An upswing in defaulted real estate loans signals a continued downward trend in the market cycle. Developers with in-progress residential condominium projects are particularly struggling with insolvency, but legal specialists who advise both lenders and borrowers report a growing demand for remedies across all types of distressed properties.

“Most discussions I’ve had involve mezzanine lenders, private lenders and those who charge higher interest rates and are more susceptible to these kinds of upsets in the market,” Norman Kahn, a partner with Aird & Berlis LLP’s real estate group, reported during a recent webinar. “But, from calls I’ve had from some of my institutional clients, I know they’re also getting ready, expecting there will be mortgage defaults coming their way.”

Many creditors and debtors are now grappling with the fallout from a largely unexpected change in market conditions over the course of their loan agreements. Kahn noted that his 42-year career has thus far encompassed two real estate recessions, but, tellingly, they occurred in the early 1980s and early 1990s. With a majority of today’s real estate players lacking familiarity with those times, he and other Aird & Berlis colleagues offered something of a crash course in the machinations of power of sale, foreclosure, judicial sale, receivership and workouts.

Beginning with the most precarious market segment, Sam Billard, a partner with Aird & Berlis’ financial services group, stressed that condo projects are most vulnerable to unexpected upheaval during the construction period when their financing has been fixed and they can’t generate income until completion. Typically, developers look to presell about 70 per cent of the units and use deposits from those buyers to secure the remainder of their financing. Prior to 2020, they could generally expect to retain 10 to 20 per cent of total funds from unit sales once they had completed the project and paid off the construction loans, but delays and spiking costs have recently eroded those margins.

Statistics Canada has pegged construction cost inflation at about 80 per cent between the second quarters of 2020 and 2022, which occurred alongside pandemic-related work slowdowns or outright stoppages and supply chain constraints. Even if developers had foreseen that trio of challenges coming, it’s unlikely they could have successfully accounted for it in unit presales.

“When you’re selling on day one, you couldn’t tell people: You have to pay double the (current) market rate to get your condo. Nobody could price that much price increase into a presale contract; you wouldn’t sell it,” Billard observed. “Also, they have been working on slower cycles and delays are rampant. If you start out at 15 per cent recovery on the basis of an 18-month construction cycle and that becomes as 36-month construction cycle, that’s a problem.”

He concludes that most developers in southwestern Ontario are taking losses as they complete projects. For now, that’s primarily flowing through to subordinated debt holders when lenders are affected.

“It hasn’t got up to the senior secured level yet, but it may get there,” Billard mused.

Power of sale unfolds outside the courts

Kahn sketched out the relative merits of power of sale versus foreclosure and some scenarios in which each approach may work best for lenders or borrowers. Either action must begin with a series of required steps to give debtors notification and time to repay the loan, but power of sale is typically faster and less costly because it does not involve court proceedings. Meanwhile, Sanjeev Mitra, a partner in Aird & Berlis’ financial services group, explained that receivership, which involves a licensed third party to oversee all aspects of recovering funds owing, is typically more time-consuming and costly than either power of sale or foreclosure, but is often favoured for complicated insolvencies with multiple creditors.

Through power of sale — which is authorized under Ontario’s Mortgages Act (or equivalent statutes in other provinces) and is generally also contractually stated in mortgages — creditors take possession of and sell a property in order to recoup the debt. This option allows them to recover the defaulted loan amount only and makes them responsible for disbursing surplus earnings from the property sale to other creditors and/or back to the borrower.

On the flipside, lenders have the right to pursue borrowers for the remaining loan amount if the property sale is insufficient to cover the debt. Since creditors don’t take ownership of the insolvent property, they avoid land transfer tax and many obligations that landlords incur, although there are special circumstances for power of sale of a residential complex.

“The other big liability you try to avoid is, of course, environmental issues. So that’s the best way to keep yourself out of it,” Kahn said.

For their part, insolvent borrowers can legally challenge a power sale and require creditors to prove it is valid. Beyond adhering to statutory or contractual requirements for notifying borrowers and providing time to repay the debt, creditors must be able to prove the sale price reflects the property’s market value.

“The best practice would be to make sure that you’ve got at least two appropriate appraisals from appraisers who understand the market, and that you have listed the property with an appropriate real estate broker who markets the property appropriately, advertising it widely to the appropriate audience,” Kahn advised. “If you can establish you’ve done that and sold the property within the appraisal values, you are likely to be okay.”

Foreclosure claims often converted to judicial sales

With foreclosure, creditors take ownership of the property in exchange for the debt. In doing so, they pay land transfer tax, relinquish the right to further pursue the borrower and are entitled to keep all profits from the eventual sale of the property. However, other legal mechanisms to protect borrowers makes this a relatively rare outcome.

Foreclosure is a legal proceeding, which begins when the creditor issues a statement of claim. At this point, the borrower can appeal to the court to convert the foreclosure to a judicial sale. If granted, that will force the creditor to sell rather than hold the property and it will reestablish other creditors’ and the borrower’s entitlement to any surplus proceeds beyond the amount owing. Kahn likened judicial sales to the power of sale process, but with court oversight that eliminates the debtor’s ability to challenge its validity.

“If the lender wants to foreclose on the property and the borrower has good grounds to believe that the property is worth more than the amount of the debt, the bar is low to go to court, within a certain time limit, and require the court to turn that into a judicial sale,” he said. “The reason is, the borrower should have the right to redeem the mortgage to pay it off and get an accounting if there are excess proceeds.”

A straightforward foreclosure is most likely to occur in cases where the debt surpasses the value of property. In this, Kahn speculated there could eventually be a payoff if the new owners hold it until market conditions change.

“If you have patience and patient money, you may think: well this property may turn around in the future and I may take a windfall on it down the road with a redevelopment. Foreclosure, in those circumstances, may make some sense,” he mused. “The reason the remedy is not used very often is because, in most instances, a borrower will require you to sell the property under judicial sale so you’re stuck with selling it anyway, especially if the property is worth more than the value of your mortgage.”

Receivership relies on licensed third-party trustee

Receivership unfolds similarly to a judicial sale, but with the third party receiver administering it. In some cases, a mortgage contract will include authority to appoint a receiver, but, more commonly, receivers are court appointed and act as legal officers of the court.

“Usually when you’ve got an insolvent situation, all the creditors are scrambling to try to get their money back. The receiver focuses first on monetizing the collateral and then taking steps to distribute to the creditors based on the statutory scheme of priorities — property taxes get paid out first; the first mortgagee gets paid out next; there may be CRA (Canada Revenue Agency) trust claims; there may be unsecured creditors; there may be new claimants,” Mitra said. “It’s complicated, but that’s one of the reasons that you have a court supervised process. It’s meant to get priorities and disputes resolved and moneys paid to the correct parties as transparently and efficiently as possible.”

Receivers also oversee any required emergency maintenance and repairs or ongoing property management, as well as the marketing and sales process. Much of the added costliness of the process is for covering the receiver’s professional services, which, along with property tax, take precedence over other claims.

“If you’re going down this route, you want to know that there’s probably enough equity to pay for this process,” Mitra said. “The other reason you might be using a receiver is if there are some environmental concerns and the lender doesn’t want to even risk getting associated with the project — let the receiver and the court make the determination as to how the property should be wound down, decommissioned or sold.”

Workouts derived from lender-borrower collaboration

Alternatively, lenders and borrowers may choose to resolve a default collaboratively through a workout. Such a plan and schedule for remedying the debt could be enacted through amendments to the original loan agreement or a forbearance agreement, which is a new contract stating conditions the borrower must fulfill.

“It’s a lot less risky and more efficient to get a voluntary payout than going through the process of enforcement, but it requires a good level of trust and cooperation between the borrower and lender,” maintained Mistrale Lepage-Chouinard, a partner with Aird & Berlis’ real estate group. “On the borrower’s side, it requires a solid plan to remedy the situation. On the lender’s side, it requires some financial and legal due diligence to determine the strength and weakness of the borrower and the lender’s security.”

Kahn cited a current example in Allied Properties REIT’s recent announcement that it is converting the mezzanine loans it holds on Westbank Corp. developments in Vancouver and Toronto into equity in the projects. The deal, which is expected to be completed next month, will give Allied Properties respective ownership stakes of 90 and 95 per cent — an increase from its previous 50 per cent interest in the Toronto project. “The transactions will reduce Westbank’s debt to Allied materially and afford Allied a large ownership position in two triple-A urban properties as they near successful completion and full lease-up,” the REIT’s announcement states.

“I wouldn’t exactly call it a quit claim, but it’s tantamount to what a quit claim really does and represents,” Kahn submitted. “I assume they think they are better off having an ownership interest than having a debt that is in default.”