What is a Discounted Payoff
The discounted payoff is the repayment of a loan in an amount that is less than the principal balance outstanding. A discounted payoff (DPO) is one of the alternatives available for resolving a problem debt situation in commercial real estate. Such problem debt occurs when a real estate asset has declined significantly in value, resulting in the outstanding loan amount being greater than the amount that can be refinanced. Since writing off part of a loan results in a financial hit to the lender, the lender will only consider a discounted payoff if all other avenues for recovery of the full amount of the outstanding principal have been exhausted.
BREAKING DOWN Discounted Payoff
A lender may resort to a discounted payoff if the borrower does not have the willingness or capacity to inject additional equity in order to refinance the asset, and if foreclosure and subsequent sale of the asset will not result in full recovery of the outstanding loan amount.
Once the DPO has been negotiated between the borrower and the lender, the borrower has to raise the capital to pay off the loan. Since it is generally unlikely that a new lender will finance a payoff on which the previous lender took a haircut, the borrower may have to opt for a bridge loan until such time as conventional refinancing is available.
The discounted payoff amount will form the new cost base for the property. Bridge lenders will require the borrower to pump in a substantial amount of equity into the asset, in order to have a sufficient margin of safety on the bridge loan.
For example, assume a $10 million building was financed with $7.5 million in debt and $2.5 million in equity. After five years, because real estate prices have slumped, the building is now worth only $6.5 million, while the principal amount outstanding on the loan is $7 million. The buyer therefore is "underwater" on the property to the extent of $0.5 million.
The borrower is unable to refinance the full $7 million principal amount outstanding. The lender decides that due to the soft property market, the best option available to minimize its loss is to go for a discounted payoff. The DPO is therefore established at $6.5 million. The borrower then raises the $6.5 million by injecting $0.5 million as its equity contribution, raising $2.5 million from other equity investors, and obtaining a bridge loan of $3.5 million. This amount of $6.5 million is then used by the borrower to pay off the DPO amount to the original lender.