Publications
Alert

Negotiating with Commercial Lenders in Turbulent Economic Times

Real Estate Update

Real estate professionals are well aware of the dramatic decline in the origination of commercial real estate loans in these last few months of economic turbulence. Projections for 2009 consistently demonstrate a steep fall in loan volume from the peaks of just a few years ago. However, it is important for real estate professionals to be aware of an emerging trend in real estate lending—some lenders who are willing to fund new commercial loans are assuming an inflexible “take it or leave it” approach, forcing borrowers to assume legal and/or business risks that they previously would have strenuously resisted.

Lenders have never been known to tolerate lengthy negotiation of their loan documents. However, financially solid borrowers with good reputations could reasonably expect some healthy give and take in the negotiation of the loan documents. Particularly in the past few years when the CMBS market was hot and lenders were competing for deals, lenders were much more willing to accommodate borrowers of all reputations.

Now many lenders are simply saying “no.” Moreover, to address deficiencies that have been exposed by the CMBS implosion, lenders are revisiting their longstanding loan forms to further limit lender risk and exposure. Experienced and reputable borrowers who are accustomed to using pre-negotiated forms from prior deals are now finding that they are forced to negotiate a set of loan documents from scratch.

As a result of this shift, borrowers and their attorneys face difficult challenges. Facing impending maturity dates or defaults under existing loans, borrowers are so thrilled at the possibility of obtaining new financing, they are willing to accept onerous business terms that they would have never entertained in the past, such as low loan-to-value ratios, hard lockboxes, ongoing financial covenants, significant upfront reserves and expanded recourse liability.

Therefore, when it comes to negotiating the loan documents, borrowers expect their counsel to quickly pinpoint a few hot button issues, and to deemphasize language and other legal issues that counsel would have addressed in the past. However, the bright line between these two categories is not always clear. In the face of pressure from clients, lawyers for borrowers must strive to obtain a clear understanding of their clients’ business operations and risk tolerance, and should surgically tailor their comments to only the most meaningful provisions in the loan documents. Below is a primer of some critical issues on which counsel to borrowers should focus:

(1) Economic Terms: Attorneys should never be reluctant to confront lenders if the terms of the proffered loan documents are inconsistent with those in the term sheet.

(2) Financial Covenants: Lenders are, more than ever, seeking ongoing financial covenants (such as ongoing loan to value, debt service coverage and guarantor net worth covenants). Often, there are a lot of grey areas in the definitions of these financial terms which lenders try to exploit to their benefit; it is therefore well worth a lawyer's time to examine these definitions carefully. Attorneys should also consider requesting notice and cure periods as well as the right to cure any non-compliance with cash or other collateral.

(3) Default Remedies: Recognizing the greater likelihood of borrowers being in default, attorneys should review carefully late charges, default rate interest, remedies and prepayment penalties on defaults. They should always try to exclude late charges on the balloon payment due on the maturity date.

(4) Personal Liability: It is, of course, essential to make sure your client understands the scope and full impact of recourse liability. For example, as part of the typical recourse carve-out guaranty, more lenders are looking to guarantors to become responsible for foreclosure costs (including attorneys’ fees and transfer taxes). In addition, many lenders are now looking to principals or credit entities to guaranty repayment of all or a portion of the debt.

(5) Transfer Rights: Transfer rights are always crucial for a borrower as they affect a borrower’s business strategy. A borrower will likely need some measure of flexibility to admit minority partners, raise capital, exercise buy-sell rights or reorganize. As lenders’ underwriting criteria have become more regulated, lenders will want to reserve the right to scrutinize new equity participants. In addition, it is becoming increasingly harder to obtain special rights regarding releases, substitution of collateral or third-party assumption of debt.

(6) MAC Default: To protect against future economic downturns, in addition to strict financial covenants, many lenders are looking to add a “material adverse change in the condition of the borrower, guarantor or the property” to the enumerated list of loan defaults. This should be aggressively resisted, as it essentially gives the lender a call right if economic conditions worsen (including if a tenant defaults or files bankruptcy).

(7) Reserves: Another area where lenders are protecting themselves is by requiring significant up-front and ongoing reserves. Even if borrowers are willing to fund these reserves, borrowers need to make sure the proceeds held in these accounts will be made available when needed without major hurdles. In addition, in light of many lenders’ financial instability, it is prudent for a borrower to have the right to offset such reserve amounts against the debt if its lender files bankruptcy, is placed into receivership or refuses to fund. Similarly, if lenders will be making periodic advances of loan proceeds (e.g., construction loans or earn-out advances), borrowers may need to examine the lenders’ balance sheets to determine whether there is any risk that the lender will not be able to perform its obligations and provide for appropriate protections.

(8) Leasing/Operations:  Flexibility on leasing parameters is always a concern for borrowers. However, lenders are equally as concerned, especially if there is large rollover risk. Counsel should carefully review the leasing parameters with the client and determine whether any changes based on future leasing are necessary.

(9) Renewal Conditions: With many lenders providing short-term loans with renewal options, focus on the specific conditions for renewal is increasingly important, especially any conditions which are not within the control of the borrower. If a lender imposes a minimum creditworthiness standard on an interest cap provider as a condition of the renewal option, the borrower could simply lose the renewal option because the cap provider’s creditworthiness could not be satisfied, most likely due to market conditions.

In these turbulent times, it is incumbent for both borrowers and their counsel to recognize that life has changed. But adapting to the tougher lending climate does not mean that the borrower should rush into any lending transaction. There is still an important role to be played by counsel in identifying key provisions and assuring that the client gets the best deal possible.