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Navigating The Surge: A Strategic Guide For Lenders Amid Rising Loan Defaults

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By Jay Steinman and Karina Leiter

Jay Steinman, left, and Karina Leiter, right, of Duane Morris. Courtesy photos.

Jay Steinman, left, and Karina Leiter, right, of Duane Morris. Courtesy photos.

Loan defaults and workouts are on the rise again due to a confluence of factors causing headwinds including: the surge in interest rates and real estate owners inability to refinance maturing loans at affordable rates; the continued rise in the cost of certain materials needed for renovation and construction; the staggering cost of flood and windstorm coverage and the impossibility of even obtaining coverage; and the loan maturing in the near future without satisfactory options to refinance or be otherwise paid off on time.

Anticipating the fallout from potentially billions of dollars in distressed loans, lenders must be on high alert. Drawing from lessons learned in the last two historical downturns, where we witnessed unprepared lenders face severe consequences, it is imperative for lenders and financial institutions to act now.

Identifying distressed borrowers and projects is a critical first step, acknowledging the inevitability that many loans are already or may default in the near future. By taking proactive measures now, lenders can not only brace for the storm but also enhance and protect their available legal remedies in the event of a borrower’s default.

The subsequent steps outlined in this article offer a strategic guide for lenders, empowering them to navigate the complexities of loan workouts and enforcement actions with resilience and foresight.

Nonwaiver Letter

If a default has occurred the lender may want to have counsel draft a form of reservation of rights or nonwaiver letter. The letter should identify the known breaches and should also include “nonwaiver” type language which generally states that notwithstanding the breach or default the lender is reserving all rights under the loan documents and is not waiving any right or remedy thereafter even though it may be taking no action at that time to enforce its remedies.

Review Loan Documents

Before discussing a potential loan workout with a borrower or proceeding to exercise the remedies available, lenders should first evaluate their legal position, which includes conducting a thorough review of all loan documents including all organizational documents, title insurance policies, surveys and other due diligence materials received at closing and thereafter. Taking inventory of all collateral is also important if possible. A careful review of the loan file should be conducted to identify any documents and correspondence that may adversely impact enforcement of remedies. You don’t want to go to war with defective loan documents or due diligence issues that should have been addressed before the loan closed or thereafter.

We recommend that a new pair of eyes go through all relevant documents. Unfortunately, it is human nature that the counsel who handled the loan previously may have missed or overlooked something that will become critical during the workout, foreclosure or REO sale thereafter. Further, lenders should consider whether there are any technical issues with the loan documents and loan structure that could complicate enforcement.

Lenders should pay particular attention to what constitutes an “event of default” under the loan documents, keeping in mind the borrower’s financial and non-financial covenants, as well as the remedies available to both parties when an event of default occurs, including, without limitation, any required notices and applicable cure periods.

Perform Updated Diligence

After the lender and its counsel have reviewed the loan documents and defects if any have been identified, it is also prudent to conduct an updated review of diligence items with respect to the collateral which secures its loan, the borrower and any guarantors, including, without limitation, updated searches, title, review of financial information with respect to the property, borrower and any guarantor and current organizational documents. The lender may also want to obtain an updated appraisal and environmental audit.

By performing loan document review and analysis and the updated diligence, the lender will better understand its position and leverage before entering into negotiations with the borrower. Any existing liens or other title defects may complicate any foreclosure sale and further slowdown enforcement, which is already a lengthy process.

Execute a Pre-Negotiation Letter

Before beginning any substantive discussions with a borrower regarding a loan modification or forbearance agreement, we recommend that the lender require that the borrow and any guarantor execute a pre-negotiation letter agreement. A pre-negotiation letter agreement sets forth the parameters of the negotiations between borrower and lender prior to memorializing such negotiations in any written document. We recommend that the pre-negotiation letter agreement include a requirement that the borrower and any guarantors provide certain updated due diligence information described above to the extent that the lender’s file does not include this information.

Workout Negotiations

To the extent that a lender elects to withhold from enforcing its rights under the loan documents as a result of a borrower or lender default, the parties should enter into a loan modification or forbearance agreement. Generally speaking, it is best practice that the forbearance agreement include an acknowledgement by the borrower and any guarantors that a default has occurred under the loan documents and that the lender agrees to refrain from exercising its rights and remedies for a specific period of time, provided that the borrower and any guarantor comply with the conditions set out in the loan modification or forbearance agreement. The forbearance agreement at a minimum should include the following provisions: recitals, admission of outstanding loan balance, debt service payments during the period of forbearance, forbearance period, conditions precedent to the effectiveness of the forbearance agreement, forbearance events of default and remedies, retroactive default interest from the date of the initial default, release of lender, waiver of bankruptcy stay, consent to appointment of a receiver and foreclosure, agreement not to contest foreclosure and reaffirmation of guaranty.

Enforcement Actions

The process for enforcing a loan through foreclosure varies across jurisdictions, so lenders should understand the unique process in their jurisdiction.

The loan documents may allow the lender to ask a court to appoint a receiver to take possession of and manage the property until the foreclosure is finalized and the property is sold through a foreclosure sale; provided, however, the applicable standard for the appointment of a receiver varies by jurisdiction. Lenders should also be aware that language in a loan document that allows a lender to “request” or “apply” for the appointment of a receiver does not necessarily entitle the lender to that appointment in most cases. Most states have recently adopted a model receivership law making it a bit easier to obtain a receiver in different venues around the country.

In light of the current interest rate environment, borrowers are getting more desperate to hold onto their current financing and will employ various delay tactics to prevent lenders from enforcing their rights. These types of defensive tactics can significantly increase the time and expense associated with enforcement of the loan.

Be Aware of Lender Liability

Throughout the workout and/or enforcement process, lenders should be aware of their exposure to potential lender liability claims. Borrowers may bring claims based on a lenders’ failure to honor its obligations under the loan documents, unreasonably delay, or lack of good faith. These claims will open lenders up to discovery, which can be time-consuming and expensive. Therefore, lenders should keep in mind that all non-privileged communications may be discoverable and keep all internal and external communication professional. Lenders should ensure that all discussions with the borrower and any guarantor are well documented and subject to confidentiality requirements set forth in the pre-negotiation letter agreement and/or forbearance agreement.

In conclusion, with loan defaults and workouts on the rise due to various challenges, lenders must act proactively to safeguard their interests. By taking measures now, lenders can enhance their readiness to navigate the challenges ahead, protecting both their assets and legal remedies. In the evolving financial landscape, foresight and preparedness are key to resilience.

—Meagen E. Leary and Phillip Hudson, attorneys with the firm, assisted in the preparation of this article.

 

Source: DBR

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Top 15 CRE Investing Mistakes

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The CRE industry is different than all other industries in that it is a transaction-based model. The lifeblood of the industry is dependent on sale, financing, and lease transactions. The more transactions there are, the more money the industry and everyone in it makes and the more successful the business. 2021 was a record year for transaction volumes and a phenomenal boom year for CRE.

The most successful companies and individuals in the industry are usually adept at selling, financing and/or leasing CRE property. However, in pursuing these transactions the same key mistakes are made over and over again which usually results in poor performance, the loss of equity in a property or the loss of the property in foreclosure. Below are the 15 biggest investing mistakes in CRE that are the root cause of bad deals, according to Joseph J. Ori, Executive Managing Director at Paramount Capital Corporation, a CRE Advisory Firm.

  1. Acquiring properties at low cap rates. Cap rates below 5.0% are not justified even if the investor believes that future rent increases, which may not happen, will make up for the low initial return. Buying CRE at sub-5.0% cap rates is like buying a tech stock at a 100-price-to-earnings ratio.
  1. Not diversifying a national portfolio by property type, location, and industry. Many national firms diversify a large fund by type and location but forget about industry diversification. If an investor buys only apartments and offices in Silicon Valley, 70% of the apartment tenants work in the tech industry and 70% of the office tenants are technology or related companies. If the tech industry retracts in a downturn, many of the apartment tenants may be laid off and unable to pay their rent or may move home or double up with roommates. This will negatively affect the apartment market. Many of the office tech firms may default on their leases or shrink their space requirements, which will negatively affect the office market.
  1. Not performing property level and financial due diligence on all properties in a portfolio acquisition. Many institutional investors that acquire large portfolios consisting of dozens or hundreds of properties do not do sufficient property-level due diligence. They only look at the larger and more valuable properties in the pool or hire inexperienced third-party firms to do the property-level due diligence.
  1. Acquiring properties with negative leverage. Negative leverage occurs when the cap rate is less than the mortgage constant, which means the cash-on-cash return will be lower than the cap rate, which is a “no-no” in CRE. Many firms acquire properties with negative leverage believing that future rent increases will more than make up for the low initial return.
  1. Using short-term floating rate debt without the protection of a swap or collar to finance a long-term real estate asset or portfolio. This is what has occurred during the last two years as the Fed abruptly raised the federal funds rate from 0.0% to 5.25%. Many CRE investors were caught flat-footed by the quick increase in interest rates from floating rate debt and no interest rate protection and are now scrambling to lower their financing costs and risk.
  1. In underwriting an acquisition, using a terminal cap rate that is less than the going-in cap rate. This is often done by the acquisition or other internal group within a large CRE firm to “juice up” the internal rate of return on the equity in a deal underwriting.
  1. Institutional investors who commit capital to sponsors who have inexperienced senior management teams. The senior management team should have gray hair and have been through at least the last two secular CRE downturns of 1987-1992 and 2007-2012. One of the most important drivers of success in CRE investment is having individuals on the team with significant and long-term experience and knowledge in all property types, markets, and economic recessions.
  1. Using overly optimistic rent projections in underwriting a deal. This often occurs when  the acquisition or other internal group wants to make the deal look better and the deal to be developed or acquired.
  1. Not analyzing the sales volumes per square foot of retail tenants, a key metric when buying shopping centers. One of the most important metrics when buying shopping centers after the cap rate, is the sales per square foot of the anchor tenants. High sales per square foot means the center is in an A location, will remain fully leased and in high demand from tenants and shoppers.
  1. Using high leverage of more than 75%. One of the highest risks in CRE investment is using high leverage and this was one of the causes of the Great Recession from 2007 to 2012.
  1. Not giving senior-level employees an equity interest in the company, portfolio, or fund. This is what is known as the “golden handcuffs” in CRE. If you don’t take care of your key people, they will leave and become your competitors.
  1. Not incorporating the 15 risks of CRE in a real estate firm. The risks include cash flow, value, tenant, market, economic, interest rate, inflation, leasing, management, ownership, legal and title, construction, entitlement, liquidity, and refinancing into the firm’s investment strategy.
  1. Investing in property sectors like hotels and senior housing, which are more operating businesses than real estate deals, in which the investment firm has no experience. Hotels are typically 70% operating business, and 30% real estate deal and senior housing is 80% to 100% operating business and 0% to 20% real estate.
  1. Not obtaining the Kmart discount when acquiring a large portfolio of CRE assets. Whenever a large CRE portfolio trades it is typically made up of Class A queens, Class B pigs and average Class B deals, and the buyer needs a discount of at least a 1.0% higher cap rate for the risk of the Class C properties.
  1. Not checking the formulas in an XL underwriting workbook, as there is at least one formula error in every CRE underwriting worksheet. This is a common occurrence when preparing a complicated Excel underwriting workbook and firms should make sure that  all formulas are rechecked by an independent party.

 

Source:  GlobeSt.

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