Financing Focus

Making It Work

When lenders' requirements tighten, borrowers should consider these options.

I nvestors soon may feel the effects of a cooling real estate market through subtle and not-so-subtle shifts in the way lenders view commercial real estate loans. The industry experienced strong surface growth last year: National overall vacancy rates fell to 14.7 percent at the end of the year and rents experienced the highest percentage increase in five years, according to But just under the surface lenders have reason for concern. Capitalization rates have continued to drop three years in a row. Slower yearly appreciation, higher interest rates, overbuilding, plant closures, layoffs, and unforeseen economic constraints all cause lenders anxiety and affect their willingness to fund commercial real estate projects.

In the 1980s and early 1990s many lenders were forced to foreclose on projects that faltered and remained unoccupied for years. In many cases they were stuck trying to unload properties that nobody wanted. But don't expect the same situation now. As the market cools, credit will tighten and even seemingly solid projects could be scrutinized excessively. When loans are offered, lenders increasingly will insert provisions that protect them but may put the borrower at a disadvantage.

Troubled Loan Solutions
Even well-planned real estate investments can fall on hard times when the market slows down. For instance, a developer may have three phases for a project, building one at a time and selling properties in one as it is building the next. As the project progresses the economy slows and it makes no sense to build the next phase as quickly as planned. Costs of construction, labor strife, and material shortages also cause borrowers to run into trouble. However, there are strategies for commercial real estate owners and developers who encounter problems meeting their loan obligations. One approach that will increase as market conditions continue to slow is loan workouts.

Timing is everything with the loan workout process. Commercial real estate professionals should approach their lenders with a workout proposal well in advance of becoming hopelessly behind on their payments. Delaying contact with the lender until the loan is irreparably damaged implies borrowers did not adequately anticipate the short-term financial problems facing their properties.

It's important to consider that lenders sometimes are swayed by factors other than financial data: The borrower's honesty, integrity, and competency play key roles in lenders' decision-making process. Reworking a troubled loan is to lenders' and borrowers' advantage. Most lenders are willing to take the necessary steps to avoid placing loans in non-performing loan portfolios. Many times they only show reluctance to workout proposals if the loan problems have reached the crisis stage or if they have lost faith in the borrower or the property.

Preparing for a Workout
A successful loan workout begins with careful pre-negotiation preparation. Borrowers need to prove that they have thoroughly analyzed the financial status of the loan by identifying problems and developing solutions and presenting the information in reliable, professionally produced documents. These documents should include short-term (three months to six months) cash flow projections, financial trends, and a workable business plan under new loan terms that would enable the commercial property to meet its financial obligations. Implementation plans for new management methods or marketing efforts designed to increase operational efficiency, tenant occupation, and revenue also should be included in the proposal.

Borrowers should ask their accountants to prepare reports based on the property's last fiscal year and include performance projections under various workout scenarios. Once the lender is aware of the workout request, presentation material should be ready for the lender's review within 30 days.

Lender Liability
Sometimes a loan underperforms because the lender breached its promises during the life of the loan or compromised the borrower's ability to pay back the loan in a timely manner.

Lenders have a legal obligation to act reasonably and in good faith and live up to the promises made to their borrowers. Before workout negotiations start, borrowers should have an attorney experienced in lender liability review the current lending relationship. Legal counsel can determine whether any bank actions contributed to the borrower's financial troubles. In some instances, the lender may be liable for some or all of the misconduct. Signs of lender liability include:

  • requiring increased accounts receivables or collateral without sufficient justification;
  • refusing to advance the full amount available under a loan;
  • suddenly requesting the borower sign a waiver for past misconduct by the bank;
  • reducing credit lines or changing loan terms without warning; and
  • demanding performance that is not required in the loan documents.

Negotiating Points
In loan workouts almost everything is negotiable: Length of term, interest rates, payment schedules, and technical loan covenants are up for discussion. In addition, every loan workout is different. If significant changes are required, borrowers may need an entirely new set of loan documents. If the changes are minor, amendments to existing loan agreements may be sufficient. Be prepared to pay renewal or rollover fees to the bank for changes in the loan terms.

Some lenders require the borrower to pay the attorney's fees incurred by the lender in the workout process. They also usually insist on releases in new loan documents. These clauses prevent the borrower from taking legal action against them for any past misconduct.

Put It in Writing
All loan promises made during the workout must be documented in writing and reviewed by an attorney before the borrower signs. Verbal agreements are not the same and could be costly in the end. For example, in a case between a California resort and its lender, a jury awarded the resort more than $7.5 million after finding that the lender unlawfully tried to foreclose on the resort's recreational property. The lender made verbal promises to provide the resort with joint-venture capital for expansion that included a hotel and golf course. The resort won the case, in part, because its owner had documented all of the verbal agreements in correspondence with the lender.

Since the success of real estate investments often hinges on the quality of its financing, establishing a strong working relationship with a lender is invaluable as the market pulls back. If financing problems begin to occur, commercial property owners and developers should swiftly contact their lenders and discuss their options for saving the loan.

A. Barry Cappello, JD

A. Barry Cappello, JD, is managing partner of the law firm Cappello & McCann in Santa Barbara, California. His practice emphasis is lender liability and complex business litigation. You can reach him at (805) 564-2444.


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