Small business owners facing large balloon payments or payments which are increasingly less affordable may be considering closing their doors, filing bankruptcy, or simply walking away. However, there are other alternatives, one of which is being heavily encouraged by the United States government: Commercial Mortgage Modification. (Commercial mortgage modification is a restructuring of your existing loan to make the payments more affordable.)
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 a commercial mortgage modification work?
This second consideration is very important to your decision. Delaying the inevitable does not ultimately help you, or your lender: 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? Do you have plans to diversify your offerings to broaden marketshare? What are your prospects and how will they help to resolve the cause identified in your response to #1 above?
b. What will your DSCR be 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. Remember, your debts are not totally discharged with Chapter 11. Instead, the businesses assets are used to repay its creditors over time - typically 3 years when possible. 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 loan modification should not be seen as a quick fix or temporary way to stave off the bill collector; it should be taken seriously, with the intent to save your business. 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.
Michael Rooney, a San Francisco based attorney and MBA, focuses his practice on lending issues. He is a licensed California Real Estate broker who has written and instructed continuing education seminars approved by the California DRE in the area of consumer protection. He also teaches attorneys about commercial mortgage modification in San Francisco. For more information, visit his website at: http://mikerooneylaw.com/commercialmodification.aspx
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