Once the lender owns the building, the question changes from recovering a loan to running an equity investment, and the hurdle changes with it.
Compare the net sale price today with the present value of holding, discounted at the return an owner would require, not at the loan rate. On an illustrative EUR 18.0M repossessed office, selling now nets 17.64. Holding for two years to re-let it is worth 17.77 at a 10 per cent owner's rate: a gain of only 0.13, which needs a 95 per cent chance that the letting succeeds and an exit yield no softer than 6.30 per cent. At the 6.5 per cent loan rate the same hold looks 1.33 better, which is the number that keeps lenders holding.
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 has taken title to a fictional, partly let office after enforcing a EUR 24.0M loan. The asset manager proposes a two-year plan to let the vacant floors before selling. All figures are illustrative, EUR millions.
| Input | Value |
|---|---|
| Market value today, as is | 18.0 |
| Net operating income today, yield | 1.08, 6.00% |
| Sale costs | 2% |
| Net income, years 1 and 2 | 1.10, 1.26 |
| Forward income at exit, once let | 1.30 |
| Letting capex and incentives, mid year 1 | 0.90 |
| Holding costs not recovered from tenants, a year | 0.15 |
| Exit yield, end of year 2 | 6.25% |
| Owner's required return | 10.0% |
Net proceeds = 18.0 × (1 − 2%) = 18.0 − 0.36 = 17.64, or 73.5 cents on the original loan
Year 1: 1.10 − 0.15 = 0.95, PV 0.86
Year 2: 1.26 − 0.15 = 1.11, PV 0.92
Capex: 0.90 at six months, PV −0.86
Exit: 1.30 / 6.25% = 20.80, less 2% = 20.38; PV = 20.38 × 0.8264 = 16.85
Hold value = 0.86 + 0.92 − 0.86 + 16.85 = 17.77
Excel: =NPV(10%,Y1,Y2+Exit)-Capex/(1+10%)^0.5
Undiscounted, the hold returns 21.54 against 17.64: 3.90 more, the figure that appears in the asset manager's proposal. Discounted at an owner's rate the advantage is 0.13. The plan raises income by 20.4 per cent and still barely beats selling, because two years of carry, capex and risk consume almost all of it.
Two numbers make the decision usable by a committee.
| Exit yield | 6.5% | 8% | 10% | 12% |
|---|---|---|---|---|
| 5.75% | 2.89 | 2.32 | 1.59 | 0.91 |
| 6.00% | 2.08 | 1.53 | 0.83 | 0.17 |
| 6.25% | 1.33 | 0.80 | 0.13 | −0.51 |
| 6.50% | 0.64 | 0.13 | −0.52 | −1.13 |
| 6.75% | 0.00 | −0.49 | −1.12 | −1.71 |
Read across the base row. At the 6.5 per cent loan rate the hold is worth 1.33 more; at 12 per cent it is worth 0.51 less. The decision flips on the rate, which is why the rate has to be argued, not inherited from the loan file. A lender that owns a building owns its leasing risk, its capex and its exit; a loan rate prices none of those. An exit 25 basis points firmer, at 6.00 per cent, makes the hold worth 0.83 at 10 per cent, so a genuine view on yields can justify holding. It should be written down as a view on yields, not presented as a recovery plan.
There are also costs that do not appear in a property model: regulatory capital held against a repossessed asset, an asset management team diverted from the rest of the book, and the information a protracted hold gives the market about the lender's other assets. They all point the same way, towards selling, unless the hold clears its hurdle by a margin.
The way to present this to a credit committee is as an investment proposal, not a recovery plan: the capital at risk is the 17.64 the lender could bank today, holding it clears the hurdle by a present value margin of 0.13, and the downside if the letting fails is a loss of 2.59. Framed that way, few committees would approve the hold on these numbers, and the ones that do will at least have voted on the right question.
Comparing the undiscounted hold with today's sale, or discounting it at the loan's contract rate, and concluding that patience pays. Both make holding look 1.33 to 3.90 better than selling, against a true margin of 0.13. The question is the same one as before enforcement, priced in what a month of delay costs in an enforcement: time is not free, and once the lender is the owner it is spending equity-priced time. The method is the owner's hold vs sell analysis on a forward IRR; what changes for a lender is the hurdle, because the asset arrived through a loan priced at a lending rate. The earlier choice of route, between a consensual transfer and a forced sale, is worked in deed in lieu vs foreclosure.
The enforcement model behind the book, including what waiting a year costs on an improving market, is in the free workbook for this case.
A rate for owning the property, not for lending against it. Once the lender holds title it bears the leasing, capex and exit risk an equity investor bears. In the illustrative case holding looks worth 1.33 more than selling at the 6.5 per cent loan rate, but only 0.13 more at a 10 per cent owner's rate.
Solve the exit yield at which the present value of holding equals today's net sale proceeds. In the illustrative case, with income growing from 1.08 to 1.30 after 0.90 of letting capex, the break-even exit yield is 6.30 per cent: the hold wins only if the market prices the re-let building at that yield or firmer.
The hold is a bet on the letting. In the illustrative case, if net income stays at 1.10 in both years and at exit instead of rising to 1.30, the hold is worth 15.05 against 17.64 for selling now, a loss of 2.59. Holding only beats selling if the letting succeeds with at least 95 per cent probability.
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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