Two ways to enforce one defaulted loan, priced on the same basis, with a bridge of where the gap comes from and the liabilities that would close it.
Usually the share pledge, because it is faster and sells a going concern rather than a repossessed building. On an illustrative 50,000,000 loan against a 45,000,000 office, enforcing the pledge over the property company recovers 76.3 per cent in present value, against 66.5 per cent through a two-year mortgage enforcement: 9.8 points, or 4,895,679. The advantage disappears if a buyer prices more than about 6,643,276 of latent liabilities into the company, against the 1,500,000 assumed here.
Worked in full in The Real Estate Workout by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A lender secured on a property held in a special purpose company usually has two routes. It can enforce the mortgage over the building, through a court sale or a receiver, or it can enforce its pledge over the shares of the company and sell the company with the building inside it. In the United States the second route is the UCC foreclosure a mezzanine lender uses on the equity interests; in much of Europe it is a share pledge held by the senior lender alongside its mortgage. The two routes differ in time, price and cost, and the difference can be measured.
| Input | Mortgage enforcement | Share pledge |
|---|---|---|
| Loan, discounted at its 6.0% rate | 50,000,000 | 50,000,000 |
| Market value of the building | 45,000,000 | 45,000,000 |
| Time to sale | 24 months | 6 months |
| Forced-sale discount | 15% | 8% |
| Legal, receiver and sale process costs | 1,500,000 | 800,000 |
| Protective advances over the period | 1,000,000 | 0 |
| Net income collected | 1,200,000 a year | 1,200,000 a year |
| Transfer tax saving shared with buyer | 2% of value | |
| Latent liabilities priced by buyer / company creditors paid | 1,500,000 / 500,000 | |
| Selling costs, both routes | 2% | 2% |
Route 1: mortgage enforcement. The building is sold as a repossessed asset after two years.
Price = 45,000,000 × (1 − 15%) = 38,250,000; less 2% selling costs = 37,485,000
PV of sale = 37,485,000 × 1.06−2 (0.8900) = 33,361,517
Income less costs and advances = 2,400,000 − 1,500,000 − 1,000,000 = −100,000, PV −94,340
Recovery = 33,267,177, or 66.5% of the loan
Route 2: share pledge. The company is sold with its leases, manager and contracts intact, after six months. The buyer pays for the building, shares part of the transfer tax it saves on a share deal where the jurisdiction taxes those less, and deducts what it inherits.
Price for the building = 45,000,000 × (1 − 8%) = 41,400,000
Share deal adjustments = +900,000 − 1,500,000 − 500,000 = −1,100,000
Gross 40,300,000, less 2% selling costs = 39,494,000; PV at 1.06−0.5 (0.9713) = 38,359,964
Income less costs = 600,000 − 800,000, PV −197,108
Recovery = 38,162,856, or 76.3%
Excel, either route: =(MV*(1-fsd)+adj)*(1-sell)/(1+r)^T+(NOI*T-costs-adv)/(1+r)^(T/2)
| Step | Effect | Points of recovery |
|---|---|---|
| Mortgage enforcement | 33,267,177 | 66.5 |
| Time: 24 months to 6 | +2,008,105 | +4.0 |
| Forced-sale discount: 15% to 8% | +2,998,359 | +6.0 |
| Costs and advances | +936,261 | +1.9 |
| Company-level adjustments | −1,047,046 | −2.1 |
| Share pledge | 38,162,856 | 76.3 |
The price matters more than the speed. A going concern sold with its tenants and manager in place attracts a smaller discount than a repossessed building, and that alone is worth 6.0 points. Speed is worth 4.0 more. The company-level adjustments run the other way: the buyer inherits the company and prices what might be inside it.
| Time to sale | 8% discount | 12% discount | 15% discount |
|---|---|---|---|
| 6 months | 76.3% | 72.9% | 70.3% |
| 12 months | 75.3% | 72.0% | 69.5% |
| 18 months | 74.3% | 71.1% | 68.6% |
| 24 months | 73.3% | 70.2% | 67.8% |
A share pledge enforced in 24 months at the same 15 per cent discount as a court sale still recovers 67.8 per cent, slightly above the mortgage route's 66.5, because of the lower costs. The pledge only loses when the company is a worse thing to buy than the building: at about 6,643,276 of latent liabilities priced by the buyer, 14.8 per cent of the building's value, the two routes are level. The mortgage route, for its part, falls from 69.2 per cent at 12 months to 64.0 at 36.
The pledge is only as good as the company underneath it. Unpaid tax, a dispute with a contractor, a guarantee given to a third party or a defective title to the shares all become the buyer's problem, and the buyer will price them. Diligence on the company belongs in the original credit file, not in the first week of enforcement.
Comparing the two routes on undiscounted recovery. Undiscounted, the mortgage route returns 74.8 per cent and the pledge 78.6, a gap of under four points that looks like a matter of preference. Discounted at the loan rate, the gap is 9.8 points, because the mortgage route's cash arrives eighteen months later and costs more to reach. The second mistake is to assume the pledge is always available. It depends on the security package taken at origination, on the absence of a creditor at company level who ranks ahead, and on the local procedure; a pledge that can be challenged in court can take as long as a mortgage enforcement.
The book treats enforcement as the alternative every other option is priced against; the free workbooks for the case run one loan through six asset classes and price a receiver against a share pledge. What each month of delay costs on its own is worked in what a month of delay costs in an enforcement.
Because it is faster and sells a company with its leases, manager and contracts in place rather than a repossessed building. In the example the smaller forced-sale discount is worth 6.0 points of recovery and the shorter timetable 4.0 points, against 2.1 points lost to liabilities the buyer inherits.
It is the US equivalent: a secured party sells the pledged equity interests in the borrowing entity under the Uniform Commercial Code, usually much faster than a mortgage foreclosure. The arithmetic is the same as here: in the illustrative case a six-month sale recovers 76.3 per cent against 66.5 for a 24-month asset enforcement.
When the company is a worse thing to buy than the building: unpaid tax, disputes, third-party guarantees or creditors ranking at company level. In the example the routes are level once the latent liabilities a buyer prices into the company reach about 6,643,276, 14.8 per cent of the building's value, or when the pledge can be challenged and takes as long as a court sale.
This article is one calculation from The Real Estate Workout. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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