The revenue streams being generated are no longer sufficient to cover fixed costs and other operating expenses, let alone debt service. And as more and more jobs are lost, these issues are expected to hit the multifamily, office, industrial and residential sectors as well.
Borrowers are seeking direction. Loans have the potential to be in default at an exponential rate. It is important to understand what the parties rights are and what remedies can be pursued in both the short term and the long term.
What should borrowers be thinking about? While every situation is unique, and every set of loan documents is different, some of the immediate things for borrowers to be thinking about in the coming days and weeks ahead are:
What if continuing operations no longer seems viable? In addition to understanding all federal and state law requirements for shutting down (i.e. WARN Act implications, moratoriums on eviction, etc.), borrowers need to determine whether or not shutting down operations requires the consent of their lenders, or in the case of a hotel, the franchisor, and in situations where consent is required, what are the ramifications of ceasing operations, including the possibility of creating recourse exposure for the sponsorship under the loan documents.
Borrowers are being approached by their tenants for relief under their leases. Borrowers should be looking at the loan documents to determine what restrictions they contain with respect to waivers and/or modifications and amendments to leases as well as other material agreements. In instances where lender consent is required, it is important to ascertain if the documents contain “deemed approval” provisions (i.e., if the request is deemed approved because the lender did not respond within a prescribed time). It also is important to determine if modifications or amendments to leases or other material agreements entered into without the consent of the lender trigger recourse exposure to the sponsorship under the loan documents.
Payment of Expenses.
In those instances where shutting down operations may not be the prudent course of action, borrowers must wrestle with the question of what expenses can and/or should be paid, and in what order. What should take priority over debt service? Taxes and insurance because failure to pay these expenses are normally recourse events? Might there be tax relief on the horizon? What about management fees? Oftentimes, management fees, particularly affiliated management fees, are subordinate to debt service. But if managers are not getting paid, it is likely that their employees are not getting paid and, in such case there will be no one available to physically operate the real estate. Should a borrower bypass debt service to keep the manager current so that critical operations are not suspended? If so, does paying management fees ahead of debt service without lender consent trigger a default on the loan or recourse exposure to the sponsorship? Most lenders recognize that someone has to be paid to operate the property and would be very likely to grant consent to the payment of management fees even to an affiliated manager, but, with respect to an affiliated manager, the lender may require that the affiliated manager agree to a reduced fee.
Note, in those loan documents where rents and other income from the property are directed into a lender controlled account, the priority of payments has been established (often called a “waterfall”) and cannot be changed without lender consent. The typical waterfall provides for all amounts held in the account to be applied on each monthly payment date in the following order of priority: first, to a tax reserve account in an amount required pursuant to the loan documents; second, to an insurance reserve account in an amount required pursuant to the loan documents; third, to the lender to pay debt service due on such monthly payment date; fourth, to other reserve accounts (e.g., immediate repair reserve account, capital expenditure reserve account, and leasing expenses reserve account), each in an amount required pursuant to the loan documents; fifth, to the lender to pay any other amounts then due the lender under the loan documents; sixth, to the borrower to pay the monthly operating expenses for the calendar month in which such payment day occurs pursuant to the lender approved budget (which operating expenses usually include the approved management fee); and seventh, to the borrower, all remaining amounts (unless a cash management event has occurred and is continuing (e.g., the failure of the property to meet certain financial covenants), and, in such case, all such amounts will instead be held by the lender as cash collateral for the loan). In those cases, where such an arrangement or similar arrangement is in place, the borrower will need to determine whether the anticipated revenue from the property will be sufficient to cover in full those items that are required to be paid or reserved prior to the payment of operating expenses as well as the operating expenses, and, if, a shortfall is expected, the borrower will need to prepare updated projections to support a change to the waterfall – – the most likely scenario being the borrower asking for relief on the priority of items like reserves or that debt service be subordinated to those operating expenses critical to the operation of the property.
Waste or Abandonment.
Borrowers should also consider whether or not shutting down operations, or the inability to operate the property, or to keep all fixed and operating expenses current could be construed to constitute waste or abandonment, and if so, whether or not these items trigger recourse exposure to the sponsorship under the loan documents.
If it is determined that there is going to be an operating shortfall at the property, borrowers need to look at all avenues available from which to cover the shortfall. The most obvious place is the borrower’s cash accounts, which can be bank accounts or funded reserves. Has the borrower been reserving excess cash from the lender? If so, do the documents permit use of that cash for operating shortfalls? Are there other reserves which are overfunded or not likely to be needed for the foreseeable future (i.e. capital improvements reserves or tenant improvement reserves)? Borrowers with excess cash reserves or overfunded or unnecessary reserves may want to consider approaching their lenders for relief and access to these funds to fund the operating shortfalls at the property.
Another source of funding for potential shortfalls might be committed loan advances. Many commercial loans include holdbacks of the loan and commitments on the part of the lender to fund additional draws. Borrowers should be looking carefully to see whether the lender has the contractual right under the loan documents to deny future draw requests or to impose additional conditions on future funding
Available Advances under Other Credit Facilities.
Borrowers should consider whether or not this is the time to request available advances under corporate and personal lines of credit to create a war chest of available cash for future needs. Borrowers also will want to consider government backed funding that may become available (e.g., SBA loans). While borrowing under such facilities will typically be restricted under existing loan documents, a senior lender may consent to such financing depending on payment terms and the extent and nature of any collateral required.
Increase in Loan Facility.
If a borrower’s ability to meet its payment obligations and financial covenants is declining, it may want to consider requesting an increase in its loan facility. In evaluating such a request, a lender may consider, among other things, what is behind the request (i.e. is the request solely the product of the virus or are there other challenges that the property is facing), can the borrower support the additional debt (and if not, whether additional collateral is available), and is the sponsor willing to expose itself to risk in connection with an increase (i.e., take on recourse pursuant to a limited payment guaranty).
Borrowers should take stock of any financial covenants contained in the loan documents and understand the consequences of not meeting them. For example, where failure to meet a debt service coverage test will trigger cash management, a borrower might want to proactively approach the lender to ascertain whether or not the lender would be willing to permit trapped cash to be used to pay for future operating shortfalls and/or debt service. Borrowers may also want to request that their lenders defer the imposition of cash management. Given the nature and extent of the crisis, lenders may be receptive to such requests from good borrowers where the failure to meet the financial covenant is solely the result of the impact of the COVID-19 crisis and where borrowers are willing to agree not to make equity distributions until the covenant is again met.
Net Worth Covenants.
Net worth covenants may be meaningfully affected by the recent steep declines in the financial markets. Guarantors should review minimum net worth covenant requirements in their guarantees and continually update their financial statements.
Borrowers may not be able to accurately assess the effects of COVID-19 on their business and such inability may result in borrowers not meeting their financial reporting obligations under their loan documents. In most loan documents, failure to deliver financial reporting within the time periods prescribed under the loan documents is a default. To avoid a default, borrowers may want to consider timely delivering their reporting but adding a disclaimer to the effect that the virus could have an adverse impact on their business and financial results.
Force Majeure Clauses.
Borrowers should look to see if there are any force majeure clauses in any of the relevant agreements that might be triggered and evaluate the impact of those triggers.
Extensions of Deadlines.
Where the loan documents impose a completion deadline on a borrower with respect to construction projects, capital improvement projects, or required repairs, the borrower may want to consider asking its lender for an extension regardless of whether the loan documents include a force majeure provision.
In the event that a lender calls an event of default, such call may trigger cross-default provisions in other agreements. It would be prudent for a borrower to review its other contracts to see where this might be the case and determine what the consequences of the cross-default might be.
The “Catch-all” Material Adverse Change Clause.
Even where a borrower is not in default of a specific obligation under its loan documents, material adverse change clauses or “MAC” clauses in loan documents permit a lender to decline to make loan advances, disburse reserve funds and declare an event of default and accelerate the loan. While it is uncommon for lenders to use these clauses given the uncertainty that exists as to what constitutes a “material” change and the potential consequences a lender could face if it is unable to prove that there is in fact such a condition, in times where some lenders may be looking to get undesirable loans off their books and economic conditions are precarious, some lenders may be more willing to rely on such clauses where a borrower’s financial condition is declining, regardless of the cause of such decline. Borrowers should be reviewing their loan documents to see it they contain MAC clauses and whether they impose an obligation on them to provide notice to their lenders that a MAC event exists.
Loan Documents contain notice requirements and other formalities that must be observed on the part of the parties. Borrowers should review the loan documents to understand their obligations and to know where their rights are in the event that they are unable to convince a lender not to enforce its contractual rights.
The focus of most borrowers continues to be the immediate day-to-day challenges that they are facing as the impacts of the coronavirus continue to deepen. In situations where a default may not be imminent, but the borrower is at risk for a default in the coming weeks or months, when is the best time for a borrower to approach its lender? Are you likely to get a better result if you are proactive, transparent and cooperative? Or are you better off, given the volume of actual and potential defaults that the lender is likely to be experiencing or anticipating, to wait until the default is imminent and/or until various government interventions have stopped moving so that you are negotiating from an informed position? In order to grant any waivers or amendments, it is likely that a lender is going to require updated financial projections to support the borrower’s ability to ultimately service and repay the loan. Borrowers should be assessing and reassessing their assets and updating their projections and the effects of the virus on their business as they become known.
While the foregoing list is by no means all inclusive, it highlights some of the immediate issues commercial real estate borrowers are facing, the need for them to be examining their loan documents and to be assessing and reassessing their ability to comply with their obligations and to get out in front of any issues in an effort to minimize the potential impacts of the current national emergency on their assets and loans.
Please note, on April 5, 2020, the Pennsylvania Secretary of Health issued an Order mandating enhanced cleaning and disinfecting requirements for owners of large buildings. The Cleaning Order applies to owners of buildings of at least 50,000 square feet used for commercial, industrial or other enterprises, including but not limited to facilities for warehouses, manufacturing, commercial offices, airports, grocery stores, universities, colleges, government, hotels, and residential buildings with at least 50 units.
The Coronavirus Task Force at Klehr Harrison stands ready to assist you in your business and legal needs. We will continue to provide additional information and guidance as the COVID-19 situation develops.
Co-author Denise Day is co-chair of the Real Estate & Finance Department at Klehr Harrison. Co-author Heather Levine is a partner in the Real Estate & Finance Department at Klehr Harrison.