[Originally published in The Wendel Report, Spring 2010 issue.]

The Lender's Challenge
For community and local banks with portfolios of nonperforming real estate loans, the days of "pretending and extending" are in the past and lenders must now make difficult decisions on how to deal with their nonperforming portfolios. For many lenders this is going to be a new experience, as many lenders do not have sufficient experienced staff to adequately deal with the myriad of issues that must be dealt with and decisions to be made.

This article concerns those real estate loans that lenders decide to foreclose on (or accept a deed in lieu of foreclosure) after an analysis of alternatives, such as a workout agreement with the debtor or a sale of the loan to a third party, either by private sale or auction.

Importance of Pre-Foreclosure Due Diligence
The importance of pre-foreclosure due diligence should be obvious:   Depending upon the nature and condition of the real property, lenders need to have a comprehensive plan in place to manage and operate the property during the period the lender will own the property, with the twin goals of (1) disposing of the property in as little time as possible, and (2) maximizing the value of the property to minimize to the extent possible the ultimate loss to the lender.

If a lender does not have sufficient staff with the requisite experience to conduct the required due diligence, it will be necessary to retain outside consultants and firms to assist the lender, including legal counsel, real estate brokers, construction managers, market research firms, firms that prepare property condition reports, insurance consultants, and property management firms, among others.

Scope of Due Diligence
The scope of due diligence will depend on the nature of the underlying real estate asset. For example, a partially constructed residential development (be it a single family detached residential development or a high-rise condominium project) will present different issues and problems than a completed and operating strip retail shopping center.

Some of the more common due diligence issues and matters that lenders must address prior to, during, and after the foreclosure process,

Lender's Files. Initially, lenders should review their internal files for two primary reasons:   (1) to determine that all the loan documents are complete and proper and, short of the borrower's filing for bankruptcy, there appear to be no potential legal defenses available to the borrower to prevent or delay the foreclosure process, including the enforcement of any guarantees; and (2) to determine what up-to- date and relevant information and materials the lender has with respect to the property, such as certificates of insurance or copies of insurance policies, a current preliminary report regarding the state of title (including copies of all title exceptions), a current appraisal and/or marketing report, and similar materials.

Review Borrower's Files. If prior to the decision to foreclose the borrower and the lender were in workout negotiations, the lender may have certain of the borrower's files relating to the ownership and operation of the property, or have copies of pertinent documents such as rent rolls and other financial information, leases and other agreements affecting the property, environmental reports, permits and approvals, and similar materials.

Obviously, it may be difficult, if not impossible, to obtain these materials if the relationship between the lender and the borrower is adversarial.   However, if a receiver is appointed during the foreclosure process, the lender will probably be able to obtain from the borrower relevant files dealing with the property.

Status of Leases, Leasing and Marketing Plan. If the property is a commercial development involving leases (such as an office building, retail center, industrial building, or mixed use project), the lender should ascertain the status and terms of the existing leases.

A potentially serious, and often overlooked, problem is that under California law foreclosure of a deed of trust automatically terminates any leases that are subordinate to the deed of trust and are not protected by a nondisturbance and attornment agreement. As a result, the lender must decide which leases it wants to remain effective after the foreclosure process is completed and establish a strategy for contacting the tenants to enter into appropriate agreements to keep the leases in effect.

It is also advisable for the lender to consult with a commercial real estate brokerage firm to get input on certain leasing issues that must be dealt with once the lender obtains possession and control of the property—for example, whether the lender should extend the term of leases whose terms are set to expire in the near future (including determining the rent for any extension), and preparing a leasing plan for vacant space in the project.

Land Use Approvals. If the real estate is unimproved land, the lender should determine the existing status of any land use approvals and other permits covering the contemplated development to determine the need to extend expiring approvals and permits or pursue new entitlements and permits to potentially enhance the value of the land for future disposition.

Potential Construction Issues. Many real estate projects will present construction issues that the lender must address. If construction is in progress or if construction has ceased and the project is not completed, the lender must decide on how to complete construction.

Depending upon the nature of the project, the lender should consult with a construction management firm to advise the lender on a recommended course of action. It is also advisable to attempt to engage in discussions with any contractor still on the job to, among other things, determine the status of construction, including uncovering any current construction problems, determining if the contractors have been paid, and determining if the general contractor is willing to continue construction after foreclosure.

If the project is newly completed, the lender should attempt to determine if there are any current and/or potential construction defect claims that may arise. This is a very common problem with residential developments.

Management and Operation of the Property. Managing and operating a property pre-foreclosure (via a receiver) or post-foreclosure presents a variety of issues that the lender must be prepared to address to successfully maximize the value of the property. A little pre-planning will go a long way toward saving future headaches.