The wide-ranging fallout of the coronavirus pandemic will present unique challenges for commercial mortgage lending entities and their clients.
Curtailed rental cash flow will inevitably impact borrowers’ ability to submit timely debt service payments. Their retail tenants have no other option but to cease business operations altogether, whereas their residential renters will similarly default on monthly payments as unemployment rates continue to skyrocket. Amidst these types of adverse conditions, lending institutions must make hard choices as to whether to close transactions already in the origination pipeline, modify closed loans, and otherwise forbear for troubled borrowers.
Pending Deals – Fund, Walk Away, Re-Trade
The deal you underwrote on March 1 looks very different today. The term sheet that was provided was based on assumptions of cash flow, asset value, sponsor liquidity, and other factors, all of which may no longer be true.
Lenders may be nervous about not proceeding to funding based on the borrower’s substantial, or even full compliance, of the term sheet. However, the majority of loans include as part of the closing protocol that on the closing date there haven’t been any adverse events affecting the economic potential of the related project since the loan terms were settled on. Due to the considerable economic risks brought on by the virus, it is understandable that virtually every lender is wondering whether they should proceed with these early-stage transactions.
Material Adverse Change
Determining whether to move forward at this stage requires a detailed analysis of the closing conditions spelled out in the term sheet or commitment letter. These clauses related to material adverse changes may vary dramatically from each individual lending institutions and separate transaction. The virus will continue to have drastic economic impacts for the foreseeable future, which means that it will be challenging for lenders to accurately underwrite an asset—even for those that they have been planning to fund in as recently as two and a half weeks ago. Borrowers that had premised substantial equity moves and personal guaranties on the value of a particular project will harbor similar worries.
Change in Terms
Still, there are some borrowers that remain confident on their given deals and insist that the closing process moves forward. Lenders in these situations are advised to review as soon as possible the closing conditions for these transactions and determine whether they are contractually obligated to providing funding. If not, the lender could opt to either still close or unilaterally terminate the deal. There is a tertiary option, however, in which a lending entity could trigger the material adverse change clause as support for introducing revised lender protections to the transaction—such as requiring that the borrower provide a debt service reserve fund at closing, give further guaranties, or utilize cash management tools such as lockboxes. For example, many commercial lenders are requiring six to twelve months of payment reserves to be provided by borrower at loan funding to ensure liquidity in cash flow is impacted at the property.
Modifying Closed Loans
Addressing Modification Requests
Amid the economic uncertainty, borrowers will be requesting options from their lenders in the event of predicted or actual inability to timely submit their recurring debt service installments. The majority of lenders will mandate that distressed borrowers submit detailed modification terms, as opposed to vague relief requests. A borrower may ask for relief in the form of reducing the interest rate, converting to an amortizing loan that involves interest-only installments temporarily, or another type of waiver, reduction, or deferment of payments. Borrowers may also wish to add investors to their capital stack, and subsequently request that their lending institution agree to the addition of one or multiple new equity partners.
Evaluating Whether to Offer a Loan Modification Agreement
When presented with these requests, lenders will be required to complete the underwriting process on the potential modifications to decide if they are feasible and prudent. Accordingly, it would be advisable for lenders to request further property and financial info, conduct site visits, and require extended due diligence processes including title, judgment, and lien searches. These requests will also give lenders a better chance to protect themselves by reviewing their loan files to identify and resolve any deficiencies such as missing documents, filing or recordation issues, errors, and expired insurance policies. If it seems likely that the lender and borrower can potentially come to a mutually agreed upon set of modifications, the lender should require a pre-negotiation agreement prior to talking specifics. If it becomes apparent that a deal isn’t going to be reached, the lender may consent to a forbearance agreement so that the borrower is afforded more time to rectify any issues or obtain takeout financing.
Implementing Pre-Negotiation Agreements
Prior to conducting any meaningful negotiations, the lender should request that borrowers and their guarantors sign a pre-negotiation agreement (PNA) so that the parties are able to hold transparent and honest discussions regarding a possible workaround for the borrower’s financial strife. The PNA should detail the present loan status, to include the admission of any defaults as well as the following:
- Provide that any negotiations and resultant drafts remain non-binding until a final agreement is executed by all parties
- Include clauses to preserve the lender’s rights and remedies per the loan agreement
- Provide for the mutual termination of the PNA by either party regardless of the reason for doing so
- Lay ground rules for settlement discussions
- Require a full general release from the borrower to shield the lender from lawsuits down the road
Because lenders may wish to grant the borrower some leeway, another potential option is for the parties to enter into a forbearance agreement in which the lender consents to delay exercising remedies—such as foreclosure or suing the borrower’s personal guarantors—so that the borrower has a longer period for the economy to stabilize or to seek alternative refinancing. The lender also has the option to require the borrower to make lowered payments over the course of the forbearance window. Similar in nature to a modification, a forbearance is usually provided as a short-term relief or “pause” on the loan to give the borrower an opportunity to recover and resume debt service at the property.
Unfortunately, for the foreseeable future, lenders will need to divert resources from funding loans to actively managing all aspect of their loans from loan origination, loan structuring, modifications, and forbearances. Active management should hopefully prevent significant defaults and foreclosures in the foreseeable future.