The tragic and widespread effects of COVID-19 continue to unfold on a daily basis. The pandemic’s impact from both a public health and economic perspective has been literally unfathomable. For commercial real estate owners, no matter what types of properties you own, the long term implications of this novel coronavirus cannot yet be fully assessed, especially since the economic recession we are now facing has only recently been confirmed and the public health uncertainties resulting from COVID-19 continue to ensue. In June 2020, Moody’s Analytics projected a second recession in 2020 without additional fiscal support and a temporary but severe decline in commercial real estate valuations between now and early 2021 with a substantial recovery in 2022.
Since commercial real estate is a “leverage” business, one common challenge that many owners will possibly face is the need to restructure the loans secured by their properties in order to achieve more realistic and achievable economic terms and to avoid loan defaults, foreclosures and the loss of their properties. As a Primer for those lucky few real estate owners and advisors that have not worked through previous real estate cycles (and as a refresher for those unfortunates, like myself, who have), here are ten key considerations to guide you generally in pursuing loan restructuring transactions with your lenders.
1. Identify the entire “Business Problem.”
The first step in approaching any loan workout transaction is to identify the root causes of your property’s distress and why the property is facing challenges in complying with the requirements of your loan. In light of the pandemic, one obvious issue is the severe, unanticipated and abrupt decline in rental revenue experienced by many owners due to the impact of state mandated “shelter in place” orders and the seemingly ever increasing unemployment numbers. Where it is occurring, this loss of rental revenue is materially impairing the ability of owners to make regular debt service payments on their loans. What other problems at or affecting the property need to be addressed through a loan workout, such as immediately needed repairs that have been delayed or structural defects that have been deferred due to the absence of needed capital to pay for the associated expenditures or persistent vacancies due to pre-pandemic causes? Your goal in this analysis is to develop a complete picture of what’s wrong so that in restructuring the loan, all looming issues can be addressed in a comprehensive manner, enabling the property to get back on track and stabilize. From the lender’s lens, it is critical that you demonstrate a legitimate understanding of the issues and thoughtfully expressed need for relief through your proposed modifications to the loan terms. Developing this business case will best position you to respond to this lender imperative. Few lenders are willing to do successive workouts of a loan. Therefore, make your best, complete business case for your one loan workout opportunity with your lender.
2. Know your Lender.
Before you approach your lender, it is critical for you to evaluate the type of lender that currently holds your loan. This is important because lenders will approach loan restructuring requests differently depending on the whether they are private lenders, CMBS lenders, government sponsored enterprises, public debt funds, life insurance companies, commercial banks or thrifts or other types of regulated lending institutions or enterprises. Private lenders are typically more willing and able to be creative and flexible in restructuring loans than are traditional institutional lenders constrained by regulatory and financial reporting requirements. CMBS lenders, i.e., special servicers, tend to be the least flexible (and most expensive) in restructuring loans. Understanding your lender and its likely approach may enable you to better anticipate the factors that will control, constrain and guide it in a workout transaction. These considerations should be factored into your loan workout proposal. Lender constraints may include, among other things, whether the lender is subject to loan regulators or loan committees, if the lender has an aversion to setting unfavorable precedents by agreeing to modified loan terms, or the adverse consequences that could result from the loan modifications. Try to evaluate from the lender’s perspective what its goals in restructuring the loan will be, which will include the need to maximize recovery of the loan proceeds. For example, what will the impact be on a regulated lender’s risk based capital under the temporary (and still evolving) regulatory authorizations to defer loan payments and will that regulated lender be required to “charge-off” the entire loan if it is not repaid within five years of the workout? If feasible, also try to obtain intel about the lender’s approach to loan workouts during previous real estate cycles. Does the lender genuinely have an appetite and ability to take back the property? Most lenders have little or no interest in becoming real estate owners and holding a portfolio of foreclosed properties because of regulatory criticism. No doubt that one trade off the lender will be evaluating is its potential for recovery in a consensual loan workout transaction versus the recovery it would achieve through a bankruptcy proceeding or uncontested foreclosure sale which maximizes the write-down on its books. Many lenders will be more inclined to achieve a recovery of their loan through a consensual loan workout rather than through an uncontested foreclosure or bankruptcy proceeding with their attendant risks, expenses, delays and increased responsibility for disposing of the property.
3. Get Organized and Be Prepared.
Do your homework and get organized before you approach your lender with any loan restructuring proposal. Here’s a quick bullet point list of some of the actions to take in preparation for your discussions:
- Review and understand the terms of your loan documents including:
- available notice and cure periods for your defaults,
- remedies available to your lender, including receivership and “confession of judgment” rights against the borrower and/or any loan guarantors;
- lock box requirements, if any; and
- the types of recourse exposure any loan guarantors will face, ranging from loss or damage claims by the lender to full springing recourse exposure for the entire outstanding loan balance of the loan, accrued and unpaid interest and lender costs.
- Identify all stakeholders who may have an interest in the loan restructuring terms and determine whether you should coordinate with them prior to or during your negotiations with the lender. This could include:
- other lenders for the property (i.e., subordinate or mezzanine lenders),
- equity investors (i.e., institutional and private investors),
- contractors who may have pending or possible mechanics’ lien claims, and
- major commercial tenants. Since your tenants are the primary source for your monthly loan payments, research their financial health and probability of making their lease payments. You may need to be coordinating lease workouts with your lender at the same time you are doing your loan workout.
- Review the organizational and governing documents of the borrower and any other relevant entities in the property’s ownership structure to identify requirements you must satisfy (such as approval rights by investors) before you initiate or finalize any loan restructuring terms.
- Obtain a title report on the property and run a UCC lien search on the borrower, any guarantor or other borrower affiliated parties to identify if there are outstanding mechanics’ liens or other title issues or recorded financing statements that will be of concern to the lender or that could trigger guarantor liability (and consider resolving these prior to engaging with your lender).
- Develop a list of unpaid operating expenses, real estate taxes, insurance premiums, utilities or other property related expenses and deferred maintenance and capital expenditures so that you can negotiate modified loan terms that will enable these to be paid.
- Prepare financial statements accurately reflecting the current financial condition of the property, borrower and any loan guarantors.
- Study emergency legislation in response to the pandemic which provides payment deferrals for borrowers and tenants, grants or forgivable loans for businesses, and moratoriums on evictions and foreclosures so you know your rights, your tenants’ rights and limitations on your lender’s enforcement rights. If you are eligible for a grant or forgivable loan, apply for it to prove you are doing everything you can to support the property.
- Be prepared for the lender to require an appraisal of the property and consider obtaining informal or formal broker opinions of value (so you have a sense of the property’s current fair market value going into the negotiations). This will enable you to prepare your position as to whether the appraised value is fair and accurate under the circumstances we are currently facing and how the market value will recover as the economy recovers.
4. Beware of Guaranty Obligations.
Be sure to understand and do everything within your control to comply with the terms of any loan guaranties given in favor of your lender. Your goal is to make sure you do not (inadvertently or otherwise) trigger either non-recourse “loss or damage” liability or full “springing recourse” liability (i.e., for the entire outstanding principal balance and unpaid accrued interest under the loan, plus the lender’s enforcement costs) for your loan guarantors. A few examples of possible guaranty liability triggers include (depending on the type of property securing the loan):
- amending or working-out leases for the property without the lender’s consent,
- failing to timely provide materially accurate financial statements to the lender,
- failing to timely pay real estate taxes or required insurance premiums or failing to bond off or insure over any mechanics’ liens affecting the property,
- transferring ownership interests in entities that directly or indirectly own interests in the borrowing entity or loan guarantors; or
- filing or colluding in the filing of any bankruptcy petitions or otherwise admitting in writing the borrower’s inability to pay the property’s debts or obligations as they become due. It is critical to check your loan documents carefully so that you understand all guaranty liability triggers.
If you determine that you have already potentially triggered exposure under the loan guaranties, before you approach the lender, evaluate the various strategies you can implement to minimize any resulting loss or damage to your lender resulting from the guaranty breach and to otherwise cure the relevant default so as to reduce the possible exposure of the loan guarantors.
5. Propose a Comprehensive Loan Restructuring Plan.
Before you initiate communications with your lender, develop a comprehensive plan that you, in good faith, believe will address all the business issues the property is facing in meeting its obligations under the current loan terms. Your proposed loan modification terms should be ones that you genuinely believe are achievable in light of the current facts and circumstances affecting the property and will ultimately stabilize the economic performance of the property. Be prepared to communicate to your lender the assumptions you have made in determining the terms you have proposed, including assumptions that directly speak to the tremendous uncertainties we all still face as a result of the continuing global rise of COVID-19 cases and the continuing economic fallout from the pandemic. If you are proposing only payment deferrals with the continued accrual of interest and possibly an extension of the loan term, one of your goals will be to enable the lender to consider the loan in good standing and a “performing loan” once your plan is fully implemented. It is critical that your proposed plan address who will bear any losses that may result from the implementation of the modified loan terms (with a view toward minimizing the losses your lender will face). If your plan includes forgiveness of principal or interest by a regulated lender, include a requirement that you will sell the property or refinance the loan within five years so that lender will not have to write-off the loan unless the workout plan fails.
Where possible, your plan should include a range of possible solutions that could resolve the property’s issues under the loan including terms that vary with external, objective economic factors that will impact the performance of your property and can be easily measured. This comprehensive approach, which must take into account all concerns – from your lender’s perspective as well as from your own – will enhance your creditability with the lender and better position you to achieve a favorable outcome in the loan workout. Here are some points to consider for your proposed loan restructuring plan, with the caveat that any plan you propose must be customized to address the specific needs of your property and the regulatory and financial reporting impact on the lender:
- Set the stage with reasonable expectations. Be reasonably transparent about the issues and direct about the solutions will best enable the issues to be addressed.
- Ask for maximum recovery time. Evaluate the timeframe that you think will be needed to allow the property to recover, and then add a commercially reasonable amount of additional time so that you have a buffer in case your assumptions are incorrect. However, don’t expect a regulated lender to give you longer than five years.
- In any loan restructuring transaction, there will be a loss. Your plan should endeavor to mitigate the lender’s loss while protecting your ownership interests in the property. Consider offering additional value to the lender, such as the following possibilities:
- offer the lender an economic interest in the upside (once the property recovers) until the lender is made whole (based on the original loan terms),
- contribute something valuable to the workout to demonstrate you have “skin in the game,” such as additional cash in the form of escrows, additional collateral for the loan, or a contribution to the property of unique services that the lender cannot buy or replace without a cost (e.g., rehab competencies within your organization that can be completed at cost plus overhead and without profit), or
- commit to that you will offer future financings to lender on a right of first offer basis.
- Make specific requests for needed modifications to the loan’s economic terms based on the reduced revenue currently being generated by the property, including:
- the deferral or complete waiver of interest and/or principal payments under the loan for a limited period of time to enable the property time to recover,
- converting the loan to an interest-only payment schedule for some period of time,
- a reduction of the interest rate payable under the loan,
- a forgiveness of some portion of the principal amount of the loan, or
- an extension of the maturity date of the loan, but not more than five years for a regulated lender.
- If you cannot envision a circumstance where the property and the loan can get back on track through a successful loan modification transaction, then consider requesting that the lender agree to take the property back by accepting a deed-in-lieu of foreclosure or holding an uncontested foreclosure sale, assuming there are no junior liens on the property. This might be a more favorable approach (than a costly and lengthy contested foreclosure process) from the lender’s perspective and give you bargaining leverage to achieve needed relief for the loan guarantors of liability for loss or damage or even full springing recourse exposure under the loan. This may also give the borrower’s investors some time to plan for the tax impact of a deed-in-lieu or uncontested foreclosure sale.
- If the borrower or its affiliate has received a Paycheck Protection Plan (PPP) loan, be prepared to disclose to the lender specifically how the PPP loan proceeds were applied and whether you, in good faith, believe that the PPP loan qualifies for forgiveness under the Small Business Administration’s current regulations and related guidance.
- Be prepared to explain in reasonable detail how, in the midst of continuing public health and economic uncertainty generated by the pandemic, you have in a commercially reasonable manner “stressed tested” the assumptions underlying your proposed restructuring plan and that your plan expressly takes into account the lender’s concerns.
6. Act Quickly and Communicate Often.
Even though in today’s stressful circumstances, you might prefer to act like an ostrich and hide your head in the sand, acting quickly and communicating regularly with your lender is the better approach. The sooner you approach the lender and reach an agreement about the needed restructuring terms for your loan, the greater the likelihood you will be able to achieve this outcome before the property securing the loan faces further deterioration in its market value. This will better position you to achieve a workout agreement with your lender. Unlike other real estate market cycles or distressed property scenarios, the pandemic could not be anticipated, it is not your fault nor your lender’s fault and, assuming it is the root cause of the property’s distress, you cannot be blamed for the economic distress your property is experiencing or its impact on the loan. Your lender and you must work together to achieve the best available outcome for both parties. Once you begin the discussions, be sure to act in good faith and to provide accurate information requested by your lender. Additionally, be sure to communicate frequently and consistently. By taking on the burden of facilitating communication you will not just preserve, but also enhance your relationship with your lender.
7. Keep in Mind that “Cash is King.”
Cash is king in any distressed property situation and associated loan restructuring transaction. Wherever possible (i.e., without triggering guarantor liability), you should endeavor to conserve the property’s cash where you control it in a separate account not subject to the lender’s UCC lien. However, do not take cash subject to the lender’s UCC lien unless you are permitted to do so by the loan documents. As you evaluate the revenue currently being generated by the property and how to apply it to the property’s obligations, first use it as needed to pay real estate taxes and insurance premiums, expenses that will avoid mechanics’ liens from being imposed on the property (which could trigger full springing recourse exposure under the loan guaranty) and to operating expenses that keep the property safe for tenants (including from COVID-19) and to avoid a lender claim that you committed “waste” at the property (even if necessary, at the expense of missing debt service payments). If your loan is non-recourse, don’t fund debt service payments from your personal assets or provide additional collateral for the loan until you have an acceptable and binding loan workout agreement. Having “dry powder” in the form of cash can also be used by borrowers as leverage in their negotiations with their lenders (including to bring “value” to the lender through the loan restructuring negotiations, as noted above).
8. Understand the Bankruptcy Options and Beware of Tax Ramifications.
Every loan restructuring transaction presents considerable bankruptcy issues and tax ramifications which are far too numerous to address in this Primer, especially if you have owned the property a long time. It is essential that you evaluate your bankruptcy options and the tax impacts of your loan restructuring transaction with competent and experienced professional advisors. For bankruptcy, a key consideration is that any action you voluntarily (or collusively) take in pursuing bankruptcy relief will likely trigger full springing recourse guaranty liabilities for your loan guarantors. From a tax perspective, a key consideration is that any reduction, by compromise or negotiation, of the principal amount of your loan, without a foreclosure sale will result in cancellation of indebtedness income for the borrower that will be taxed at ordinary income tax rates. If the borrower files for bankruptcy protection and the lender convinces the bankruptcy court to abandon the property and exclude it from the bankruptcy estate, there will be a risk of non-dischargeable tax liabilities for the investors when the lender forecloses. The IRS is a more dangerous creditor than your lender. Make sure to seek assistance for these issues from your trusted advisors.
9. Be Prepared for the Pre-Workout Agreement.
Once you initiate communications with your lender about your desire to pursue a restructuring of your loan, be prepared for the lender to require a “pre-workout agreement.” Typically, your execution of this agreement will be a condition to the lender’s willingness to discuss any loan modifications with you. The agreement essentially lays the groundwork for your negotiations and imposes an obligation on the lender to forbear from exercising any default remedies under the loan documents while the loan workout is being negotiated and tolls certain deadlines. In exchange for this forbearance, the agreement will likely require you to stipulate to any existing material defaults under the loan and to waive all claims you may have against lender (without giving you any reciprocal waivers from the lender in return). It is critical that you carefully review this agreement in detail (preferably with your trusted legal counsel) because it is binding and could have an adverse effect on the borrower, any loan guarantors and the loan at a later time.
10. Assemble a Competent and Experienced Professional Team.
Before engaging in any discussions with your lender, it is critical that you engage a professional team that includes legal counsel, accountants and tax advisors that are experienced in commercial real estate loan restructurings and enforcement. Your legal team should include, at a minimum, real estate, tax and bankruptcy attorneys. These professional advisors will be invaluable in guiding you and protecting you from the host of issues and risks you will face in pursuing a loan restructuring transaction.
I have learned through the years (and I must admit it has been quite painful for me), that real estate cycles are unavoidable. The good news is that they do tend to come and go, and based on previous experiences, it seems that we can survive them (assuming we remain COVID-free and healthy). In our current circumstances, the length of this cycle cannot yet be determined for many reasons, including due to the tens of millions of jobs that have been and will continue to be lost, the immeasurable number of resulting permanent business failures, and the reality that the pandemic’s global public health crisis has not yet been contained. The longer this cycle continues, the greater the possibility that you may need to engage with your lenders to restructure loans secured by your properties in order to protect your assets. The practices and considerations recommended in this Primer will help you prepare for and position yourself to achieve a successful restructuring of your loan in a way that can be a “win-win” for your lender and you.
Pamela V. Rothenberg, firstname.lastname@example.org, is a commercial real estate attorney in the Washington, DC office of Womble Bond Dickinson (US) LLP and is currently struggling through her third real estate cycle. Her partner, John D. Hagner, email@example.com, also a commercial real estate attorney in the Firm’s Washington, DC office (and who is currently supporting his clients and colleagues through his seventh real estate cycle), contributed to this article.