Lenders, borrowers must speak same language.

Negotiations involving troubled real estate can no longer be settled verbally or on the back of a napkin. With the increasing influence of regulatory authorities and scrutiny by "third party" credit and creditors' committees, real estate decisions must be based on written answers to four critical questions regarding the borrowing entity, its owners and guarantors in addition to property-based appraisals: Where did the money go? Is enough information available to make an informed and well documented decision? Is additional collateral value in the borrowing entity and guarantees available? And what are the financial implications of various litigation and bankruptcy scenarios to the borrowing entity and the guarantors?

Unfortunately, most borrowers and lenders do not have this information available in advance of litigations and, therefore, must spend thousands of dollars in fees and costs on the discovery process. Information that can be accumulated and presented for $1 per asset before litigation often costs up to $5 per asset once litigation commences.

Without this information, the time pressure of the regulatory environment often forces lenders to "push the button" by default and start litigation proceedings without understanding the true and probably damaging cost of their action. The situation between borrowers and lenders is tantamount to an emergency meeting of the U.N. General Assembly in which two nations on the brink of war have set down negotiation time limits without speaking the same language or having the benefit of translators.

When borrowers and lenders sit down at the table, there must be an effective exchange of information that satisfies both parties. Generally, this is accomplished with a full disclosure or factual "fishbowl" report. Regardless of which side provides this " arms length, "forensic report, its objective is to provide a level playing field for all parties and their counsel, and to adequately describe the key issues utilizing real numbers for decision alternatives. Only then can both parties negotiate and achieve satisfactory results.

1. Where did the money go and does the borrower have clean hands?

An explanation and independent verification of how funds were used is the most critical element of the presentation process. Lenders must have written confirmation that borrowers are providing full and adequate disclosure, and that no undisclosed payments or transfers have been made contrary to their position. This analysis is designed to portray the true operating levels of the assets, a necessary component when evaluating opportunities to bring in new investors or provide additional funds.

The report must also include a full disclosure of other financial obligations, deals with other lenders and any other information that is relevant to timely, ultimate recovery for the lender. Examples of transactions that require detailed disclosure include transfers to related parties, dispositions of assets, and current negotiations and recent deals with other creditors.

2. In addition to a property-based appraisal, does the lender have adequate information on the borrowing entity and guarantors to evaluate the other real estate, accounting and credit issues directly affecting the value of the property, its recoverability and liquidity?

While standard highest and best use appraisals provide an important valuation, they are designed to value situations between willing buyers and sellers. Troubled real estate negotiations by definition do not fall in this category unless the impact of the other real estate, accounting and credit issues can be reconciled. In addition, actual income and expenses at the property ownership level may be quite different from those at the management level that were used in the appraisal. Many of the "soft cost" dollars and issues of ownership do not influence appraisal valuations, yet provide critical information in lenders' decisions to foreclose or settle.

Other indirect issues that require evaluation include the nature and status of other liabilities facing the property, its borrowing entity, the indirect owners and guarantees. Specific issues include envirommental problems and the going concern of the borrowing entity and/or its owners and guarantors.

3. Is there additional collateral value in the borrowing entity and the guarantees, or is recovery potential realistically limited to the specific collateral?

The evaluation of collateral value in the borrowing entity and the guarantees is a major and required analysis of troubled real estate negotiations. Decisions made without this information in advance often do the lender more harm than good, especially when the borrowing entity and guarantors are real estate developers and investors with multiple properties. The borrower and lender must recognize the realistic recovery value of the borrowing entity and the guarantees before direct property litigation commences.

In cases involving most real estate developers, litigation should be avoided at all cost because the underlying properties are the only source of recovery for the lender. Non-litigation alternatives must be seriously considered since property litigation will, almost always, reduce the ultimate recovery and liquidity of the property. On the other hand, if the borrowing entity and the guarantors are determined to have significant value to the lender, settlements can be expedited based on realistic estimates of costs and losses associated with litigation and bankruptcy.

4. What are the expected financial outcomes of litigation and bankruptcy scenarios in terms of the property, the entity and the guarantees?

A timely evaluation of the impact of litigation and bankruptcy is probably the most overlooked analysis prior to actions by borrowers and lenders. With most litigations and bankruptcies costing in excess of $75,000, an evaluation that can probably be obtained for less than $15,000 is a prudent investment. If litigation proceeds, the evaluation is the most cost-effective method of accumulating relevant data compared to the standard discovery process.

The evaluation must combine three forensic analyses. First is the realistic valuation of the real estate once litigation, foreclosure and bankruptcy commences. This can be estimated in terms of a percentage reduction in value and an increase in the disposition time due to expanded due diligence requirements on the part of prospective investors lenders.

Second is a realistic evaluation of the overall property, borrowing entity and guarantors financial positions and true operating conditions. This is required in multiple asset litigations and bankruptcies, and single assets with recourse. The third is an evaluation of the liabilities and going concern issues facing the borrowing entity, its owners and guarantors. Very often, the actions of other creditors play a significant role in the ultimate recovery of a specific asset.

Today, troubled real estate negotiations are examined in a fishbowl rather than quietly, under a rock. By answering these four important questions, borrowers and lenders can see eye-to-eye and communicate in the same language with a clear understanding of how future actions will affect the value of problem real estate.

Real Estate Evaluation Services (REES) is a Rye, New York-based, national forensic accounting and real estate consulting firm with offices in Manhattan, Los Angeles, Philadelphia, Atlanta and San Francisco.