A protective advance priced as a decision: enforce the building as it stands, or fund the fit-out, wait for the letting and sell it stabilised.
A lender should fund the letting of a defaulted building when the probability that the letting works is above the break-even at which the advance and an immediate enforcement are worth the same. On an illustrative 50.00m loan secured on a half-empty office, a 6.00m advance for fit-out, fees and incentives lifts the expected recovery from 55.2 to 63.3 cents on the euro at even odds, and it pays whenever the letting has better than a 28.0 per cent chance of success.
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 building in default is often half empty, and empty space is worth very little in a forced sale. The lender could enforce now and sell the building as it stands. Or it could fund the work that lets the vacant floors, add the money to its secured claim as a protective advance, and sell the building stabilised two or three years later. The second route usually looks far better on a valuation, because let space is worth a multiple of its fit-out. It is also slower, and it can fail, in which case the lender has spent new money and enforced later anyway. All three outcomes have to be put on the same basis before they can be compared.
| Input | Value |
|---|---|
| Loan outstanding | 50.00 |
| Net operating income in place, half the space let | 2.40 |
| Market yield | 7.00% |
| Forced-sale discount in enforcement | 15% |
| Enforcement costs, share of gross proceeds | 5% |
| Years to enforce as it stands | 1.5 |
| Lender's advance: fit-out, letting fees, incentives | 6.00 |
| Extra income once the vacant space is let | 1.30 |
| Years to let, stabilise and sell consensually | 2.5 |
| Consensual sale costs | 2% |
| Probability the letting succeeds | 50% |
| If it fails: share of the advance reflected in value | 25% |
| If it fails: years to cash | 3.0 |
| Lender's discount rate for a distressed asset | 9% |
The income in place is paid to the lender throughout, under a cash sweep or by a receiver. While the new space is let and in its rent-free period, income stays at 2.40.
Step 1: enforce as it stands. The building is worth 2.40 ÷ 7.00% = 34.29. A forced sale and its costs leave 34.29 × 85% × 95% = 27.69 at 1.5 years, after income of 2.40 in year one and 1.20 for the half year. Undiscounted that is 31.29; discounted at 9 per cent it is 27.58, or 55.2 cents.
PV = 2.40 ÷ 1.09 + (1.20 + 27.69) ÷ 1.091.5 = 27.58
In Excel: =NPV(9%,2.4)+(1.2+27.69)/1.09^1.5
Step 2: advance and succeed. The lender pays 6.00 today. Income rises by 1.30 to 3.70, so the stabilised value is 3.70 ÷ 7.00% = 52.86, and a consensual sale nets 51.80 at 2.5 years. The lender's claim is now 56.00, the loan plus the advance, so all 51.80 comes to the lender. With 2.5 years of income in between, the present value is 40.95, or 81.9 cents.
Step 3: advance and fail. The space does not let. The fit-out adds 1.50 to the value, a quarter of what was spent, so the building is worth 35.79 and a forced sale nets 28.90, a year and a half later than in step 1. Net of the 6.00 advance and with three years of income, the present value is 22.39, or 44.8 cents.
Step 4: weigh and compare.
Expected PV = 50% × 40.95 + 50% × 22.39 = 31.67, or 63.3 cents
Break-even probability = (27.58 − 22.39) ÷ (40.95 − 22.39) = 28.0%
In Excel: =(Enforce-Fail)/(Succeed-Fail)
At even odds the advance is worth 4.08 more than enforcing now: each euro advanced adds 0.68 of present value. The more useful figure for a credit committee is the break-even. The leasing team does not have to be confident; it has to be more than 28.0 per cent likely to be right.
| Probability | Expected PV | Gain over enforcing now |
|---|---|---|
| 20% | 26.10 | −1.48 |
| 40% | 29.81 | 2.23 |
| 50% | 31.67 | 4.08 |
| 60% | 33.53 | 5.94 |
| 80% | 37.24 | 9.65 |
| Extra income | Stabilised value | Paid to lender | Surplus to borrower | PV if success | Break-even probability |
|---|---|---|---|---|---|
| 0.70 | 44.29 | 43.40 | 0.00 | 34.18 | 44.1% |
| 1.00 | 48.57 | 47.60 | 0.00 | 37.56 | 34.2% |
| 1.30 | 52.86 | 51.80 | 0.00 | 40.95 | 28.0% |
| 2.00 | 62.86 | 56.00 | 5.60 | 44.34 | 23.7% |
At an extra 2.00 of income the building sells for more than the lender is owed, and the 5.60 above the 56.00 claim belongs to the borrower. The lender's upside is capped at its claim; its downside is not. Raise the lender's discount rate and the decision tightens too: the break-even probability is 23.2 per cent at 7 per cent, 35.0 at 12 and 41.9 at 15, because the advance is paid now and the reward arrives a year after enforcement would have.
Comparing the advance with the uplift in value. Letting the space turns a forced-sale recovery of 27.69 into a sale at 51.80, a gain of 24.11 for an outlay of 6.00, and on that basis the advance looks like a fourfold return. It is not. The uplift arrives a year later, it happens only if the letting works, and above the lender's claim it is the borrower's money. Once those three things are applied, the 6.00 adds 4.08 at even odds and destroys value below 28.0 per cent.
Check the documents before relying on the ranking. A protective advance is secured and senior only if the facility agreement or the intercreditor says so; in a syndicate or behind a mezzanine lender, new money may need consent or rank pari passu with the debt it is meant to protect.
Price the advance as three discounted outcomes, solve for the break-even probability, and ask the leasing team whether it is above that line, not whether the building would be worth more let. The book's case runs enforcement, extension, consensual sale and discounted payoff on one horizon; the free workbooks for the Harbour Quay loan include the enforcement model this sits against. The buyer's side of the same problem is in how to price a non-performing CRE loan.
Money the lender pays out to protect its collateral, such as insurance, taxes, essential repairs or, in a workout, the fit-out and fees needed to let empty space. The loan documents usually add it to the secured debt with interest. In the example a 6.00m advance raises the lender's claim from 50.00m to 56.00m, which matters only if the building is ever worth more than the original loan.
Value three outcomes at the same discount rate: enforce now, advance and succeed, advance and fail. The break-even probability is (enforce minus fail) divided by (succeed minus fail). Here that is (27.58 minus 22.39) divided by (40.95 minus 22.39), or 28.0 per cent. Above it the advance adds value; below it the lender should enforce the building as it stands.
Because the advance is paid today and the recovery arrives later. At 9 per cent the break-even probability is 28.0 per cent; at 15 per cent it rises to 41.9 per cent, since the letting route returns its cash a year after enforcement would. A lender under pressure to clear its book is, in effect, using the higher rate.
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.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: real estate investing, finance and fund management → · All 1614 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.