As swings in values play havoc with coverage ratios and commercial maturities pile up, whole lenders are looking for ways to navigate the current commercial environment that extend beyond their two current options: foreclosing or extending loans, while hoping credit markets repair themselves sometime soon.
For the past year, commercial real estate has been caught in a negative feedback loop of inaction. Values are difficult to establish because there aren’t any sales to provide data comps. Buyers can’t get financing. Buyers with cash are demanding high returns, and are awaiting distressed asset fire-sales. Lenders, however, are wary of taking back cash-flowing properties. They fear a wave of distressed sales would create a set of data points that would decimate the loans on their books. So they continue to kick cans down the street.
“They’re doing extend and pretend, delay and pray,” said David Bright, a partner in Brown Rudnick’s real estate practice. “Most banks are doing it because they’re not being forced by regulators to mark values down. On the balance, they think their best course is to delay and wait it out.”
There’s a problem with that equation. By extending loans, ignoring loan-to-value ratios, and avoiding marking down values, lenders are shouldering markedly increased risk. The risk is that the recipients of an extension will wind up defaulting when the commercial market is at an even lower level than it is now. The benefits of that risk flow to the borrowers, who get to get to keep their keys and any cash their properties throw off.
Pay To Play
Lenders have taken to requiring cash infusions in exchange for loan extensions. That’s not always an easy proposition, given how quickly declining values and rising cap rates can erode borrowers’ capital positions. So Brown Rudnick attorneys are huddling with their lender clients, devising new programs that will let banks avoid taking the keys to stable commercial properties – and bring their returns in line with their risk. These programs are still being formulated, and have not been taken to borrowers yet.
“The discussions we’re having with clients are about getting programs in place to give lenders more tools in their toolkits,” said Edward Hershfield, a partner in Brown Rudnick’s real estate practice. “They want to be able to say to borrowers, ‘There’s a whole range of things we can do.’ It’s not just extend or foreclose. They want to give themselves more alternatives.” He added, “Banks are being asked to take all the downside, with no prospect of upside. That’s not what they bargained for when they made the loan.”
Notably, Hershfield said, many lenders are looking at ways to take slices of any appreciation in income or value.
“The bank will continue to carry it, but wants to be compensated,” he said. “They want to be paid off, and if they’re the reason that somebody is able to move on, they want to be compensated for that.”
In this scenario, both income streams and final transactions are in play.
“There’s no way to get the money to finance it out now, and as long as you’re getting cash flow, it’s worth it to stick around,” Hershfield explained. “If there’s a transactional event – a refinancing or sale – the bank is saying, ‘I want a piece of the appreciation above the current value.’”
Bright and Hershfield noted that candidates for this type of income play are stable, cash-flowing properties. Lenders are looking less at occupancy levels than at income predictability.
“If you’re at 70 percent occupancy and you get another tenant, the bank gets a piece,” Hershfield added. “Lenders are not acting like an ostrich sticking its head in the sand. They understand what they’re doing. It’s just a better course of action. For the lender, the downside risk is that the economy could be in a far worse place. They’re willing to take that risk, but not for a 5 percent coupon rate.”
