CRE Loan Defaults: A Brief Guide for Lenders and Borrowers

The coronavirus pandemic could create a lot of distressed assets.

After the COVID-19 pandemic forced many U.S. businesses to go dark, the inevitable effects on the economy are highlighting new risk considerations. Notwithstanding the many federal, state and local initiatives to limit the damage, commercial real estate is clearly facing many challenges. As the industry turns to managing CRE loan defaults, it is helpful to revisit lessons learned from past real estate downturns from the lender and borrower perspectives.

Advice for Lenders

Prepare your team now, and not just the workout officers. Given that it’s been nearly a decade since the last real estate recession, it is safe to assume that lenders’ workout teams have decreased both in number and experience. This presents a great opportunity to train loan officers in the strategy, law and economics of workouts and the exercise of remedies. Transitioning from origination mode to workout mode can be difficult for relationship-based loan officers, but it is extremely valuable training.

The first thing to emphasize is the need to enter into pre-negotiation (sometimes “pre-workout”) agreements before any material negotiations regarding a loan in default or likely to end up there. This ensures that candid discussions and early optimistic statements don’t come back to bite the lender.

Make sure files are in order. Too often, a review of lenders’ asset files reveals problems that decrease the value received in asset resolution. Missing an original copy of the note, other key documents or instruments such as the title policy? That’s not good to discover while heading into court for foreclosure or attempting to sell the defaulted loan. Make sure files are in order, especially those for the loans expected to default soon. Organized and complete files convey an impression of good order that is well received by judges, regulators and potential asset purchasers, while missing documents can prevent the exercise of remedies or result in reduced valuations.

Work hard to get up-to-date property information. It’s important to collect the quarterly and annual borrower and property financial statements required under the loan documents. Up-to-date information is even more important. Without it, the lender, the regulators and the loan purchasers will have to assume the worst. That can lead to overly pessimistic valuations.

Even worse are situations where the property’s operating income is being diverted by the borrower without the lender’s knowledge. Trigger cash traps where agreements provide for them, and demand evidence that project revenues are being applied to project costs and, to the extent available, debt service. If reliable information isn’t provided quickly, consider starting foreclosure to immediately seek a rent receiver to protect whatever cash flow there is.

Develop an asset-disposition strategy. In addition to improving their balance sheets, financial institutions can reduce costs associated with servicing and carrying distressed assets, improve overall portfolio quality (with resulting positive impacts on stock price and market perception), and free up time and attention to focus on more profitable assets. A seller of distressed assets has several possible distribution channels, including a private sale to targeted buyers, online auctions or one-off single-asset sales.

Properly executed bulk sales allow the lender to mix desirable assets with less desirable ones and avoid selling the cherries and getting stuck with the pits. On the other hand, bulk sales are typically the most highly negotiated, time-consuming and difficult (read “expensive”) transactions to execute.

Online auction sales provide a fast and economically efficient way to dispose of assets, at least when considered on a cost-per-asset basis, but they often result in the lender retaining the least desirable assets.

Consider a (former) friends and family program. This is a program to accept discounted payoffs from, or make asset sales to, the defaulting borrower. Obviously, it’s emotionally difficult for a lender to grant a benefit to a borrower who is not paying a loan, but in many cases it can achieve the best economic result in the shortest time.

Compared to arm’s-length buyers, the borrower is inherently far more invested in and optimistic about the future value of its project and doesn’t have to discount as deeply to protect itself against unknown or unpredictable risks. Borrowers don’t need to diligence the property, so the process is much more streamlined than a typical sale to an arm’s-length buyer.

Advice for Borrowers

Triage. Look critically at each asset — is it worth investing new capital to preserve it, or could it be let go in a worst-case scenario? While it is incredibly difficult to sacrifice projects that have come to fruition through a lot of hard work, focus attention and capital first on the assets most salvageable and worth saving.

Review loans and loan documents. First, get a clear-eyed understanding of recourse exposure. Which assets are fully recourse to a creditworthy party (particularly individuals)? Which assets have limited or no recourse? While putting the portfolio through triage, it’s important to understand which loans can take down the whole company, and which properties can be sold without further damage.

Even with “nonrecourse” loans, pay particular attention to carve-outs from the nonrecourse provisions in loan documents and guarantees. These carve-outs are supposed to exempt items that would make the nonrecourse agreement look stupid — unpaid property taxes, environmental issues, misdirected rents, unpaid insurance premiums — because they detract from the value of the underwritten collateral.

Lenders and their lawyers, though, are constantly trying to expand the carve-outs by slipping in carve-outs for broad “indemnities” and other matters that have no relevance to the collateral and can make the loan effectively recourse. Bottom line: be sure recourse isn’t inadvertently tripped on a nonrecourse loan.

Finally, for the same reasons, look for loans that are cross-defaulted or cross-collateralized.

Look for documentation issues from the lender’s perspective. It is always useful to try to understand how a lender (or its lawyers) views the loan documentation. Are signatures missing? Is the promissory note correctly described in the deed of trust? Is the deed of trust recorded against the right property? Consider consulting with a lawyer experienced in representing both borrowers and lenders in distressed-asset situations to see whether flaws in the documents might provide any useful leverage. However, don’t be overly aggressive. There is usually just one shot at a negotiated resolution, and adopting a hardball approach at the start is not the best way to get there.

Come up with a plan and communicate proactively. Once the loan documents are in order, consider the benefits of proactive communication with lenders. Let them know that the business is being run as well as it can be run right now, issues are being addressed and there is a plan.

In previous recessions, borrowers were rewarded for being prepared and proactive when their properties wouldn’t fully pay debt service or could not justify loan refinancing. When tenants start failing, rents start dropping and values start sliding, come up with a plan to maximize long-term revenues and minimize costs. That allows a borrower to present solutions to a lender.

Lenders, and particularly special servicers of securitized loans, are quickly swamped in a major economic downturn, especially one that starts as quickly as this one did. As a result, they are often unable to muster experienced personnel to evaluate their many new problems, let alone come up with creative solutions.

Showing candid good faith and presenting the best approach to a bad situation is much more likely to get a lender’s attention and forbearance than the borrower who just waits for the lender’s call when the monthly debt service payment fails to show up. Governmental regulators have gone to some lengths to encourage lenders to work with borrowers affected by COVID-19, and in particular borrowers in industries that have been especially hard hit by the economic downturn. While things may look bleak now, thoughtful and creative work and planning will minimize the impact on businesses, leaving savvy operators stronger than their competitors when the economy returns to health.

The authors are attorneys with Manatt, Phelps & Phillips, LLP. Clayton Gantz is a partner in the San Francisco office. Steve Edwards is a partner in the Orange County (California) office. Tom Muller is a senior counsel in the Los Angeles office.