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Blood, Sweat and Tears may or may not have had Isaac Newton’s law of universal gravitation in mind when they penned the lyrics to their hit song “Spinning Wheel,”—“What goes up must come down, spinning wheel got to go ‘round,”—but they did put their fingers on the inevitably cyclical nature of real estate markets. For some time it has seemed to us that a downturn in real estate markets was just around the corner, but the wheel continued to spin despite the apparent fragility of the markets. It now seems clear that dislocation caused by COVID-19 has brought the good times to a close and a recession seems unavoidable, though the questions of “How deep?” and “How long?” are open ones.
The current situation and the dislocation it has caused present issues of immediate concern, as well issues of more general concern revolving around how market participants should prepare for the downturn by revisiting lessons learned from past real estate downturns. In this article, we address matters of concern to borrowers.
One of the most important lessons we have learned from past downturns is that first movers—those who act quickly and decisively when the market turns—gain a real advantage over those who respond more slowly. The best executions seemed to come early in the downturns, and those who were reactive—whether because they were in denial or otherwise—paid a real price. So, we think that both lenders and borrowers will be well served by giving thought now to how to prepare for the inevitable. In order to best prepare, we suggest that borrowers systematically address their entire portfolio, using a framework of investigation, followed by triage and strategic analysis, and then recovery.
Below are a few thoughts for borrowers, which we hope are helpful.
Investigate
To address the downturn in an intelligent manner, you must first be clear-eyed about your portfolio and the opportunities and challenges it presents. We can guarantee you that your lender will be undertaking the same exercise!
- Force Majeure. It seems like every day we are asked to consider the impact of the current pandemic on contractual obligations. For borrowers, particularly those with construction financings, and operating and financial partners in development joint ventures, consideration should be given whether to assert force majeure to excuse or postpone performance obligations. Prohibitions on construction activities, the inability or unwillingness of governmental authorities to hold meetings or conduct ordinary business (e.g., issue certificates of occupancy) and other fallout of the coronavirus pandemic all are potential events of force majeure. For instance, even as to construction projects which are exempt from governmental orders to stop work, is loss of productivity caused by social distancing requirements a force majeure event? In addition, many contractual force majeure provisions require timely assertion of a claim of excused delay in accordance with the specific provisions of the contract. We suggest that borrowers and development joint venture partners immediately review force majeure provisions in their contracts (including both loan agreements and other agreements such as leases and joint venture agreements) and assert their rights thereunder if it is appropriate for them to do so. Also, be prepared to deal with force majeure claims asserted by others to excuse their nonperformance for your benefit (e.g., contractors, tenants, etc.).
- Take Another Look at Your Loans. Hopefully you have a reasonably good idea of the value of your properties and have kept your loan-to-value ratios sensible. But even if you haven’t, figure out where you stand today. If, as we do, you view the market as just coming off the top of the cycle, as we do, consider the debt service your properties will be able to service in the coming stress test. Identify any remargining provisions that might be lurking in your loan documents. Revisit your schedule of maturities to be sure you’re not stuck trying to refinance half your portfolio in the middle of a recession, when asset values are depressed and lenders will have temporarily lost their appetite for lending. Addressing any issues early, before lenders duck and cover, makes it more likely that you can address any problems that arise.
- Look at Your Access to Capital. In a recession, equity is lost because of illiquidity. Consider starting to reserve cash now for a rainy day fund and signing up for a line of credit if that option is available to you.
- Consider Your Recourse Exposure on an Asset-by-Asset Basis. A borrower cannot make sound decisions with respect to an asset without first having a clear-eyed understanding of her recourse exposure. Which assets are fully recourse to a credit-worthy party (particularly an individual)? Which assets have limited or no recourse?
- Watch Out for Creeping Carveouts. This is a corollary to what was discussed above, but it bears emphasis. When determining recourse liability, don’t stop with the guaranty and assume you know what is covered by that instrument. With nonrecourse loans, pay particular attention to carveouts from the nonrecourse provisions in your loan documents and guaranties. These carveouts are supposed to except from the nonrecourse agreement matters that would make the nonrecourse agreement look stupid—e.g., unpaid property taxes, environmental issues, misdirected rents, unpaid insurance premiums—because they detract from the value of the underwritten collateral. But lenders and their lawyers are constantly trying to expand the carveouts by slipping in carveouts for indemnities and other matters that have no relevance to the collateral and can effectively make the loan fully recourse. In a recession, the liabilities resulting from one or two bad loans might threaten your entire empire.
- Consider Conditions to Future Funding. Make sure you’ve considered and done what you can to satisfy any funding conditions applicable to undisbursed loan proceeds. Don’t assume that waivers that your lender has granted in the past will be available in the future. Ask yourself whether you will be able to get access to undisbursed loan proceeds, as a matter of right, which are needed to accomplish your business plan for any asset. This is a key point of leverage for you in workout negotiations with your lender.
- Identify Assets That Are Cross-Collateralized and/or Cross-Defaulted. While this is relatively rare, it can be tempting to agree to cross-collateralization and/or cross-default provisions in order to lower the interest rate or maximize proceeds—after all, when everything’s great, what could go wrong? Real estate investors who survive recessions are those with good firewalls—yes, they lose a few properties, but they’ve taken precautions to save the ship. Identify cases where you’ve succumbed to temptation. Resolve not to do it again.
- Look for Documentation Issues From the Lender’s Perspective. It is always useful to try to understand how a lender (or its lawyer) might feel about its documentation. Are there missing signatures? Is the promissory note correctly described in the deed of trust? Do any guarantees contain typical suretyship waivers, etc.? It is always useful to try to understand how the lender might view its own position from the perspective of future negotiations and leverage. Now might be a good time to consult with a lawyer who has experience representing both borrowers and lenders in distressed asset situations. However, we don’t recommend that you go all Rambo out of the gate. One usually gets only one chance to have a negotiated resolution, and in our experience adopting a hardcore legal strategy as your starting point is not the best way to get there.
Triage Your Loans and Think Strategically
Now that you have a better understanding of your position and your assets, it would behoove you to begin a process of triage and strategic thinking in order to clarify your priorities and develop a plan. Don’t be an ostrich with your head buried in the sand, hoping the lender won’t notice or call. They will.
- Triage Your Assets. Organize assets by recourse exposure to borrower principals. Group assets that contain cross-collateralization and cross-default provisions and, therefore, must be dealt with as a package. Look critically at each asset or package. Would you invest new capital to preserve them, or would you let them go in a worst-case scenario? While it is incredibly difficult to sacrifice projects you’ve worked so hard on, you should focus your attention and capital first on the assets you most want to save.
- Come Up With a Plan to Deal With Tenant Stress. Consider coming up with plan to address tenant stress, particularly with respect to mom and pop shops and other small and medium-sized tenants. Consider rent deferral and/or forgiveness, particularly in concert with other transaction participants, including franchisors, as a mechanism to insure that your property is in a position to thrive when the country is back in business.
- Consider the Benefits of Proactive Communication. Once you have a handle on your assets, consider the benefits of proactive communication with your lenders. Let them know you are conducting business, addressing issues as they arise and that you have a plan.
- Be Prepared and Proactive. In previous recessions, borrowers were rewarded for being prepared and proactive when their properties wouldn’t fully pay debt service or justify refinancing of their loans. If you see tenants failing, rents dropping, values sliding or other early indications of trouble ahead, start coming up with a plan, so that when it’s time to bring the lender up to speed, you can give them not only a problem but also some decent solutions. Lenders, and particularly special servicers of securitized loans, are quickly swamped in a recession, often unable to muster experienced personnel to evaluate their many new problems, let alone come up with creative solutions. Resist the temptation to go to war at the outset. If you show good faith and present the best approach to a bad situation, you’re more likely to get the lender’s attention and forbearance than will the borrower who waits for the lender’s call when the monthly debt service payment fails to show up. Indeed, federal and state financial institution regulators are encouraging lenders to work prudently with borrowers affected by the coronavirus pandemic and seeking extensions, fee waivers, payment deferrals and other accommodations.
Recover and Take Stock
As you successfully implement your workout strategy, give thought to how to administer your assets, knowing that even if this is your first downturn, it likely won’t be your last.
- Renew Your Attention to Diversification of Your Tenants and Their Businesses. Is your tenant base today as diversified as you had originally planned? Or will a recession in a few sectors of the economy—restaurants, airlines, hotels, energy—have a disproportionately unfortunate effect on your properties?
- Be Conservative in Making Capital Improvements. If the economy suffers more than a momentary decline, will you be happy about the couple of million dollars you put into making the property look better? Maybe yes, if it helps you outcompete other properties for the fewer remaining potential tenants. But maybe not, if all it did was give you an argument for higher rents when the rental market has tanked and no tenant can afford to pay them.
While things may look bleak now, we hope and believe that a little work and planning will lessen the impact on you and your business.