Making Lemonade from Lemons: A Mortgage Lender's Guide to Successful Loan Workouts, Part 1

Although the overall economy is improving, the real estate sector continues to confront serious challenges. More than $2.2 trillion in commercial real estate debt is expected to mature before the end of 2027¹, and much of it will be difficult to refinance.

Problems with the office sector have been well publicized. Many borrowers who want to walk away from their investment are encountering lenders who are unwilling to take it back. Even multifamily investments, once considered virtually fail-safe, will be difficult to refinance because of loan-to-value ratios that are too high and debt service coverage ratios that are too low. As a result, an increasing number of mortgage borrowers will approach their lenders for loan modifications.

If you are a mortgage lender, you would be wise to assess your portfolio and start preparing now to address real estate loans that are either currently nonperforming or likely to become nonperforming shortly. Following is a brief summary of some important steps you should take before commencing workout discussions with respect to a commercial real estate loan:

The Lender(s)

• Understand the Lenders. If you are not the only mortgage lender (e.g., syndication or participation) on the loan, identify each of the other mortgage lenders and the percentage interest that each holds in the mortgage loan. What percentage approval is required to consummate a workout or move forward with a foreclosure? Which lender (e.g., Administrative Agent) will take the lead on the workout discussions? Are the interests of the various lenders aligned or are there different tranches of debt (e.g., A Note and B Note) secured by a single mortgage? What factors (other than the prospects for recovery on the loan) may affect the decision-making of a lender (e.g., additional capital requirements applicable to banks)? Are any of the lenders experiencing liquidity problems?
• Establish a New Workout Team. Put new people in charge of the workout. The relationship managers, analysts and attorneys who put the loan in place are predisposed to view the loan in a favorable light because they understand that it will reflect badly on them if there was a problem or mistake at origination (e.g., underwriting or documentation). Their biases may favor an attempt to "save" the loan by providing the borrower with additional loan proceeds (i.e., putting in good money after bad). Do not take that risk. A fresh set of eyes will bring objectivity to the situation and increase the likelihood that you achieve a favorable result.

The Collateral

• Inventory the Collateral.
  • Real Property. Prepare a description of the real property (e.g., age, size, type of construction, condition of property and nature of asset) to make sure your workout team understands the asset's key attributes.
  • Personal Property. Make a list of other material tangible and intangible assets (e.g., furniture, computer equipment, generators, leases unvested entitlements or franchise agreement) that comprise the collateral.
  • Cash. Locate the cash. Is it in a lockbox or in borrower's operating account under borrower's control? If the latter, do you have the right to take control from the borrower (e.g., springing lockbox)? Check with counsel before exercising remedies with respect to the cash to avoid unintended consequences (e.g., violation of California's "one action/security first" rule).
  • Letters of Credit. Is any of the collateral a letter of credit? If so, confirm that you are holding the original. Make note of the expiration date. If it is an "evergreen" letter of credit, make sure that the issuer has your current address for any notice of nonrenewal.
• Inspect the Property. Make a site visit and inspect the property. Is the property in the condition you expected? Is construction complete (and if not, identify the expiration dates on the entitlements)? Is there ongoing tenant improvement work? Is there deferred maintenance? Is the tangible personal property on site? Where are the property files? Are there problems that could affect the revenue stream (e.g., inhibit future leasing or constitute a default under a franchise agreement or lease)?
• Assess the Environmental Condition. Order an updated Phase I and, if recommended, Phase II of the Environmental Site Assessment. If the loan documents required the borrower to remediate an environmental issue, has the remediation been completed? Has a "no further action" letter been issued? Is there any ongoing remediation or monitoring? Are there any new environmental issues?
• Review Title.
  • Real Property. Confirm that you have the complete original title policy and endorsements (or an electronic policy with an endorsement making the electronic copy the equivalent of an original title policy). Obtain an updated title report. Does your borrower still own the property? Does the title report identify any exceptions (whether before or after your lien recorded) that are not on your title policy? Are there monetary liens besides yours? Even if you appear to be in a first priority position, junior lienholders can 1) challenge the priority of your lien (e.g., mechanic's lien holder may challenge the date that work commenced), 2) constitute a separate class of secured creditor in a borrower's bankruptcy proceeding, and 3) in California, assert rights under California's one-action rule.
  • Personal Property. Conduct Uniform Commercial Code (UCC) searches. Are there any liens on the borrower's assets besides your liens (e.g., equipment leases that cover property material to the project's operations, such as the HVAC system)? Determine whether title to any personal property (e.g., contracts or furniture) is held by an affiliate of the borrower rather than the borrower, and if so, whether those assets have been pledged as security for the loan.
• Evaluate Operations. Obtain a rent roll and current property operating statements. Do the statements present a detailed picture of operations? Are they prepared in accordance with generally accepted accounting principles (GAAP) or other recognized accounting method? Is there the potential for gamesmanship (e.g., combining cash and accrual accounting)? Are the balances in the bank accounts consistent with the operating statements? What is the occupancy rate? Are there leases in progress? Are there any major tenant delinquencies?
• Gauge the Recovery Prospects. Conduct a holistic assessment of the medium- and long-term prospects for the asset, including pre-pandemic performance, prospects for the asset class generally, local market conditions and tenant quality. If the prospects are poor, is repositioning a possibility (e.g., hotel into student housing)?
• Establish a Valuation for the Property. Determine an approximate property value. This may be based on internal analyses or a third-party appraisal. Be aware that a formal third-party appraisal could have consequences for you (e.g., require additional capital reserves based on a newly established loan-to-value ratio or create a default from a failure to satisfy a specified loan-to-value ratio).

The Principals

• Obtain Financial Statements. Request income statements, balance sheets and tax returns for each of the principals. How much liquidity do the principals have? Do the asset valuations seem realistic? Do the principals have unencumbered assets? Does it appear that the principals' financial difficulties are property-specific or global?
• Consider the Intangibles. Do the principals appear trustworthy? Have they exhibited a willingness to work in good faith with you? Do they remain committed to the project or are they looking to get out? Do they bring any special attributes to the project (e.g., managerial expertise or general contractor on project)? Have the principals made any threats (express or implied) against you?
• Order Searches. Obtain litigation, judgment, tax and bankruptcy searches on the principals. Have other creditors filed claims against any of the principals? Do any of the principals appear to be on the verge of bankruptcy? Have any of the principals' assets been attached?
• Determine Scope of Potential Liability. Is the loan recourse to the borrower? If it is, does the borrower have any assets other than the property that you could reach? Are there any guarantors? What is the nature of the guaranties (e.g., partial payment, debt service, completion)? Has the borrower taken any action that could trigger liability (losses or full loan repayment) under a limited recourse guaranty?
• Identify Limitations on Recovery. Do the principals appear to have sufficient assets to satisfy the potential liabilities? Are all of the principals located in the United States, and if not, is there a U.S.-based agent for service of process? If a guarantor is a private equity fund, what is the status of the fund? Does it still exist or has its term expired? Do the financial statements of individuals include community property or trust assets that could be segregated from your claims?

The Documents

• Review the Loan File. Confirm that you have all original loan documents and amendments, fully executed with exhibits. Or, if you do not have originals, confirm that there is language in each of the documents that permits electronically executed copies to carry the same weight as originals. Review the loan documents and the entire loan file. What are your rights when the borrower defaults? Are there any matters that could give rise to a legitimate lender liability claim? Was your borrower a party to the material third-party agreements (e.g., franchise agreement or construction contract), and did you take a collateral assignment of each of them? What actions must you take to preserve your rights under the material agreements (e.g., provide copy of default notices)?
• Read the Lender Agreements. Identify all loan-related agreements to which you are a party (e.g., syndication agreement, participation agreement, intercreditor agreement). What are your obligations with respect to a default (e.g., notice requirement)? Are there any restrictions on your ability to exercise remedies (e.g., notice, consent, additional cure periods)? What cure rights and approval rights do the other parties have?

Communications with the Borrower

• Send a Default Notice. Send the borrower (with a copy to all applicable parties) a notice identifying all defaults. Determine whether acceleration of the loan is appropriate at this time.
• Execute a Pre-Workout Agreement. Enter into an agreement with the borrower and guarantors that outlines the terms of your discussions, including that 1) the discussions are settlement discussions within the meaning of Rule 408 of the Federal Rules of Evidence and analogous state laws (e.g., Section 1152 of the California Evidence Code); 2) no loan modification is binding unless and until an agreement is executed by all parties; 3) any party may terminate the agreement at any time; and 4) the negotiations do not create a waiver of any rights or obligations of any party under the loan documents.

The next article in this series will explore the general options available to a lender in managing a nonperforming mortgage loan.

Notes

¹ "The Bill Is Coming Due on a Record Amount of Commercial Real Estate Debt," Peter Grant, The Wall Street Journal, Jan. 16, 2024.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.