In Part I of this three-part blog series, we discussed, from the lender's perspective, the June 2023 policy statement on prudent commercial real estate (CRE) loan accommodations and workouts jointly issued by federal financial institution regulatory agencies. The series dealt with anticipated impacts of the current CRE crisis arising from a significant nationwide decrease in office fair market values (down approximately 30%), historically high office vacancy rates (approximately 18.2%), and $4-$5 trillion in office mortgage loans maturing in 2024 and 2025. For the many CRE borrowers experiencing declines in cash flow, collateral value depreciation, and/or prolonged sale and/or rental problems, the agencies understand that loan extensions and restructurings, rather than industry-wide foreclosures and bankruptcies, may be in the best interest of both the borrower and the lending financial institution. The 2023 policy statement applies to numerous CRE asset classes and provides guidance to financial institutions and examiners in planning, negotiating, and reviewing loan extension and restructurings.
The agencies provide examples of CRE loan workout arrangements and offer guidance intended to direct financial institutions through the loan workout process. They also provide a transparent look at the approach examiners are expected to take when reviewing a lender's[JF1] documented loan extension and restructuring arrangements. The agencies expect financial institutions to perform comprehensive reviews of their borrowers' situations and to implement prudent loan workout arrangements. Likewise, the agencies expect examiners to "take a balanced approach in assessing the quality of a financial institution's risk management practices for loan accommodation and workout activities." (The immediately preceding quoted language and all quoted language in italics below are quoted from the 2023 policy statement.)
Safety and Soundness Standards for Extensions and Restructurings. The 2023 policy statement urges financial institutions to implement risk management practices appropriately proportional to the lender's normal lending activity and ability to monitor its loan portfolio. These risk management practices must be "consistent with safe and sound lending policies and supervisory guidance, real estate lending standards and requirements, and relevant regulatory reporting requirements." Whether the lenders find themselves considering either short-term accommodations or loan workout restructurings to improve the borrower's prospects for repayment of the CRE loan, they are acutely aware that their workout decisions will be reviewed and graded by federal bank examiners. Examiners will evaluate a financial institution's risk management practices, which typically include:
- "A prudent loan workout policy that establishes appropriate loan terms and amortization schedules and that permits the financial institution to reasonably adjust the loan workout plan if sustained repayment performance is not demonstrated or if collateral values do not stabilize;
- Management infrastructure to identify, measure, and monitor the volume and complexity of the loan workout activity;
- Documentation standards to verify a borrower's creditworthiness, including financial condition, repayment ability, and collateral values;
- Management information systems and internal controls to identify and track loan performance and risk, including impact on concentration risk and the allowance;
- Processes designed to ensure that the financial institution's regulatory reports are consistent with regulatory reporting requirements;
- Loan collection procedures;
- Adherence to statutory, regulatory, and internal lending limits;
- Collateral administration to ensure proper lien perfection of the financial institution's collateral interests for both real and personal property; and
- An ongoing credit risk review function."
When put together, "An effective loan workout arrangement should improve the lender's prospects for repayment of principal and interest, be consistent with sound banking and accounting practices, and comply with applicable laws and regulations." For each loan they review, the examiners will want to see "a well-conceived and prudent workout plan that supports the ultimate collection of principal and interest and that is based on key elements such as [the following]":
- Analysis of the borrower's global debt service coverage;
- Analysis of guarantors' and sponsors' available cash flow;
- Prudent monitoring of borrower and guarantor performance;
- Continued internal risk rating or loan grading framework; and
- Appropriate allowance calculations in accordance with GAAP.
Examiners will also evaluate the financial condition of guarantors that support a loan. Guarantors should demonstrate the ability to fulfill their obligation to support the loan through payments, curtailment, or re-margining if necessary. "Examiners should consider whether a guarantor has demonstrated the willingness to fulfill all current and previous obligations, has sufficient economic incentive, and has a significant investment in the project." To be effective, an evaluation must consider whether a guarantor is financially able to support all guaranties, not only for the particular CRE loan subject to workout arrangements.
Evaluation of Collateral Value. Updated CRE property value information is also critical for both the lender working with the borrower to agree on a plan and for the examiner's review of such agreements. The 2023 policy statement emphasizes the importance of the estimated value of a loan's underlying collateral when borrowers formulate a plan and the lender reviews it. Examiners will rely on the "...institution's original appraisal or evaluation, any subsequent updates, additional pertinent information (e.g., recent inspection results), and relevant market conditions...." Financial institutions should be prepared to show the examiners the valuation approaches, assumptions, and underlying factual details that substantiate their collateral value analysis.
This new value analysis may require the borrower to obtain a new or updated appraisal of the real estate collateral. "For a CRE loan in a workout arrangement, a financial institution should consider the current project plans and market conditions in a new or updated appraisal or evaluation, as appropriate. In determining whether to obtain a new appraisal or evaluation, a prudent financial institution considers whether there has been material deterioration in the following factors:
- The performance of the project;
- Conditions for the geographic market and property type;
- Variances between actual conditions and original appraisal assumptions;
- Changes in project specifications (e.g., changing a planned condominium project to an apartment building);
- Loss of a significant lease or a take-out commitment; or
- Increases in pre-sale fallout."
However, "a new appraisal may not be necessary when an evaluation prepared by the financial institution appropriately updates the original appraisal assumptions to reflect current market conditions and provides a reasonable estimate of the underlying collateral's fair value."
Finally, in addition to the underlying fair market value of the CRE property, the lenders and examiners will also look at the property's operating cash flow. "For an income-producing property, examiners evaluate:
- Net operating income of the property as compared with budget projections, reflecting reasonable operating and maintenance costs;
- Current and projected vacancy and absorption rates;
- Lease renewal trends and anticipated rents;
- Effective rental rates or sale prices, considering sales and financing concessions;
- Time frame for achieving stabilized occupancy or sellout;
- Volume and trends in past due leases; and
- Discount rates and direct capitalization rates.
Adverse Loan Classification. The 2023 policy statement makes it clear that CRE loans should not be adversely classified based solely upon industry-wide financial difficulties. When a financial institution negotiates loan workout arrangements with "...borrowers who have the ability to repay their debts according to reasonable terms, [these borrowers] will not be subject to adverse classification solely because the value of the underlying collateral has declined to an amount that is less than the outstanding loan balance."
Generally, if a loan extension or restructuring shows the borrower's ability to continue making loan payments based on reasonable terms, despite the decline in cash flow or market value of the collateral, a lender may classify such an extension or restructuring as "pass and is monitoring the credit." The policy statement reads: "In general, renewals or restructurings of maturing loans to commercial borrowers who have the ability to repay on reasonable terms will not automatically be subject to adverse classification by examiners. However, consistent with safety and soundness standards, such loans should be identified in the financial institution's internal credit grading system and may warrant close monitoring."
If the extension or restructuring meets the requirements for a "pass and is monitoring the credit," but there are weaknesses in the collateral that, if left uncorrected, may result in a deterioration of repayment prospects, the loan should be classified as "special mention." Examples of such future weaknesses can include major leases expiring in the future, rents forecasted to trend downwards or the fair market value of the property being on a downward trend. If examiners agree with the "special mention" classification, a financial institution will not be adversely impacted, but it must maintain a process to monitor the loan.
If the weaknesses in the collateral are more severe such that repayment in full of the loan is not adequately protected, it may be "appropriate to classify a performing loan when well-defined weaknesses exist that jeopardize repayment....The portion of the loan balance that is adequately secured by the fair market value of the real estate collateral less the costs to sell generally should be classified no worse than 'substandard.'"
As to "[t]he amount of the loan balance in excess of the fair value of the real estate collateral, or portions thereof, [it] should be adversely classified 'doubtful' when the potential for full loss may be mitigated by the outcomes of certain pending events, or when loss is expected but the amount of the loss cannot be reasonably determined. If warranted by the underlying circumstances, an examiner may use a 'doubtful' classification on the entire loan balance. However, examiners should use a 'doubtful' classification infrequently, as such a designation is temporary and subject to a financial institution's timely reassessment of the loan once the outcomes of pending events have occurred, or the amount of loss can be reasonably determined."
Finally, if the lender and/or examiners believe the extended or restructured loan is uncollectible or of such little value that its continuance as a bankable asset is not warranted (e.g., a property with recently discovered large environmental problems), such extended or restructured loan will be classified as a "loss."
Nonaccrual Status. Examiners must also determine if an extended or restructured loan should be placed in nonaccrual status to ensure that interest income is not materially overstated. If "...a loan that has been restructured so as to be reasonably assured of repayment and performance according to prudent modified terms [it] need not be placed in nonaccrual status. Therefore, for a loan to remain in accrual status, the restructuring and any charge-off taken on the loan must be supported by a current, well-documented credit assessment of the borrower's financial condition and prospects for repayment under the revised terms. Otherwise, the restructured loan must be placed in nonaccrual status." Accordingly,if the loan is extended or restructured at a current market interest rate with a payment schedule that reasonably supports repayment of the loan in full at the end of the extended term, the borrower's plans and projections for the property support such repayment, and the borrower has a demonstrated history and future path showing the ability to make regularly scheduled payments, the loan may maintain its accrual status even with the decline in the borrower's creditworthiness.
Hence, the lender must walk carefully among many regulatory guardrails. Contrary to their populist Snidely Whiplash reputation, financial institutions generally do not want to foreclose on properties. They will, of course, to protect themselves, but their first hope is that the borrower walks into the meeting with good answers and a great plan. However, since that is not always the case, a lender may negotiate with the borrower in modifying its initial proposal to relieve pressure on the borrower while, at the same time, making sure that final agreed-upon plan does not result in a loan reclassification or change to nonaccrual status.
Lender Liability. In a workout, a lender may not dictate the actions the borrower must undertake or risk stepping into the unpleasant world of lender liability. That does not mean the lender has to sit back silently. There is no requirement in a commercial loan that the lender must agree to change the terms of the original loan documents. It can reject any proposal the borrower may make until the borrower offers a proposal satisfactory to the lender. It also may ask questions such as "have you thought about X" or "have you considered or investigated Y." The lender may also counter with its own requirements. For example, if the borrower offers to pay down the loan by a truly insignificant amount, the lender may counter with the pay down amount it feels is necessary to protect the debt or require evidence of the borrower's true commitment to the extension or restructuring plan. But to tell the borrower, "take this action," risks claims that the lender is controlling of the borrower.
Attorneys at KRCL have often worked with their lender clients to assist the lender in reviewing and commenting on a borrower's proposal. We have often been asked to review a borrower's plan to see, from the legal side, if the borrower is trying to obscure relevant details or take advantage of the lender. We understand the issues facing both sides thereby allowing us to assist in finding a common ground for the parties to proceed. Of course, some properties are so underwater that there is no reasonable path to full repayment of the loan. In such cases, KRCL's attorneys switch from their negotiating hats to their combat boots in order to protect their clients.
[JF1]used "lender" here because not every institution is a "bank" per se.
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