Timothy McCandless Esq. and Associates
FAX (909) 382-9956
If you are a small business owner facing a large balloon payment you can not refinance or payments which are becoming increasingly less affordable, you may be considering closing your doors, filing bankruptcy, or just letting it all go. But there may be another alternative for you, which is being heavily encouraged by the government: Commercial Mortgage Modification. (A commercial mortgage modification is an alteration to your existing loan that would make the terms easier for you to afford.)
What is your best option?
It depends on several factors. They are: the cause of the problem, whether a modification will “work,” your long term goals, and the pros and cons of applying for a commercial mortgage modification.
1) What is the Cause of Your Cashflow Problem?
Commercial mortgage defaults fall into one of two categories: 1) debt service default and 2) balloon payment default. The latter of these categories is a bit easy to explain; i.e., after 3 years of payments on your commercial mortgage, you do not have a lump sum principal payment per the loan agreement and cannot refinance for one reason or another (these days, the economy has practically halted all lending so it should be no surprise). However, a debt service default arises from another problem: insufficient cash flow.
As a business owner and a commercial borrower interested in a commercial mortgage modification, it will serve you best to identify when your cash flow problem began, whether it was from a) drop in business, b) increased defaults on your own receivables, c) an increase in other recurring expenses, d) a single event, such as a lawsuit or partner’s bankruptcy, e) some combination of the above, or f) some other circumstance. Identifying the cause of the problem will help you and your lender to identify the most fitting solution.
2) Will mortgage modification work?
The importance of this second consideration to commercial mortgage modification cannot be overstated. It is neither in the lenders’ best interest, nor many times your own, to delay the inevitable: foreclosure. Some factors are:
a. Prospects for your business. Have you landed new contracts? Is business picking up? Is something set to happen in the industry that will help your business? Are you expanding into another more lucrative area? What are your prospects and how will they help to resolve the cause identified in your response to #1 above?
b. Debt Service Coverage Ratio after modification. Your “debt service coverage ratio” is a calculation of whether the money coming into your business is sufficient to cover the outflow, and by how much (or if not, by how much?) A DSCR of below 1 is desired, with a DSCR of over 1 indicating insufficient cash flow. The question the bank is most interested in is, if the loan is modified, will your coverage ratio be low enough to service your debt without default, and is the new proposed ratio sustainable based on your prospects (see 2.a. above)?
c. What is your exit plan? Finally, to determine whether the plan will work, you must be able to identify an exit strategy, or a plan for what happens at the end of the loan. If the term is only set out for a few more years, where will the next balloon payment come from? If the interest is reduced sufficiently to ix your current cash flow situation, what will happen if/when the interest rate goes back up, or when the balloon payment comes due? Your exit plan (and the bank’s) should never be overlooked when considering a commercial mortgage modification.
3) What are your long term goals?
For the business owner considering a commercial mortgage modification, an assessment of the company’s future, and the mortgage holder’s own goals can help in deciding whether a modification is the answer to your problems, or an exercise in futility. For some business owners, mortgage default and allowing the bank to exercise its interest in the security may be financially superior to the alternative of fighting to keep the business going. If your long terms goals do not sync with the mortgage modification plan, then even if you obtain a commercial mortgage modification, it is likely to fail sometime later down the road.
4) Consider the pros and cons of bankruptcy
The United States commercial bankruptcy statutes including Chapter 11 are specifically aimed to aid persons who are unable to pay business debt. The filing fee for a chapter 11 is $1000.00, and a debt management plan must accompany your filing. Keep in mind, Chapter 11 does not discharge business debt. Rather, the assets of the business will be used to repay its obligations over a specified period of time, commonly 3 years. Additionally, the attorney fees are high. So high that often the bankruptcy judge will order your firm liquidated to pay the fees.
Commercial bankruptcy may be able to be avoided, if you still have some cash flow into the business and you can restructure your debts, including commercial mortgage modification, to improve your debt service coverage ratio (i.e., so you are back in the black every month). Commercial mortgage modification should be considered part of a long term, serious plan, and not a quick fix or a temporary way to stall an eventually unavoidable foreclosure. The cause of the problem, whether modification will work, your long term goals, and the pros and cons of bankruptcy should be among your major considerations.