Lender's Approach To Commercial Real Estate Loan Extensions And Restructurings Under The June 2023 Policy Statement, Part I

In his recent KRCL blog series, Charles Aster discussed, from the borrower'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 was a proactive approach to the anticipated CRE crisis resulting from $4-$5 trillion in office mortgage loans maturing in 2024 and 2025. Because of the significant nationwide decrease in office fair market values (approximately 30%) and historically high national vacancy rates (approximately 18.2%), a large portion of today's performing loans, even those making current debt service payments, would not, under standard federal¹ banking policies, qualify for loan extensions or refinancing. For the many CRE borrowers experiencing declines in cash flow, collateral value depreciation, and/or prolonged sale and rental absorption problems, the agencies understand that loan extensions and restructurings, rather than industry-wide foreclosures, may be in the best interest of both the borrower and the lending financial institution.

Taking a proactive approach to the impending maturity crises, theagencies, in their 2023 policy statement, explain that "[w]hen there has been deterioration in collateral values, a borrower with a maturing loan amid an economic downturn may have difficulty obtaining short-term financing or adequate sources of long-term credit, despite the borrower's demonstrated and continued ability to service the debt. In such cases, financial institutions may determine that the most appropriate course is to restructure or renew the loan. Such actions, when done prudently, are often in the best interest of both the financial institution and the borrower." Further, "[p]roactive engagement by the financial institution with the borrower often plays a key role in the success of the workout." (The immediately preceding quoted language and all quoted language in italics below are quoted from the 2023 policy statement.)

The 2023 policy statement provides guidance to lenders and examiners in planning, negotiating, and reviewing CRE loan extensions and restructurings. It also provides examples of workout arrangements in various CRE loans. The agencies' approach applies to numerous CRE asset classes including office, retail, hotel, multifamily, owner occupied, land loans, and construction loans. The agencies encourage lenders to perform a comprehensive review of the borrower's, guarantors' and sponsors' financial conditions and implement prudent CRE loan extension and restructuring arrangements to "... improve the lender's prospects for repayment of principal and interest...." Examiners are expected to take a balanced approach when reviewing lenders' extension and restructuring arrangements, and not criticize lenders "for engaging in these efforts, even if these arrangements result in modified loans that have weaknesses that result in adverse classification." Further, "[m]odified loans to borrowers who have the ability to repay their debts according to reasonable terms 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."

Most Borrowers Are Not Aware of How to Work Within the 2023 Policy Statement. Lenders are encouraged to be proactive and monitor CRE loans approaching maturity. Lenders should not assume their borrowers are aware of the 2023 policy statement, nor will they know how to propose a plan of restructuring that works within the statement. Although borrowers will be keenly aware of declining market valuations and increasing vacancy rates, most borrowers will need guidance assembling information needed by the lender, understanding the statutory and accounting parameters the lender must work within, and what elements to include in a plan of restructuring.

Lenders Should Anticipate Requests for CRE Loan Extensions and Restructurings. For loans maturing in 2024 or 2025, lenders should now review their loan files to anticipate any loans that could potentially face underwriting problems that would prevent them from being refinanced by other lenders. Lenders need to be aware of what their borrowers are facing, maintain open lines of communication, and be ready for when its borrower explains that, due to a low market value, high vacancy rates or expiring leases, it cannot find a new lender to refinance and pay off the existing loan. As part of their ongoing commercial loan due diligence, lenders should independently and actively monitor fair market values and occupancy levels; talk to property appraisers and leasing brokers; study borrowers' monthly and quarterly financial reports and rent rolls; view tax payment records to ensure current status; and perform site visits. Early contact and communication with borrowers are essential for managing loans facing difficulty.

Short-Term Loan Extensions. Prudent monitoring of each borrower's situation will allow lenders to identify borrowers in financial, market value or occupancy distress. The agencies encourage lenders to consider, if prudent, short-term loan extensions as a mitigation effort to avoid larger loan workout restructurings. Examiners will still expect lenders to abide by all applicable laws and regulations and operate under prudent risk management practices and internal controls. Lenders considering accommodations must ensure proper policies and practices remain in place, maintain a comprehensive management approval framework and continue credit risk monitoring for stressed loans.

Loan Workout Restructuring. Short-term extensions will only be appropriate for a portion of a lender's distressed loans. Loan restructurings may be necessary to provide long-term arrangements for issues that require involved cure actions, such as renovations, bringing in a new manager, instituting new rental rates, finding a new equity investor, etc. Such restructurings may include renewing or extending loan terms, providing time to complete curative actions, funding additional credit, requiring a principal pay down, and/or seeking additional collateral or guarantors. However, the above arrangement, while sounding good on paper, will still need the active and constant monitoring by the lender to ensure that the arrangements are carried through.

The Bank Examiners. Additionally, lenders are acutely aware that their workout decisions will be reviewed and graded by federal bank examiners. The consequences of the examiners' grading can have very serious consequences for the bank. The 2023 policy statement makes clear that examiners should not criticize a lender for entering into loan workout arrangements, even though the subject loan may be adversely classified, so long as the lender remains consistent with safety and soundness standards. "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." Examiners will monitor each lender's practices, including:

• Development of a prudent workout plan tailored for the borrower;
• Analysis of 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.

Lender's Loan Due Diligence Review. A lender's approach to loan review and due diligence should be similar to that performed at origination. An in-depth review of property and financial information together with, possibly, a new appraisal to confirm current market value should be conducted or obtained by the lender to confirm that the decision to extend or restructure complies with internal bank policies and the 2023 policy statement. An extensive review takes time. Therefore, for loans maturing in 2024, if their borrowers have not already contacted them, lenders need to actively monitor and communicate with borrowers and guarantors to confirm repayment at maturity. If such confirmation is not given, the borrower, and if not the borrower, the lender, should request a meeting to review the borrower's problem or proposal and, if necessary, develop a plan forward.

The 2023 policy statement advises lenders to require borrowers to present, "...a well-conceived and prudent workout plan that supports the ultimate collection of principal and interest... Based on key elements such as:

• Updated and comprehensive financial information on the borrower, real estate project, and all guarantors and sponsors;
• Current valuations of the collateral supporting the loan and the workout plan;
• Appropriate loan structure (e.g., term and amortization schedule), covenants, and requirements for curtailment or re-margining; and
• Appropriate legal analyses and agreements, including those for changes to original or subsequent loan terms.

Lenders should also require borrowers and guarantors to provide:

• Borrower's global debt service coverage, including realistic projections of the borrower's cash flow, as well as the availability, continuity, and accessibility of repayment sources; and
• The available cash flow of guarantors and sponsors.

The bank's examiners will critically analyze the lender's review and analysis of the borrower's ability to repay the loan. "The major factors that influence this analysis are the borrower's willingness and ability to repay the loan under reasonable terms and the cash flow potential of the underlying collateral or business." The examiners will analyze and look to see that the lender reviewed the following factors, among others:

• "The borrower's character, overall financial condition, resources, and payment history;
• The nature and degree of protection provided by the cash flow from business operations or the underlying collateral on a global basis that considers the borrower's and guarantor's total debt obligations;
• Relevant market conditions, particularly those on a state and local level, that may influence repayment prospects and the cash flow potential of the business operations or the underlying collateral; and
• The prospects for repayment support from guarantors."

In addition to the financial information coming from the property, lenders should analyze the assistance a guarantor or sponsor/principal of the borrower might provide. The lender should consider "...whether the guarantor has the financial ability to fulfill the total number and amount of guarantees currently extended by the guarantor. A similar analysis should be made for any material sponsors that support the loan." This consideration should include "...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. An important consideration is whether any previous performance under its guarantee(s) was voluntary or the result of legal or other actions by the lender to enforce the guarantee(s)."

Updated property value information is critical for the lender's analysis. This analysis includes "...real estate collateral values based on the financial institution's original appraisal or evaluation, any subsequent updates, additional pertinent information (e.g., recent inspection results), and relevant market conditions.... 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."

Even if the current appraised value comes in significantly below the original appraisal when the loan was made, under the 2023 policy statement, a property currently valued below the outstanding debt is not fatal to the request for an extension or restructuring: "... modified loans to borrowers who have the ability to repay their debts according to reasonable terms 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."

To see if the property possesses the cash flow ability to service and repay the loan according to reasonable terms, the examiners will look to see that the lender's analysis considered "... expected cash flow from the property, current or implied value, relevant market conditions, and the relevance of the facts and the reasonableness of assumptions used by the financial institution." For an income-producing property, such an evaluation should include:

• "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."

Not surprisingly, a lender's review should include in its assessment the borrower's actual payment history and the likelihood of the borrower actually making future payments, in addition to actual cash flow available for repayment: "One perspective on loan performance is based upon an assessment as to whether the borrower is contractually current on principal or interest payments.... A second perspective...is to consider the borrower's expected performance and ability to meet its obligations in accordance with the modified terms over the remaining life of the loan."

The 2023 policy statement refers to extending or restructuring the loan and providing for repayment on "reasonable terms." One of the reasonable terms discussed in the 2023 policy statement is the conversion of the loan, at the time of extension, to a current market interest rate if the property's income will support it. The agencies often state that the use of a current market rate "provides for incremental risk." It is not mandatory that a current market rate be used, and there are a number of scenarios in the 2023 policy statement where the existing interest rate was extended into the new term. However, there is clearly a preference for lenders, in any extension or restructuring, to increase the loan's existing interest rate to current market rates so lenders do not suffer a loss on interest rates. A decline in the market value of the property does not necessarily mean that the property's income has declined to the extent it cannot support an increase in interest rates. Any increase near current market interest rates would go a long way toward making the extension or restructuring one that can be viewed as being repayable on "reasonable terms."

Finally, though not in the 2023 policy statement, lenders may still want to require a borrower to pay down the loan in consideration for the extension or restructuring. A debt paydown² lessens lenders' loan exposure and provides assurance that the borrower (a) is willing to share the burden of the extension or restructuring and (b) believes in its own presentation that its plan will lead to a viable and reasonable payoff of the loan.

We at KRCL have extensive experience representing both borrowers and lenders. We understand the issues facing both sides thereby allowing us to assist in finding a common ground for the parties to proceed. Unfortunately, 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. Whether you believe negotiations are a potential path or you need an attorney to protect your position, we can assist you in this endeavor.

Footnotes

1 lowercase when using as an adjective

2 As a noun, paydown is generally one word. (As a verb, use two words.)

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