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August 2010

Commercial Loan Modifications: Finding a Way Out of the Storm

In these challenging economic times businesses are experiencing difficulty in meeting their commercial real estate loan obligations.  Many factors contribute to the current market conditions.  Billions of the dollars in financing that mature in 2010 were funded through commercial mortgage-backed securities (CMBS) transactions.  The CMBS market is slowly emerging from its near demise, and as such, it is not generally a viable funding source for refinancing.  Commercial loans to refinance debt on reasonable terms are difficult if not impossible to find.  Many lenders are requiring equity contributions of 50% or more of the current value of a property before even considering a new real estate loan.  Moreover, personal guaranties are becoming a standard requirement.

Adding to the difficulty are: (i) the steep decline in property values across all commercial real estate industry sectors and (ii) higher vacancy rates.  In many instances property values have dropped below the secured loan amount.  Compounding the problem of pending maturity defaults is the specter of defaults based on covenants such as debt service coverage ratio requirements and loan-to-value thresholds, the breach of which may constitute a direct default or may preclude negotiated extensions on terms acceptable to the borrower. 

What steps can a borrower facing a pending maturity date or a default in one or more of the loan covenants take? 

The most practical solution is a loan workout with the existing lender providing for the modification of the loan terms on a basis that is both acceptable to the parties and is realistic given the anticipated performance of the real estate market during the modified term.  The lender already has the loan on its books and has every incentive to maintain the loan as a performing loan.  The borrower wants to preserve as much of its equity investment as possible and the lender wants to avoid foreclosure and have as much of the principal and interest paid on the loan as possible.

The borrower's first step in a loan workout is to review and understand all of the loan documentation.  Given the volume of financing transactions that were closed during the years preceding the financial crisis, many loans were negotiated—and documented—in haste, often with a misunderstanding by the borrower of the loan documents' conditions and covenants.  The borrower and any guarantor should have a clear understanding of the terms and conditions of the existing obligations before undertaking negotiations with its lender.  For example, is the loan "non-recourse"?  In other words, will the lender be limited to foreclosing on the property in the event of a default and be precluded from going after other assets of the borrower or the guarantors?  If a loan is non-recourse, and there is no reasonable expectation that the property will be worth more than the current loan amount, a negotiated foreclosure or a conveyance of the property to the lender by a deed-in-lieu transaction may be borrower's best course of action.

Secondly, open communication with the lender is critical at all stages of any negotiation.  Lenders do not like surprises.  If the borrower is unable to make a scheduled payment, or may otherwise violate its loan documents, it is generally a good idea to advise the lender in advance.  The lender's preference is to have the borrower perform its obligations on a timely basis; as a general matter, the preferred choice, if there is a default, is not to immediately foreclose on the collateral.  However, if the borrower is less than forthright, the lender may not be willing to engage in any loan workout discussions.

Next, the borrower must carefully evaluate the prospect of its ability to perform the loan obligations and the market conditions of the local real estate market. Is it reasonable to expect that the local market will recover in the near future?  Would the lender agree to interest-only under the loan, in lieu of the current amortization.  Can the borrower, in fact, make interest-only payments?  

There are a number of other modifications to the loan documents that can be proposed in negotiating a loan workout including: (i) raising or lowering interest rates, (ii) extending maturity dates, (iii) principal prepayments reducing the loan amount, (iv) additional security, (v) changing payment dates, and (vi) permitting the assumption of the loan by a new borrower without a release of the original borrower entity or guarantors.

Ideally, the goals of a successful loan workout are to negotiate a modification agreement acceptable to all parties which maximizes both the borrower's potential for recovery of its equity and the repayment to the lender of as much of the principal and interest of the original loan as reasonably possible.  This can be achieved only with a realistic evaluation of the legal obligations of the borrower (and those of any guarantors), and the local real estate market conditions, together with honest negotiation among all the parties. 

Bankruptcy, Restructuring & Creditors' Rights

Bankruptcy, Restructuring & Creditors' Rights
Real Estate