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Many owners of commercial properties across the country encumbered by mortgage debt are still struggling to navigate the distressed real estate market, primarily due to their inability to pay current debt service resulting from a lack of net operating income (or increased debt service under floating rate loans) and/or their inability to refinance the existing mortgage debt resulting from decreased valuations and debt service coverage ratios. The main culprits – high interest rates, high operating costs and lease-up costs, and (specific to certain sectors, such as office) significantly reduced tenant demand for space – have not yet meaningfully abated.

When a borrower is faced with an inability to pay current debt service or the debt at maturity of its mortgage loan (or a failure of another material economic covenant under the mortgage), invariably the borrower will evaluate its options, from a sale of the property (which, in most distressed cases, will not be a viable solution) to investing additional equity to relinquishing ownership, whether through a foreclosure, deed-in-lieu or short sale. Among the borrower’s options, the borrower will typically consider attempting to negotiate a loan modification permitting the borrower to maintain ownership of the property (i.e., a “loan workout”).

However, in guiding several clients through the loan workout process, we have found that there are several factors for the borrower to consider “prior to” the borrower initiating mortgage loan workout discussions with its mortgage lender. Set forth below are a few of those key factors.

Who is the Lender

An institutional lender that is holding the loan on its balance sheet will typically have more flexibility to negotiate workout terms than a loan servicer of a securitized mortgage loan. Loan servicers are usually limited by “REMIC” tax rules with respect to what loan modifications they can agree to; and in most cases the loan is required to be in default (or an imminent default must exist) in order for meaningful modifications to be made.

In today’s market, most institutional lenders and loan servicers have an interest in avoiding taking ownership of property if a reasonable plan can be agreed-upon, as discussed below. However, certain mortgage holders (such as certain debt funds, or purchasers of distressed debt) may be very aggressive in their approach, as they have little issue with acquiring (and may even desire to acquire) title to the underlying real estate.

Understanding who the lender is, and accordingly, its potential motivation and interest in a loan workout, will help define the borrower’s realistic goals that may be achieved in the workout and the borrower’s workout strategy to achieve those goals.

Review of Loan Documents and Financial Projections

Reviewing the existing loan documents, and any relevant communication between the lender and the borrower, is a critical step to undertake before approaching the lender. What defaults have occurred? Have other conditions occurred, such as the mortgage property being subjected to a “cash trap”? What potential remedies are available to the lender, including against a guarantor? Are there any defenses or claims available to the borrower?

In addition, the borrower will need to update and review its projections for revenues and expenses for the property. It will also need to forecast its requirements for funds to cover any repositioning and tenanting costs, and/or to fund operating shortfalls.

Formulating a Plan

The lender will most likely have little interest in granting the borrower’s requested relief if the borrower does not show it has a plan. Does the borrower have a plan to attract new tenants, find new equity or a refinancing or sell the property? Where applicable, does the borrower have a plan to fund operating shortfalls through the current distressed real estate market or bring in more equity to fund operational or capital investment needs? The more detail that the borrower can show the lender with regard to its plan, including pro forma budgets, the better.

In addition, as part of the plan, the borrower needs to consider what relief would be best to secure to successfully execute the plan. The most obvious relief for a borrower facing an imminent maturity date would be an extension of the maturity date. But in other contexts, a deferral of monthly debt service and/or forgiveness of accrued interest (or reduction in the interest rate), a temporary relaxation of cash trap triggers or financial covenants (i.e., leasing covenants, DSCR, and LTV), and/or application of available reserves may be needed or may make sense. In addition, some workout plans may involve obtaining approval from the lender to permit new equity partners or a change in property management.

With that said, the borrower will need to be realistic in its objectives and with respect to what relief the lender will be willing to consider.

Anticipate Lender’s Requirements

The borrower should prepare itself for the conditions and requirements that its lender may impose in the workout, in exchange for granting the borrower’s request for relief. The lender may require that fees be paid (in addition to its costs), additional guarantees be delivered or that additional collateral be posted (including pledges of equity or a deed in escrow), a cash management system (including a hard lock-box) be implemented and/or additional financial reporting. In some instances, the lender may require a partial paydown of the loan, or that a reserve be funded for future planned capital investments, with new equity. On the legal side, the borrower should certainly expect that the lender will require an acknowledgement of the debt, the borrower’s waiver of defenses and claims, and a full release of the lender.

The Pre-Negotiation Agreement

The borrower should anticipate that the lender will be unwilling to commence workout discussions without a pre-negotiation agreement in place. In summary, the pre-negotiation agreement generally provides that the parties acknowledge that none of their rights will be waived or affected by the exchange of information and negotiations to be undertaken as part of the loan workout discussions. Although the lender typically requires this document, the borrower is equally well-served to have this agreement entered into prior to commencing discussions. As is the case with the lender, the borrower may not want information it divulges in workout discussions to be used against it in a later court action. In particular, the borrower does not want to inadvertently trigger personal liability under a loan guarantee, such as by stating in writing an inability to pay its debts as they become due (a common springing, full-recourse event under many recourse carve-out guarantees).

The borrower should be aware that many lenders will attempt to obtain admissions of defaults, waivers of borrower’s claims and releases of lender liability in pre-negotiation agreements. However, we view these terms as overreaching by the lender in the context of a pre-negotiation agreement, and the borrower is certainly advised to have its attorney review the pre-negotiation agreement and attempt to have these provisions removed from the agreement.

Conclusion

There is no one-size fits all in a loan workout, as every loan, property, lender and other circumstances are distinctive. Accordingly, the relief obtained by the borrower and the concessions obtained by the lender will rarely look exactly the same from loan workout to loan workout. But in almost every case, the aspects outlined above are best considered prior to undertaking loan workout discussions, in order for the borrower to best formulate its strategy for a successful workout. It is also worth noting that, in general, the earlier the borrower initiates discussions with the lender (rather than waiting for the economic circumstances to further deteriorate, and worse, for the lender to act), the better the chances of a successful workout.

About Tannenbaum Helpern’s Real Estate practice

Tannenbaum Helpern’s Real Estate practice consists of experienced real estate attorneys who regularly advise on commercial sales and acquisitions, real estate financing and development, joint venture transactions, loan workout and restructurings, and commercial leasing. With deep experience across a broad spectrum of property types, Tannenbaum Helpern counsels clients on real estate transactions involving office, shopping centers, hotels, hospitals, healthcare facilities, storage facilities, industrial and warehouse properties, multi-family and mixed-used properties, located in New York City and across the country. Clients include public companies, REITs, real estate private equity funds, national and regional owners, investors and developers, institutional lenders, hotel operators and property managers. Tannenbaum Helpern’s Real Estate practice has been recognized in Best Lawyers’ Best Law Firms rankings since 2019.

For more information on the topic discussed, contact:

• Ari Davis  |  adavis@thsh.com  |  212-508-6796
• Lauren Erbst  |  erbst@thsh.com  |  212-508-6712
• Caryn Ettinger-O'Brien  |  ettinger@thsh.com  |  212-702-3159
• Michelle Greenberg  |  greenberg@thsh.com  |  212-508-6735
• Robert E. Helpern  |  helpern@thsh.com  |  212-508-6720
• Joel S. Hirschtritt  |  hirschtritt@thsh.com  |  212-508-6707
• Matthew I. Levine  |  mlevine@thsh.com  |  212-508-7542
• Eric S. Schoenfeld  |  schoenfeld@thsh.com  |  212-508-6713