By May 2020, the adverse financial impact on property cash flows resulting from various COVID-19 pandemic-related governmental restrictions and tenant rent relief/deferral executive orders was apparent to mortgage lenders and borrowers. In subsequent months, the parties negotiated and documented forbearance agreements and loan modification agreements in an effort to buy time for commercial real estate owners to begin recovery and to stave off a wave of commercial mortgage loan defaults. In addition, some lenders and borrowers also renegotiated key loan commitment terms for new mortgage loan transactions to adjust pricing and other key economic terms. During the last six months of 2020 lenders were closing some new loans, but at a slower pace than in prior years.
Also, the recent creation and growth of the cannabis industry has created some loan documentation challenges for lenders and borrowers.
While some industry observers predict continuing difficult times ahead for commercial real estate, during the last quarter of 2020, and on into the first quarter of 2021, new mortgage lending activity slowly has increased for certain product types and in certain geographic markets. Also, many existing mortgage loans are moving from forbearance/deferral status back into (i) regularly scheduled loan payments under existing loan documents, or (ii) documenting of more comprehensive loan modifications. Lenders have become more conservative in loan underwriting, financial covenant and other loan document provisions, while borrowers continue to seek as much flexibility as possible.
Below is a brief discussion of some provisions that borrowers and lenders currently are negotiating in connection with documenting and/or modifying commercial mortgage loans.
Loan Document Provisions
- Financial Covenants. Lenders and borrowers are spending substantial time during the loan term sheet stage “pre-negotiating” key financial covenants. Loan-to-value, debt yield (i.e., the quotient of property net operating income and loan amount), debt service coverage ratio and other key financial covenant measurements help a lender determine initial loan sizing. Borrower’s compliance with financial covenants affect the borrower’s ability to: (i) obtain disbursements of any future “earnouts” of committed loan proceeds, (ii) qualify for future increases in loan size, (iii) make equity distributions of property revenue to its constituent members/partners, (iv) obtain releases of a guarantor’s obligations under any payment and/or operating deficit guaranties, and (v) avoid implementation of cash management (i.e., lockbox) provisions in the loan documents. Financial covenant adjustments also are a key component of many current loan modification transactions
- Escrows for Impounds. Depending on the (i) loan-to- value determination, (ii) loan term, (iii) current and projected future property taxes in the property jurisdiction, (iv) the physical condition of the property collateral at loan closing, and (v) the financial strength of the borrower’s sponsor, a lender may require that its borrower make monthly reserve deposits with the lender for taxes and insurance, tenant improvements and leasing commissions, and future capital expenditures.
- Force Majeure Provisions. The pandemic is causing lenders and borrower to take a closer look at, and modify if necessary, the force majeure provisions in their loan documents. Many existing “standard” force majeure provisions do not contemplate the types of delays (particularly construction-related delays) resulting from the pandemic. These delays include (i) labor shortages due to illness and delays in material deliveries, (ii) delays in construction plan reviews, permit issuances and site inspections by municipalities, and (iii) in the case construction of senior living facilities, delays at the state level in conducting property inspections and issuing operating licenses. Lenders also are taking a more careful look at the force majeure provisions in key commercial tenant leases, as tenant rents payments are the primary source of monthly debt service payments.
- Payment and Carry Guaranties. In addition to any ongoing loan-to-value covenant requirement, the lender also may require a payment guaranty and/or an operating deficit guaranty (sometimes referred to as a “carry” guaranty) from a financially strong borrower sponsor entity. If the lender requires such guaranties, then the borrower should try to negotiate (i) phased reductions in guarantor liability based on the borrower’s satisfaction of certain financial covenants (e.g., the property maintaining a specific minimum debt service coverage ratio for a specific period), and (ii) an overall cap on guarantor liability under any guaranty.
- Cash Management Provisions. Some loan documents may require that, upon the breach by borrower of a key financial covenant (or the occurrence of another event of default), the borrower deposits all property operating revenues into a lender-controlled bank account. The lender then permits disbursements from that account in a specific order of priority (i.e., the “waterfall”) to pay debt service on the loan and various other property-related operating expenses. Any operating revenue remaining after payment of current debt service and operating/capital improvement expenses remains in the lockbox account to pay future such expenses, until the borrower satisfies the conditions in the loan documents for release of the lockbox requirement. Conditions for termination of the cash management system requirement may include the borrower attaining certain financial covenant benchmarks, either by improving property operations or by repaying an amount of loan principal sufficient to bring the loan and the property into compliance with the defaulted financial covenant(s).
- Benchmark Replacement Provisions. As has been anticipated by lenders and borrowers for some time, the Federal Reserve and United Kingdom bank regulators announced in November 2020 that: (i) the London Interbank Offered Rate (or LIBOR) should not be used as an interest rate option in loans originated after December 31, 2021, and (ii) any existing loans providing for LIBOR as an interest rate selection option should have all LIBOR contracts end by June 30, 2023. Even before the announcements, lenders using LIBOR as a variable interest rate option began inserting so-called “benchmark replacement” language into loan documents. The complexity of the benchmark replacement provisions runs the gamut from a few general paragraphs (stating that, ultimately, lender and borrower will cooperate to select a replacement rate for LIBOR), to several pages of very complicated language. Most benchmark replacement provisions contemplate that the secured overnight financing rate (or SOFR) (i.e., the rate for overnight borrower collateralized by US Treasury securities) will be the first choice as the benchmark replacement rate for LIBOR. Modification documents for variable rate loans also now include benchmark replacement provisions.
- Default Cures. Borrowers continue to request: (i) longer cure periods for standard loan defaults, and/or (ii) the ability to cure a financial covenant default by repaying a portion of the loan in the amount necessary to bring the loan into compliance with the defaulted covenant.
- Waivers/Reductions of Prepayment Premiums. Borrowers in loan modification/workout situations for fixed rate loans often are asking lenders for the ability at all times prior to loan maturity to prepay the loans at par or at a reduced prepayment premium amount.
- Loan Syndications. Recently, a construction lender conditioned its obligation to fund the full construction loan amount to the borrower on the lender’s ability to syndicate a significant portion of the loan, with the borrower having some approval rights regarding the financial institution(s) that would be prospective purchaser(s) of loan funding obligation that lender needs to sell. The effect of this arrangement was to (i) reduce the lender’s risk exposure on the loan, and (ii) incentivize the borrower to help the lender arrange a partial sale of the loan funding obligation (or the borrower would have to increase its equity contribution to the development), while giving the borrower some control over the identity of the member(s) of the loan syndicate.
- Cannabis. Currently, 48 states now permit the sale and use of cannabis for medical and/or recreational use. However, the production, manufacture, administration, distribution, use or consumption of cannabis remains prohibited under federal law (the Controlled Substances Act). Major bank and insurance company lenders subject to federal regulations are addressing the resulting conflict between state and federal law on this subject by prohibiting any cannabis-related uses of real property collateral for loans. While federal law preempts state law on this issue, nonetheless borrowers (and their tenants) in cannabis- permissible states may argue that because state law (i) permits cannabis-related property uses, and (ii) rather than federal law, governs tenant leases, lenders should acquiesce to state law. This issue arises with increasing frequency in loan transactions, and lenders are holding firm in prohibiting cannabis-related uses.
For lenders, the primary goals in making mortgage loans are to receive the fees and interest payable under the loan documents, and to receive repayment in full at loan maturity. While borrowers obtain mortgage financing for a variety of reasons (e.g., paying for property improvements, distribution of loan proceeds to constituent members/partners, and refinancing existing mortgage debt on better terms), perhaps the most important reason for borrowers to repay those loans in a timely manner is to preserve accumulated borrower equity in their properties for the benefit of their respective constituent members/partners. Careful negotiation and drafting of the provisions discussed above is an important means to help both parties achieve their desired outcomes.
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