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Lender’s Approach to Commercial Real Estate Loan Extension and Restructuring Under the June 2023 Policy Statement, Part III

In Part I of this three blog series, we discussed the June 2023 policy statement on prudent commercial real estate (CRE) loan accommodations and workouts jointly issued by federal financial institution regulatory agencies. This series addresses the current real estate crises and the impact of  $4-$5 trillion of office mortgage loans maturing in 2024 and 2025, and how the agencies have modified guidelines to assist both lenders and borrowers in extending and restructuring their troubled CRE loans. In Part II, we discussed 2023 policy statement guidelines for the bank examiner’s review of CRE loan extensions and restructurings, and reviewed guidelines provided by the agencies to help lenders stay within the regulatory guardrails during the CRE extension and restructuring process.

Now in Part III, we, from the lender’s perspective, look toward the upcoming meetings between lenders and borrowers to help lenders prepare for reviewing borrower presentations. The borrower must present a balanced plan to the lender that aims toward repayment of the loan on reasonable” terms and provides the lender with a reasonable” probability of being repaid in full. We will touch on what the agencies consider a “well-conceived and prudent workout plan” and the key components that lenders should expect to see from their borrowers. (The immediately preceding quoted italicized language and all quoted language in italics below are quoted from the 2023 policy statement.)

Elements of Borrower’s Presentation and Plan. A well-prepared borrower with a reasonable presentation and plan increases the likelihood of a successful CRE loan extension or restructuring negotiation. The lender should hope and expect that its borrowers take an honest and comprehensive look at their property and competing properties. Are the property issues aftereffects of the 2020 pandemic and continued delay of workforce return to the office? Are there problems with the property itself? Or are there issues with the borrower’s or manager’s operation of the property? Well-informed and savvy borrowers should have given thought to and have answers for specific market issues. If the borrower is coming to the lender asking for relief, the lender should rightfully require that its borrower walk into the meeting equipped with detailed information and suggestions for a path forward. Failure to do so should signal to the lender that either the borrower is not taking its situation seriously enough or it is not capable of identifying and handling the problems. Either of those reasons should severely undercut the confidence of the lender in the borrower and, in our experience, usually leads to a rejection of the borrower’s proposal.

In our first two blogs, we explained that part of the borrower’s presentation must contain updated financial information regarding the property, the borrower, the guarantors and the sponsors so the lender can calculate what money the property and borrower parties can provide for the proposed restructuring. Please see Blogs I and II for detailed lists of such financial information.

However, while updated financial information is crucial, it is not the entire story of a property and loan that needs help. The drop in property values and increase in vacancy rates are caused by factors that every lender will want to make sure their borrower can answer.

Hangover from the 2020 Pandemic: Worker Reluctance to Return to the Office. For many office properties, the primary reason the property is in trouble is the hangover from the 2020 pandemic and worker reluctance to return to the office. Everyone was surprised by the pandemic, the quick ability of employees to work from home and their desire to continue to work from home once the crisis subsided.

So, what is the fix for employees returning to offices? Unfortunately, other than time and hoping that corporate America requires its employees work in offices, there is no silver bullet. Because this is a universal market problem and not focused on individual properties with unique problems, a market-wide solution has yet to arise. At present, office owners are hoping that time will see a return of employees to the office, or that new companies take over the empty space. The 2023 policy statement indicates that the federal agencies don’t have a better answer. Otherwise, they would not have published a policy which favors granting borrowers more time to figure this out.

One popular answer currently being discussed is to convert uneconomic office buildings to residential towers thereby killing two birds with one stone: getting rid of excess office space and increasing needed urban residences. However, the costs and engineering of such conversions does not work with every building. In fact, due to the last half-century’s fixation on large cube office buildings (which are the most efficient for office use), a huge percentage of such buildings are not profitable or practical to convert to residences. For two very informative presentations on the advantages and difficulties of office-to-residential conversions, see the following video presentations by the Wall Street Journal and CNBC:



Therefore, regarding the 2020 pandemic and worker reluctance to return to the office, lenders should not be surprised to receive a request for a year or two extension to get past this lingering impact. However, this hope, by itself, is not enough of a basis to grant an extension or restructuring. The proposal still must be backed with other elements that will cause the lender to believe the requested extended loan will have a reasonable” likelihood of being repaid in full at reasonable” interest rates. Such other elements should include the following issues if applicable to the particular loan or property.

Loss of Major Tenants and/or Leases Expiring in the Near Future. The current national office market finds itself caught in a predicament of overall higher national vacancy rates and competition among building owners for possibly fewer future tenants. In its presentation, the borrower must address this problem and present a plan that shows how they will replace tenants and keep the property’s occupancy at acceptable levels and rates. The plan can address property renovation and updating, introduce additional or new technology to the property, change the mix of tenants, add roof leases for telecommunication towers, redesign floor plates for different types of tenant operations, and/or switch portions of the property from strictly commercial tenants to a mix of hotel on some floors, residences on others, retail on others, etc.

Of all of the elements of the borrower’s presentation, solving the problem of terminating leases with fewer future tenants may be the truest test of a borrower’s skills as an office owner.

Addressing the Decrease in Fair Market Value. Nationwide, CRE fair market values are down approximately 30%, causing property valuations to be a focal point of the lenders heading into loan extension negotiations. Lenders will be anxious to hear their borrower’s suggestions to deal with the declining value. Borrowers should understand that decreased fair market values are now often determined by using cap rates of income based on existing leases, and that this issue is related to and similarly solved when the borrower addresses a loss of tenants and future rent rolls.

Providing updated property value information is critical for the borrower’s presentation and is discussed in detail in Blog II. However, the truly good news is that the 2023 policy statement clearly, and in more than one place, states that the fact that the current fair market value of the property is below the outstanding balance of the loan is not fatal to an extension or restructuring. “[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.” The key, as noted many times in the policy statement, is for the borrower to show in their presentation to the lender that its plan will in fact offer “…the ability to repay their debts according to reasonable terms….”

Updating or Renovating the Property. A few scenarios provided in the 2023 policy statement discuss properties in need of updating or that have become non-competitive due to outdated technology or other reasons. This part of the plan is crucial as it tells the lender whether the borrower is honestly and realistically looking at its property. If such issues exist and are not properly answered in the borrower’s plan, a lender should question whether the borrower is the right party to solve the property’s problems. Therefore, it is reasonable for the lender to require the borrower to properly deal with such issues.

Additionally, while it is crucial for borrowers to include proposed renovations and updating plans in the presentation to the lender, another major question will be who pays for the renovations or updating? If the borrower party’s funds are truly exhausted, it would not be unusual for the borrower to request a mini-renovation loan to be added to the primary loan. However, if the borrower has liquidity, the lender should insist that the borrower pay for the renovation. Also, if the borrower’s renovation or updating plans are inadequate, the lender will recognize the deficiency and determine that any funding request by borrower is just throwing good money after bad. Accordingly, the  borrower’s plan should address what renovations need to be conducted, the timeline for completion, the projected increase in occupancy and income, and how the borrower will pay for as much of it as it can.

Change of Managers and General Contractors. Borrowers should pay close attention to the management and construction of their properties. While frequent changes in managers and contractors can be a red flag, lenders want their borrowers closely monitoring their company’s performance. If an existing manager is not appropriately maximizing income and/or decreasing costs, or the general contractor is over budget and/or late on construction, then replacing the manager or general contractor should be an important element of the borrower’s plan. If such a change is part of its plan, then borrower should include in its presentation why the manager or general contractor is being changed;, how the borrower sees the change improving revenues, decreasing costs or getting construction back on schedule; who the new manager or general contractor will be so the lender can confirm it approves the new company; the difference in management/contractor fees, if any;and when the changeover is to occur and the time to complete it.

Principal Pay Down. Although not a part of the 2023 policy statement, in recent extensions and restructurings we have been involved with, whether on borrower or lender side, it is not uncommon for the lender to require a principal paydown of some type. Usually, the paydown is an amount to allow the loan, at the new interest rate, to fit within a debt service coverage ratio (DSCR) test that provides the lender some level of comfort. Since the context of the meeting is a troubled loan, the new DSCR will most likely not be the normal 1.25-to-1.00, but some easier/tighter ratio if a DSCR test makes sense to use at all. Assume the lender has/will carefully review the borrower, guarantor and sponsor’s financial statements. If any of the parties possess liquid funds to contribute to the deal, the lender, to prove that the borrower really believes in its own presentation and plan, will justifiably want to see the borrower reach into its own pocket and contribute more equity to the deal.

Additional Collateral or Guaranties. When a borrower’s financial position does not allow for a principal paydown, the lender could offer the borrower alternative methods of reassuring the borrower’s commitment to the restructuring negotiation while also increasing the security for the loan. Rather than a principal paydown, the lender may allow the borrower to offer additional collateral, an additional guaranty or the expansion of an existing guaranty. In numerous places, the 2023 policy statement encourages lenders to look to the borrower’s financial statements for sources of additional support.

Whether a general guaranty of the entire loan, a bad boy guaranty of non-recourse carve-outs, or a guaranty focused on specific risks in the loan such as construction cost overruns, deferred interest or other third-party costssuch as ground rents or franchise fees, having an additional source of payment is a definite advantage for the lender and will be considered in the examiner’s analysis of the restructuring arrangement. This may be more palatable to the borrower side at the time of restructuring because there is no current cash out of the borrower’s or guarantor’s pocket. But if the borrower’s plan or projections fall apart, the lender has an additional valuable piece of collateral in the event of foreclosure or may seek repayment under a guaranty it did not have before the workout.

The Extended Loan Interest Rate. This is often the toughest part of the restructuring negotiation. Borrowers are simultaneously facing lower occupancy rates and higher interest rates that are causing many of them to request a reduced interest rate during the loan extension term. 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. 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, by making such a request, the borrower is asking the lender to decrease the lender’s profit. Why should the lender agree to a cut in interest rates just so the borrower can suffer fewer losses? What is in it for the lender? Borrowers proposing a reduced interest rate should also include some concession to the lender or benefit to the property so that the proposal is a cooperative effort between lender and borrower and not one where the lender is being asked to make all of the sacrifices.

KRCL’s attorneys have counseled numerous lender clients with reviewing and analyzing borrower extension and restructuring proposals. We have worked with many borrower and lender clients. Understanding the issues facing both sides allows us to assist in finding common ground for both parties to proceed in loan negotiations. Whether you believe negotiations are in your future, or you need an attorney to protect your position, KRCL can assist.