During the Great Recession, the delinquency rate for commercial real estate loans peaked in the second quarter of 2010 at 8.76%.1 Fallout from the current pandemic may dwarf that number. If debt service ratios are reviewed after April 2020, a significant number of loans will be in technical default as tenants request abatement or deferral of rent. As credit markets tighten, loans fall into default, and certain owners begin to sell, many are already predicting another recession. The business community is cognizant of the chaos being caused beyond anyone’s control and it will be a surprise if banks declare widespread defaults for breaches of technical covenants. In the short term, Banks will likely work with borrowers when payments are missed. But eventually lenders and their borrowers will disagree about the best approach regarding debt service ratios, loan to value ratios and the long-term approach to repaying debt. Borrowers must be aware of their legal options, current regulations, and other pressures on lenders to understand when to strike a fair deal or appropriately exert leverage.
The Short-Term Extension
There is no better solution than one that is mutually reached. There are many workout options regularly adjusted for a short-term period including extension of loan maturity, deferral of payments, interest only periods, or refinance with a reduced interest rate (especially in the current interest rate market). These options generally do not provide long-term solutions absent a quick rebound, but they do allow the parties to work together to gather more information and solidify projections so the situation can be reevaluated once the market stabilizes. Unless you are betting on a quick economic recovery following the pandemic, borrowers should not make substantial paydowns, voluntary liquidations, or capital contributions related to these short-term concessions. Hopefully, the only negotiation will be whether fees for the short-term extension including attorney’s fees will be waived, deferred, or paid at the time of the extension.
The Long-Term Extension
With the federal funds rate at 0%, there may be no better time to find a long-term financing option. Contrary to the discussion above, a long-term financing option may require a principal paydown to provide adequate security to your lender. The question is how long will the lender be willing to finance the debt compared to the cost for such extension. As a practical matter, the recovery time for most commercial properties to approach pre-recession values following the 2008 collapse was approximately six years.
A restructured loan term for 5-10 years, at a low interest rate may be a good option even if requiring a principal reduction of 10-20%.
The Lost Cause
If a property struggled to service its debt prior to the pandemic and the prediction emerges for a slow economic recovery following the pandemic, a critical determination must be made whether to invest additional resources into the property or to let it go. In times of economic crisis, some of the best restructuring deals are achieved by those who are willing to walk away from their property. Voluntary sales usually net a higher result for a lender than foreclosure sales or sales after foreclosure. As a result, such circumstances should make lenders willing to work with borrowers on a structured liquidation or more favorable restructure terms. The amount that the lender is willing to work with borrower usually turns on two issues: (1) how unique is the property and (2) how strong is the guarantor. If the property needs an operator to net the highest value, even a substantially underwater property could encourage a bank to release or substantially modify a guaranty. If a guarantor has limited assets or is judgment proof, the lender can only turn to its collateral and must work with the borrower to maximize value. However, if a guarantor is strong, the most impactful leverage point in Arizona is the guarantor’s fair market valuation defense, a right that cannot be waived in Arizona.2 It allows a judge to decide the fair market value of the property without a forced sale.
The Forced Restructure
At some point, lenders will either: (a) be overwhelmed with the number of defaults, such that they will not respond to requests to restructure; (b) find that they are restricted from negotiating based on agreements with the parties who shared the risk of the loan; or (c) simply disagree with the borrower on the proper way to pay loans and the appropriate length of an extension. If any of these situations exist, a bankruptcy may be the only way to restructure these debts. As one retired bankruptcy judge often stated, “I’m the banker now.” There are several tools available to a bankruptcy court to establish a fair and equitable resolution for distressed real estate: adjusting interest rates – using the national prime interest rate as a base rate and adjusting upward based on risk factors; allowing for years of interest-only payments; determining an appropriate amortization period; and determining the appropriate time for a balloon payment. The court may also adjust the amount of the loan to the value of the real estate (a “cramdown”). Such relief, however, may not be a favorable option for a strong guarantor. The law is unsettled as to the degree to which a bankruptcy court can protect guarantors who do not file bankruptcy themselves; but this open question of law creates additional opportunity for negotiation that may not exist outside of the bankruptcy court or an extended interest-only period.
- https://fred.stlouisfed.org/series/DRCRELEXFACBS
- A.R.S. §33-814(A)
