While real estate financing is still available, it is about to become expensive and tightly underwritten – and it will require more equity participation.
Existing loans also are challenging. Troubled but performing loans and nonperforming loans are at levels unheard of since the 1980s recession. Some developers may seek to restructure their loans, while others may seek loan workouts.
Understanding the difference is important.
Restructured transactions modify a currently performing loan or a loan that can become performing. In essence, lenders will consider restructuring loans if a borrower can show potential success.
Alternatively, workout transactions involve nonperforming loans on projects in which no amount of change will achieve the parties’ expectations. A workout deal is really an agreed-upon exit strategy.
A lender looks at two major issues when deciding how to proceed – borrower trust and the cause of default. If a lender trusts and has confidence in a borrower, a restructure or workout is more likely to occur. If the source of the situation is beyond the borrower’s control (e.g., the market for new homes has fallen flat and is not expected to recover soon), there is little reason to restructure a deal, but a workout may be in the cards.
But if the borrower is at fault – robbing Peter to pay Paul – even a workout makes little sense.
What to expect
The lender will look at a borrower’s other projects to see how they are performing and how they interrelate. The borrower must provide accurate and complete financial statements, which will be carefully examined.
In most restructure deals, the lender will look at issues of project control and may adjust operational and financial parameters and the frequency of reporting on these areas. When default is due to an interruption of cash flow and better financial conditions are expected to occur, loan terms may be modified.
Changes may include an extended term for repayment, payment forbearance for a limited time, reduction in the interest rate (followed by an increased rate later in the term), an advancement of additional loan funds or a demand for additional collateral.
Lenders will seek additional collateral in the form of personal guarantees, control rights of escrows, direct payment of rents and the like. They may require termination of “insider” property management contracts.
If the value of the collateral has changed since the loan was underwritten, lenders may seek a mortgage or trust deed against unencumbered property not related to the loan. If the original loan was nonrecourse, the lender will demand recourse liability.
In the end, the terms of a restructure transaction will aim to provide an environment of success for the borrower and an environment of greater security for the lender.
Working it out
The workout is an altogether different animal – an exit strategy rather than a recovery strategy. In effect, it serves as an alternative to foreclosure or bankruptcy. Some workouts involve a change in management, surrender of possession by the borrower or appointment of a receiver.
Other approaches may require the borrower to provide a deed in lieu of foreclosure, which may not be advisable if junior liens and encumbrances have come into place since the original loan was made. In this case a “friendly” foreclosure may be in order.
When all else fails, a lender may consider instituting bankruptcy proceedings. In most cases this will require cooperation of other creditors.
We have entered into a new credit world. It is one in which defaulting developers and real estate investors need to be prepared to deal with lenders who have much less tolerance for default and fewer alternatives for restructuring deals. But lenders will continue to value the trust aspect of the lending relationship and their own confidence that you will weather the storm.
Jeff Bennett is a shareholder in Jordan Schrader Ramis PC, regularly advising clients in real estate law and commercial leasing. He can be contacted at 360-567-3900 or jeff.bennett@jordanschrader.com.
