Can Zombies Come Back to Life?

By Jay Maddox, Principal, Avison Young: One doesn’t hear much about real estate zombies, but they do in fact exist.
James Maddox

One doesn’t hear much about real estate zombies, but they do in fact exist.  What’s a real estate zombie?  It’s a property that’s worth less than the mortgage, so it can’t be refinanced for anywhere near the current loan amount, yet it has enough cash flow to service the debt.  It is the proverbial “dead loan walking” of real estate.

Commercial property values have recovered to pre-recession levels in many gateway cities, however, the recovery has not been so robust in secondary and tertiary markets where the zombie phenomenon is far more prevalent.  Many of these zombie loans that were originated during the 2005 to 2007 bubble will come due over the next 30 months, and the vultures are already circling. Smelling another potential wave of distressed opportunities, several large private equity funds have raised hundreds of millions of investor capital to chase the zombies.

Here’s an illustration of the dilemma that a zombie borrower might face on a 2005 vintage loan maturing in 2015:

  Original Underwriting Current Underwriting
Valuation $11,200,000 $6,800,000
Loan Amount $8,600,000 $7,300,000
Loan to Value (LTV) 77 % 107 %
Occupancy 100% 82%
Net Operating Income $918,000 $700,000
Debt Coverage Ratio (DCR) 1.86x 1.09x


In this zombie scenario, the original underwriting seemed prudent but the current underwriting is upside down. In-place NOI supports the current debt service, however, the value has plummeted below the loan amount because of increased vacancy, near-term lease rolls, and a drop in market rents. The loan is now due, and a default is imminent unless the borrower can refinance.  In order to do so, the borrower would need to contribute about $2.5 million to pay off the maturing CMBS loan, using a conventional 70 percent LTV first mortgage. Additionally, the new lender would require the borrower to contribute reserves to address the vacancy and lease rolls, not a pretty picture to be sure.

Many of these zombie loans will end up in the hands of CMBS special servicers as they become maturity-defaulted, and as a consequence, borrowers may find their options to be limited:

  • Loan Extension – It may be possible to negotiate a short-term extension subject to a principal pay-down and fees, which might make sense if there are property-level issues that the borrower believes it can address. However, the special servicer may instead foreclose if it believes the value is significantly impaired.
  • Recapitalize – The borrower may be in a position to contribute new equity and/or obtain third party sub-debt or equity (together with a new first mortgage) in a sufficient amount to repay the maturing debt. This approach will generally work in situations where the property value is not significantly below the loan amount. Subordinate debt or equity financing may be difficult to obtain from third party sources that are typically commanding high returns on opportunistic or value-added projects. Further, the borrower will face substantial dilution of its ownership interest using third-party capital.
  • Short Sale or Deed in Lieu of Foreclosure – In situations where the value gap is substantial, the owner can potentially sell the property to repay the debt subject to a negotiated short sale or discounted payoff. Alternatively, the seller may negotiate a deed in lieu of foreclosure. These approaches may trigger significant taxes for capital gains and recapture.
  • Debt Restructuring – For large loans in excess of $25 million where the value is not significantly below the loan amount, it may be possible to negotiate a longer term debt restructuring with the CMBS special servicer, subject to a new capital infusion that is made concurrent with a restructuring of the loan. These transactions hinge upon a credible plan to improve the property’s operations and value, and are complex and very difficult to accomplish, but they are not impossible.

Zombie borrowers that hope to rejoin the ranks of the living face daunting challenges, but there is hope.  To preserve their investment, it is critical to understand not only the available options, but also the tax consequences. Expert third-party advisors can help zombie borrowers navigate these difficult challenges, and hopefully help bring them back to life.