Financing Focus

Lenders Tighten Loan Standards in Reaction to Uncertain Economy

With interest rates at record lows, demand for new mortgage loans remains strong. However, in today's anemic economic climate, lenders face increased risk of making non-performing loans. Although it is impossible to eliminate this risk entirely, commercial real estate lenders have implemented new safeguards and follow stricter policies to minimize their exposure.

All real estate lenders, including life insurance companies and conduits, use techniques that fall under two main categories: expanding the scope of the underwriting process and altering the loan structure. However, given that some of these safeguards involve recourse issues, banks and other lenders that seek recourse against their borrowers in addition to taking real estate collateral are more likely to employ these measures. To streamline the lending process, commercial real estate borrowers should be aware of these new policies and the situations in which they are required.

Expanding the Underwriting Process

More than ever, lenders scrutinize the type of real estate serving as collateral and the factors that bear on borrowers' ability to repay. Many lenders these days won't even consider certain disfavored property types. For example, hotel loans are more difficult to obtain, even those for properties that might have satisfied prior underwriting standards. Similarly, some lenders are limiting condominium development loans in cities that have experienced a recent glut of new condo development.

Lenders also shy away from real estate that is too highly specialized, even if it has sufficient market value to underwrite, because it might be difficult to resell in foreclosure. This is particularly true for speculative loans, or loans for projects in which a tenant has not yet been obtained, secured by special-use real estate. Examples of such properties include buildings designed specifically to accommodate a unique manufacturing process or otherwise customized so they cannot be readily adaptable for another use. Lenders even are hesitant to loan on such specialized projects when a credit-worthy tenant is in place because they recognize that today's good tenants might not be as strong in the future. Thus, the real estate's adaptability has taken on new importance.

Whether or not the real estate is unique, lenders are looking more closely at tenants' credit and businesses, especially if the collateral is a single-tenant building. Lenders routinely require tenants' financial statements, focusing on the businesses' susceptibility to further economic downturn.

Similarly, lenders also conduct more homework on their potential borrowers and greatly favor those with established track records in the industry. Many lenders no longer do business with borrowers on a transaction-by-transaction basis and instead prefer borrowers with whom they have developed solid relationships. As part of this increased due diligence, lenders conduct more extensive investigations of any guarantors, including verification of sufficient capital to meet the guaranty obligation in question.

In addition, lenders want to know how projects will perform in relation to loan repayment. In this regard, they investigate alternative scenarios — as well as the best case presented by the borrower — concentrating on exit strategies. Sometimes lenders require modifications to transaction structures that shift more risk to borrowers. For example, a construction lender may require a borrower's development fee deferral until construction is completed or certain other milestones are reached. Similarly, a lender may prohibit a project's profit distribution until the loan is repaid in full.

Altering the Loan

Lenders also build more-stringent requirements into their loan structures, particularly regarding upfront equity. Whereas lenders previously were satisfied with 20 percent or less equity, now they often require equity of 30 percent or more, depending upon a particular transaction's risk. Additionally, lenders may require accelerated principal pay downs as a means of increasing borrowers' equity percentage. Moreover, for properties that are developed and sold in more than one phase, lenders may charge higher release prices as partial sales take place.

Personal recourse and other security measures also receive more stringent scrutiny in the current market. More loans require individuals to provide personal guarantees, which can take the form of full, unlimited guarantees or be limited to a percentage of the loan amount.

In some instances, lenders eliminate the guaranty or reduce the amount guaranteed when certain preconditions are satisfied, such as meeting a prescribed debt coverage ratio. To ensure guaranties' continuing viability, lenders may impose net-worth covenants on guarantors. These covenants require guarantors to continuously maintain a certain net worth during the loan term, failing which the lender could immediately call the loan due. Similarly, lenders impose new reporting mandates on guarantors, requiring them to provide periodic financial statements, tax returns, and related information in order to monitor their financial condition.

Even for non-recourse loans, the limited areas that are carved out from the borrowers' protection are expanding. These non-recourse exclusions historically comprised bad acts, such as fraud and intentional mismanagement. However, lenders now often include acts that are more negligent in nature, as opposed to individual bad acts, with respect to the management and operation of the property. This greatly expands lenders' leverage if loans later become problematic.

The requirement that borrowers post additional collateral unrelated to the primary real estate collateral is another frequently used technique. For example, lenders might require a second mortgage on borrowers' unrelated property or even a lien on borrowers' non-real-estate assets. If a lender wants a particular individual to remain involved in the property's management, it will include that requirement in the loan agreement, as well as take a management contract collateral assignment. If they want a particular individual to remain as a principal of the borrower, lenders impose change-of-control restrictions in the loan agreement and require a pledge of the individual's ownership interest.

Commercial real estate lending practices are evolving to meet today's unique challenges, which stem not just from the economic slump, but also from the new ground rules required by an increasingly global economy. Events elsewhere impact the U.S. economy now more than ever before, and lenders must analyze risk and protect themselves in new ways that may deviate from traditional lending practices.

William J. Peltin and Lawrence B. Swibel

William J. Peltin and Lawrence B. Swibel are partners with Fox, Hefter, Swibel, Levin & Carroll, a Chicago-based law firm. Contact them at (312) 224-1225 or wpeltin@fhslc.com and (312) 224-1214 or lswibel@fhslc.com.

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