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Resizing Provisions in Commercial Real Estate Loan Agreements

By Douglas S. Buck

Douglas S. Buck is a partner with Foley & Lardner LLP in Madison,WI, where he heads the firm’s office Real Estate Department. He has broad experience in real estate transactions involving lending, leasing, sales, acquisitions, development, zoning and taxation.

JUNE 2012

A s the financial crisis of 2007 and 2008 fades from memory, local, regional, and national banks are

increasingly making new commercial real estate loans. However, as these banks return to real estate lending, the institutions have begun to include new terms and provisions in their loan documents. In some cases, these new terms and provisions reflect recent les- sons learned by these banks in managing their delinquent and defaulted real estate loans. One of the more significant new provi- sions found in some commercial real estate loan documents grants the lender the right to “resize” a borrower’s loan at any time before its maturity. These so-called resizing provi- sions provide that the lender may reduce the amount of a borrower’s loan, or resize it, based on a new appraisal of the borrower’s property. Most often,lenders base these resizing provisions on a property’s underwritten loan-to-value ratio or LTV. Therefore, before discussing resizing provisions, a brief review of loan-to-value ratios is in order.

LOAN-TO-VALUE

RATIOS

Lenders use loan-to-value ratios as one measure of the risk associated with a loan. Simply stated, the loan-to-value ratio equals the amount of the lender’s loan divided by the value of the lender’s collateral (the prop- erty). For example, if the lender’s loan equals $7,500,000 and the borrower posts collateral worth $10,000,000 as security for the loan, the lender’s loan-to value ratio is 75 percent.

When borrowers default on their com- mercial real estate loans, their lenders must often sell these properties under less than ideal circumstances. Consequently, after borrowers default and banks liquidate their properties, the banks tend to receive less than fair market value for their collat- eral. Banks also incur significant legal and administrative costs and expenses managing and selling their real estate assets after a bor- rower’s default. Banks manage this risk and account for these losses by building into their loans a cushion between the amount of the debt and the value of their collateral. The loan-to-value ratio is a measure of this cushion. At the time of a loan’s origination, a bank will require the borrower’s loan to satisfy the bank’s applicable loan-to-value underwriting criteria. As almost anyone in the real estate industry can attest to, the loan-to-value ratios required by banks have been dropping significantly in recent years. In other words, banks are requiring more collateral for the same loan amount. Theoretically, once a loan closes and a bor- rower begins to make principal payments, the property’s loan-to-value should decrease over time. In addition, as time passes, asset values should (generally speaking) increase, further reducing a borrower’s loan-to value ratio. However, as lenders have recently learned, these assumptions are not often enough to protect them from significant losses. Resizing provisions are intended to allow lenders to manage a loan’s risk, even after the loan’s clos- ing, by testing a property’s loan-to-value ratio

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Resizing Provisions in Commercial Real Estate Loan Agreements

not only at the time of the loan’s origination, but also dur- ing the term of the loan.

HOW RESIZING PROVISIONS WORK

The typical resizing provision which some banks are now inserting in their commercial real estate loan documents allows the lender to reappraise a property if the bank deter- mines that the collateral for the loan has been “financially impaired.”This could mean a financial loss at a property or even a general market decline, wholly unrelated to an indi- vidual asset. If the bank’s new appraisal determines that the property’s fair market value has declined significantly, the borrower must then prepay the loan in an amount neces- sary to bring the loan back into balance with its originally underwritten loan-to-value ratio. Furthermore, the typical

resizing provision provides that the loan will go into default

if the borrower does not timely pay down its loan to the

required loan-to-value ratio. Consider the following example of a loan resizing pro- vision. Assume a borrower purchases an office building at a then fair market value of $10,000,000. As part of

this acquisition, a local bank provides the borrower with

a 10 year, $7,500,000 term loan based on a 75 percent

loan-to-value ratio. However, as part of the loan’s docu- mentation, the lender includes a resizing provision that allows it to re-appraise the property at any time dur- ing the term of the loan. Furthermore, this provision requires that the borrower make an additional, previously unscheduled, principal payment if the property’s loan-to- value ratio is less than 75 percent at any time during the term of the loan. Next, assume that in the third year of the loan the out- standing loan balance has decreased to $7,250,000 (as a result of the borrower’s regularly scheduled principal pay- ments), but the office building loses one of its key tenants. Due to the departure of this key tenant, the lender now triggers its resizing provision and re-appraises the office building. According to the bank’s new appraisal, the build- ing’s fair market value, without the key tenant, has declined to $8,000,000. With an outstanding loan of $7,250,000 and current fair market value of $8,000,000, the property’s loan-to-value ratio is now 90 percent. Because the bank’s resizing provision requires the borrower to maintain a loan-to-value ratio of at least 75 percent, the borrower must now reduce the loan amount to $6,000,000 or face default. In this case, the resizing provision requires the

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borrower to make a previously unscheduled $1,250,000 loan payment. Resizing provisions are not entirely new to real estate loan documents. Many existing commercial real estate loans contain financial covenants which borrowers must main- tain, such as debt-service-coverage ratios and loan-to-value ratios. However, a borrower’s failure to meet these financial covenants generally cannot be used by the lender as the basis for requiring a reduction in a loan’s outstanding bal- ance. Typically, if a borrower fails to maintain a required debt-service-coverage ratio or loan-to-value ratio, the loan documents provide for various penalties. For instance, the documents might require that all cash from the property’s operations be escrowed with lender until the loan is once again “in balance.” To say that resizing provisions are unenforceable would be incorrect. Lenders regularly use resizing provisions in the context of properties with unstable cash flow, such as redevelopment projects, and in the context of corpo- rate credit facilities. For instance, in 2001, in Wonderland Shopping Center v. CDC Mortgage, 1 a court enforced a lender’s loan documents which allowed it to require the borrower to make a significant principal reduction when the property failed to make its required debt-service- coverage ratios.

BORROWER’S PERSPECTIVE

The problem with the resizing provisions from a borrow- er’s perspective is that they require the borrower to come up with capital at a time when the borrower is probably least able to do so. For instance, in the example above regarding the office building that loses a key tenant, the borrower likely needs its existing capital to continue to fund principal and interest payments. Furthermore, the borrower would likely want to use some of its available capital to make any tenant improvements needed to lure new lessees into the building. While some lenders do allow borrowers to post additional collateral to meet the required loan-to-value ratio, this too can be problematic for borrowers. The bottom line is that resizing provisions place borrow- ers in the difficult position of needing capital at the same time the value of their assets have declined. Consequently, some borrowers will not agree to resizing provisions. Such borrowers see a loan’s original loan-to-value ratio as part of the risk that the lender must assume. Under this view, the loan’s interest rate not only reflects its initial loan-to-value, but also accounts for future drops in the collateral’s value

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Resizing Provisions in Commercial Real Estate Loan Agreements

during the term of the loan. According to these borrow- ers, a loan with a resizing provision provides its lender with significantly less risk and should, therefore, come with a commensurately lower interest rate.

LENDER’S PERSPECTIVE

From a lender’s perspective, resizing provisions represent prudent lending practices. These provisions require bor- rowers to be well capitalized and prepared to put their capital back to work to get a loan on track in the event a property’s value declines. Furthermore, such provisions give the lender the opportunity to get back the original underwritten level of risk that it bargained for when making the loan. Currently many of the banks across this nation have numerous loans where the loan-to value and debt-service-coverage ratios are significantly below the thresholds at which the loans were originally underwritten and below the levels required by the loan documents. However, many of these banks’ outstanding real estate loan documents do not give them the right to declare these loans in default simply because the financial covenants have been violated, particularly where the borrower continues

JUNE 2012

to make regularly scheduled principal and interest payments. As many lenders are learning, federal regulators may re-classify their loans when they fall below certain perfor- mance criteria. Once these loans fall below the required performance criteria, the banks must allocate working capital to loan loss reserves associated with the under- performing loans. This reclassification lowers the bank’s profitability. By using resizing provisions, some banks are passing this regulatory risk on to their borrowers.

CONCLUSION

Commercial real estate borrowers need to be familiar with their loan documents and, in particular, to be aware of any financial covenants contained therein.A violation of these financial covenants could potentially put a borrower’s loan into default and/or might require the borrower to pay down its loan pursuant to a resizing provision. Although many borrowers seek to avoid loan resizing provisions, it is sometimes difficult to avoid them in a market where com- mercial real estate lenders are still relatively scarce.

NOTE

1. Wonderland Shopping Center v. CDC Mortgage, 274 F.3d. 1085 (6th Cir. 2001).

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