lender’s enforcement of remedies.¹ These equitable defenses, we posited, were more likely to be made when a lender pursued a foreclosure action in reliance on a non-monetary default as opposed to plainly objective payment defaults. While recognizing that lenders would be better positioned in a litigation if they waited for a payment or maturity default, some lenders, we noted, would be unwilling to sit by, unable to take control of a troubled property while waiting for a monetary default which may take months or years to occur in some cases. This unique aspect of the current crisis and the prevalence of loans that are objectively bad but not yet in payment default has yielded a new, widely used term, “zombie loans.” This article will explore the use of deed-in-lieu transactions as a method of dealing with zombie loans as well as the possible hurdles a lender may face when choosing a seemingly logical remedy to take control of a troubled property.

Zombie loans have dominated recent discussions in both real estate finance industry journals and conferences alike. The term refers to mortgage loans that while generally considered performing, since the property cash flow or other reserves cover the cost of operating the property and the payment of debt service, are in fact destined for default at a foreseeable later date when, at maturity, the debt service reserve runs dry or the property owner will be unable to refinance the impending balloon payment due to tightening credit standards and depressed real estate values. In the event the property securing the zombie loan is supported by good tenants and is otherwise decent asset quality, one school of thought suggests that the maturity date on such loan should simply be extended until the credit crisis resolves and the loan can be properly refinanced. On the other hand, a loan that is being kept afloat by large interest reserves (providing longer-lasting debt service coverage, perhaps, due to historically low interest rates) or is secured by a property that is otherwise troubled may better be dealt with on a more immediate basis, even prior to the occurrence of an actual default.