PERSON OF THE WEEK: When an intricately structured commercial mortgage deal completed during the securitization era runs into trouble, arranging a modification palatable to all parties could be an impossible dream. Karl E. Geier, a transactional shareholder at the Walnut Creek, Calif., office of real estate law firm Miller Starr Regalia, explains why every tranche poses a new potential problem, and what lenders, borrowers and other stakeholders might learn from these experiences.
Q: The commercial mortgage industry has been awaiting a major wave of foreclosures for a while now. When do you think the highest foreclosure volumes will finally hit?
Karl E. Geier: You have to go back to the precipitous downturn in financial markets and the related drop in commercial real estate values to find a turning point.
Loans that were funded before that time will be hard to refinance in the current market due to the double whammy of lower appraised values and lenders requiring lower loan-to-value ratios, even if the specific property continues to cashflow. It will be hard to find new lenders willing to take out the previous financing, especially with securitized loans and conduit facilities.
If you assume that the affected loans were consummated sometime before the fall of 2007 and do the math, you will find many three-, five- and seven-year mini-perm loans maturing on commercial properties and going into foreclosure over the next 18 to 24 months, if not sooner.
Add to that the number of failed workouts in commercial construction loans, and you will see an accelerating trend in commercial foreclosures between now and mid-2011.
Q: What will be the major triggers for increases in foreclosures? How much will the path of the U.S. economy play a role?
Geier: The major factors will be softening rent structures in commercial and retail properties, insufficient equity to meet current lender requirements and the loss of major sources of financing in the securitized commercial loan market.
Because commercial property values and rents are usually a trailing indicator, improvement in the general U.S. economy and a turnaround in rents, values and availability of financing may be too late for many owners whose loans are maturing in the next year or so.
Most knowledgeable real estate professionals I have talked to think foreclosure trends are a train that will be very hard to slow down – much less turn around. There may be equity sitting on the sidelines that, theoretically, could be a source of additional liquidity. The question is whether this money will stay on the sidelines and then step in with equity to acquire property in distress, or whether some of it will become available to fund debt restructuring and refinancing. I think the former will be more common than the latter.
Q: How should borrowers and lenders approach loan modification when the deal includes complex components, such as mezzanine debt, securitization, etc.? Have any precedents been set for sorting through these layers and arranging an appropriate modification?
Geier: Some of these loans are extremely difficult to work through, for both the borrower and the lender group. It is surprising how often the agreements among the lenders are incomplete or nonexistent, especially with multiple tranches of debt and multiple holders of each piece.
Our experience, which is not a scientific sample, suggests that mezzanine lenders are usually so far underwater that they become non-factors in the workout, at least as far as the real estate security is concerned.
The more difficult issues are with syndicated credits where the lead lender cannot control its participants or co-lenders or, even worse, where one or more of the lenders has been taken over by the Federal Deposit Insurance Corp. Sometimes, you can't get a decision for months.
Even worse are conduit loans, where there is simply no one to talk to – just a collection agent with no authority beyond disbursing payments on account. Also, in past recessions, most real estate loans where held by a single lender, and the major conflicts were between the borrower and the lender.
Now, as of often as not, the participating lenders are looking for leverage to force the lead lender to buy them out or, at least, to set up a claim against the lead lender. Even when the parties are paying attention, cooperation among the lenders can be difficult to achieve.
Borrowers, unfortunately, are usually at the mercy of these arrangements. Other than patience and the power of persuasion, the only strategy that seems workable for fractionalized, multi-tier debt is a structured Chapter 11 workout with pre-arranged debtor-in-possession take-out financing to take out the securitized debt, but that can be hard to come by.
Going forward, I would expect borrowers and their attorneys to take a much stronger interest in the identity of their lenders and the manner in which the loan might be sold off or participated, and in making sure that some identifiable party that will still be in business when the loan matures is in control on the lender's side.
Many of us have been cautioning our clients (lenders and borrowers) about the risks of the complex multi-creditor and securitized arrangements for years, but I would expect clients to listen better now in light of recent experience.
Q: When are receiverships a sound choice for dealing with a distressed loan? What precautions should lenders keep in mind?
Geier: Traditionally, a receiver was put in place to capture cashflow and keep it available, as well as keep the property intact pending foreclosure. Although this is still the best use of a receiver, the current market has seen an increased use of receivers for active management of distressed projects, including the completion of construction and marketing of residential product.
The theory is that the receiver is the officer of the court, and therefore, the risks and liabilities associated with ownership and management of the property do not pass to the lender, but the lender gets the benefit of the receiver's actions and management. The theoretical basis for this strategy is sound, but there are a number of problems and pitfalls.
First, because the receiver is an officer of the court, everything has to be conducted through the court with appropriate court authorization. Lenders (or receivers) who forget this may run into serious problems with the court and may face liability to injured parties, including borrowers and third parties.
Second, we do not have a specific appellate court precedent upholding the presumptive liability shield afforded by a receivership when the lender induces the court to authorize actual construction and sales to consumers within the receivership; we may see this litigated in the next few years as construction defects become evident in these projects.
Third, the potential liability of the lender for costs and expenses incurred by the receiver is not entirely within the lender's control. The lender who institutes the receivership may be exposed to liability for expenses and cost overruns that were not foreseen. Even with these issues, we are seeing lenders opt for the receivership route rather than a meltdown foreclosure scenario, and there have been some good success stories thus far.
Q: Nonrecourse carve-outs are expected to continue to be featured in commercial real estate lending, but some have argued that these carve-outs may not be enforceable. What is your view? What specific provisions might these carve-outs include in the future?
Geier: The courts generally have not been a safe haven for sophisticated commercial borrowers who were represented by counsel and negotiated nonrecourse carve-out provisions, default interest clauses and a variety of other provisions that specify onerous financial consequences for the borrower group in the event of default.
Most of the cases that have actually considered bad-boy provisions that impose full recourse liability on the borrower and/or the guarantors for breach of certain clauses have found them enforceable, both in a bankruptcy and non-bankruptcy context.
The possibility exists, however, that excessively onerous clauses will be found unconscionable in particular circumstances, or that they are excessive penalties or restrictions on the borrower's statutory right to redeem or reinstate a loan in default.
In extreme circumstances, the borrower or guarantors might have defenses to enforcement, so I would expect additional litigation and reported appellate case law to develop in this area over the next few years. It is really the last resort for a borrower, however, and the best assumption is that they are enforceable.