Tighter Loan Structures
Banks and other financial institutions are facing challenging times as borrowers are unable to meet mortgage payments, or in the case of balloon loans reaching maturity are unable to refinance. In many cases, lenders will have no choice but to re-negotiate loan terms. In doing so, they are likely to insist on structural elements and remedies that were not considered necessary in the boom years just past. Some of these are described below.
Lender-Tenant Agreement
A lender may pay more attention to the legal relationship between it and
the tenants at the mortgaged property in the event of a foreclosure. The
lender, in order to preserve the income stream, may insist that tenants
enter into a non-disturbance agreement providing that if the lender
forecloses, the tenant will attorn and recognize the lender as the successor
landlord. Lenders also are likely to insist that tenants agree to pay rent
directly to the lender upon request and permit the lender to cure the
landlord’s defaults in order to prevent a breach of the lease.
Lockboxes and Rental
Income
A lender may seek to control a property’s rent income from the moment of
loan closing or loan extension, using provisions designed to survive the
borrower’s bankruptcy. The object is to prevent the borrower siphoning off
funds for weeks or months before the lender can enforce remedies in the loan
documents. In order to control rental income, a lender can establish a
lockbox or use a third-party trustee to collect rents whether or not the
borrower is in default. Rental income then would be used to pay property
expenses and debt service before any amounts were given to the borrower. The
borrower would be required to prepare requisitions similar to those used for
construction loans demonstrating that expenses were within budget.
In arranging this, however, a lender should recognize that a lockbox can create legal issues, the most serious one being whether it gives the lender so much control over the property that it is deemed the “mortgagee in possession.” In addition, lockboxes can be complex and time consuming.
Controlling Expenses
A lender is likely to pay more attention than before to the expense side
of the property. Particular attention is likely to be paid to real estate
taxes, major maintenance and refurbishment costs and leasing commissions
that are not routinely paid each month. A lender may require that tax and
insurance escrows be established, with money deposited each month before
income is distributed to the borrower. However, the lender should agree to
pay the same interest rate on escrows as the borrower pays on the mortgage
loan.
Of particular importance is the need to have assurance that reserves are created to cover the cost of major future repairs or replacements. Otherwise, when a loan is defaulted, the lender may find that the property requires extensive repairs to put the property back to its initial condition.
Guaranteed Loan
Lenders may require a guarantee of payment by a third party in the event
of the borrower’s default. A real estate lender normally requires a
guarantee to be absolute and unconditional. That is, the guarantee cannot be
subject to any right of offset by the guarantor and not affected by any
failure of the lender to give notice of default within a specified time.
However, the guarantee may cover less than all of the borrower’s
obligations. Since guarantors are “favored by the law,” the guarantee must
be explicit as to its coverage.
Secondary Financing
The first mortgage instrument normally bars the borrower from obtaining
additional financing without the lender’s consent. Such consent should only
be given after careful consideration because the existence of secondary
financing may mean that the primary lender cannot negotiate a workout or
enforce interim remedies or control the bankruptcy without the second
lender’s cooperation. In many cases, the first mortgage lender is not likely
to agree to any secondary financing.
Real Estate Focus is provided by Somerset’s Real Estate Team for our clients and other interested persons upon request. Since technical information is presented in generalized fashion, no final conclusion on these topics should be made without further review. For additional information on the issues discussed, please contact Michael Fritton, CPA. Whether you are a building owner, building manager, real estate developer, real estate professional or an investor, we hope to provide you with timely information so you may be proactive in making your business decisions.
This article was written by and published herein with the permission from professionals of BDO Seidman, LLP. Somerset is a member of the BDO Seidman Alliance, a nationwide association of independently owned accounting and consulting firms.
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P.C.
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Indianapolis, Indiana 46240
317.472.2200 • 800.469.7206 • FAX 317.208.1200
www.somersetcpas.com
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