Will Lenders Be Prepared for a Possible Downturn in the Real Estate Market?
We have certainly been enjoying a strong real estate market for the past several years. Many economists, however, believe that real estate markets run in 10-year cycles. Even though interest rates are at record low levels, and the Dow Jones Industrial Average recently surged to a record high, history suggests that we could be approaching the end of a good real estate cycle in the near future. Accordingly, prudent real estate lenders should start analyzing their existing real estate portfolios to prepare for a possible downturn in the market. This article discusses some simple steps that real estate lenders can take now to help avoid some of the problems that many lenders encountered when the real estate market collapsed in the early 1990s.
Ensure That You Have Complete Documentation
Lenders should make sure that they have a complete set of original loan documents, title documents, and similar instruments for all of their real estate transactions. While there is a strong likelihood that a lender will have a complete set of fully executed loan documents at closing, it is possible that a lender may misplace or fail to receive pertinent documents after closing. For example, loan documents may inadvertently get lost when a lender relocates to new office space, when two lenders merge with one another, or when one lender assigns its loan documents to another lender. Other times, a lender may allow a borrower or third party to execute a loan document post-closing ( e.g., a subordination, nondisturbance, and attornment agreement), but ultimately may fail to receive that document from the borrower or third party. Moreover, title agents or title companies may fail to deliver the mortgagee’s title insurance policy to the lender in a timely manner. Obviously, missing documents can be problematic if and when the lender seeks to enforce its rights and remedies in the event of a default by the borrower. Many workout lawyers discovered this in the early 1990s when they were asked to resolve troubled loan transactions, but did not have complete files to review. A missing note could be particularly harmful to a real estate lender since, as a general rule, the lender will be required to produce the original note in a foreclosure action or incur the expense over litigating lost note issues. If a lender discovers that a pertinent document is missing or was not properly executed, now is the time to consider having the borrower deliver or reexecute it. A lender should, however, be careful when asking a borrower to reexecute a promissory note since there could be adverse tax consequences in some states if the proper steps are not followed.
Perform Title Updates
It is not uncommon for a borrower, after the closing of a loan, to grant an interest in the mortgaged property to a third party or permit an encumbrance to be placed upon the mortgaged property, without realizing that it is obligated to notify or obtain the consent of the lender under the loan documents. Thus, lenders should consider performing a title update on all of their title insurance policies. Alternatively, a lender may only want to do a title update on its larger title policies. If a title update reveals an unacceptable encumbrance on the mortgaged property ( e.g., a subordinate mortgage, a construction lien, or a judgment), the lender will be in a position to demand that the borrower remove or modify the encumbrance in a manner acceptable to the lender. It may be too late to deal with a title problem if the lender first learns of it when performing a foreclosure search. Furthermore, some title problems (a subordinate mortgage, for example) can complicate or delay the lender’s foreclosure action. This, in turn, likely will result in higher legal fees and other recovery costs to the lender. Title problems also can become costly to a lender if, after taking possession of the property, the lender is forced to deal with the problem in order to operate the property properly. Likewise, the lender may end up having to sell the property to a third party at a discount because of the title problem. Title updates are relatively inexpensive to obtain, and the cost of the update may even be passed through to the borrower depending upon the provisions in the loan documents.
File UCC Continuations
and Perform UCC Searches
Lenders should check their files to determine when their UCC-1 financing statements will expire to ensure that continuation statements are filed in a timely manner. In many states, a UCC-1 financing statement will expire five years from the date of filing unless the lender files a continuation statement. If the lender fails to file a continuation statement, the lender’s security interest in the collateral covered by the financing statement generally will become unperfected. This could be very dangerous to the lender if the borrower files for bankruptcy protection (in which case the lender could become an unsecured creditor and receive less favorable treatment). Likewise, this could be problematic if the lender attempts to realize on the collateral and confronts another creditor with a perfected security interest (in which case the perfected creditor will have priority over the lender). In addition, a lender should consider performing a UCC search to determine whether the borrower has granted any additional security interests to third parties in violation of the loan documents. For example, a borrower may grant a security interest to a vendor or other third party without realizing that the borrower previously granted a security interest in the same collateral to the lender. If the borrower defaults under the loan documents, and the lender elects to foreclose on the personal property under the UCC, the lender likely will encounter competing claims in the foreclosure action. This, too, could significantly slow down the foreclosure action and add to the lender’s legal fees and recovery costs. Fortunately, UCC searches can be performed quickly and inexpensively. In fact, UCC searches can be performed on the Internet at no out-of-pocket cost to the lender; however, the documents on the Internet often are unofficial records and the search results may not be completely accurate or up-to-date. Nevertheless, if the UCC search results are problematic for the lender, it may be possible for the parties to work out the issues while the relationship between the borrower and the lender is amicable.
Enforce Financial Covenants
Lenders should make sure that their borrowers and guarantors are providing the required financial information under their respective loan documents, and should monitor the sources and uses of cash for each project carefully. Most loan documents require the borrower (and the guarantor, if any) to provide the lender with financial statements, tax returns, or other financial information on some periodic basis. Furthermore, loan documents may require the borrower or the guarantor to maintain certain net worth requirements or financial ratios during the term of the loan. When lenders were forced to deal with troubled loans in the early 1990s, it was often difficult to determine how borrowers utilized the cash flow from the mortgaged property and why there was insufficient cash for debt service. In fact, many lenders were forced to retain forensic accountants to help trace the cash generated from various real estate projects. Some borrowers used cash surpluses from one property to finance shortfalls from another property or made distributions to partners or shareholders in lieu of making necessary improvements or repairs to the mortgaged property. Enforcing these financial covenants, however, should help a lender spot dangerous trends that could lead the borrower to default on its loan obligations.
In addition, a lender should periodically determine whether the borrower is satisfying the net worth or financial ratio requirements, if any, contained in the loan documents. If not, the lender then could attempt to obtain additional collateral or security for the loan, or exercise its rights under the loan documents, if necessary. In the event of litigation, good financial information on guarantors improves the lender’s likelihood of success in collection.
Obtain Tenant
Estoppel Certificates
Generally, a lender will thoroughly review the tenant leases and obtain tenant estoppel certificates from major tenants prior to making a loan to the borrower on income-producing property. Then, at closing, the borrower typically assigns the leases and rents of the property to the lender as additional collateral for the loan. Subsequent to the closing, it is possible that a borrower will enter into new leases or modify existing leases without notifying the lender or obtaining the lender’s consent, even if the borrower is not permitted to do so under the loan documents. In addition, disputes between the borrower and its tenants may arise after the closing without the lender’s knowledge. Thus, a lender should review a current rent roll for each of its income-producing properties to find out whether there have been any material changes in the tenant roster since the closing of the loan. The lender then should consider obtaining a tenant estoppel certificate from each of the major tenants to confirm the basic business terms of the lease and determine whether the tenant is claiming any offsets against rent or is asserting any defaults on the part of the borrower under the lease. The lender will then have an opportunity to address with the borrower any issues that could jeopardize the repayment of the loan or cause a problem for the lender if the lender is forced to take back the mortgaged property.
Post-Closing Obligations
Often, a lender will uncover an objectionable issue during the course of its due diligence, but will allow the borrower to remedy the situation after the loan is funded. For example, a survey may show that there are minor setback violations or that a structure on the mortgaged property partially encroaches upon the adjoining property without an easement appurtenant. In such a situation, the lender may allow the borrower to obtain a zoning variance or an easement from the owner of the neighboring property, as the case may be, within some specified period of time following the loan closing date. These obligations are generally memorialized in a post-closing agreement. A typical borrower loves to defer these type of “cleanup” obligations since, as a practical matter, the lender rarely monitors whether the borrower is complying with its post-closing agreement. Even though the post-closing obligations typically are not material in nature (otherwise the lending presumably would require the borrower to perform the obligations prior to funding the loan), if the lender ends up having to take title to the property, it is possible that the lender will have to pay money to resolve the problem. Alternatively, the lender may be forced to sell the property at a discount to a third party who will, in turn, spend its own money to resolve the problem. Therefore, lenders should review their post-closing agreements and follow up with those borrowers who still need to fulfill any material post-closing obligations.
Obtain General Release
After a loan is advanced and the loan documents have been signed, the parties occasionally find themselves in a position which necessitates an amendment to the original transaction. If a borrower requests that the lender modify or waive any of the terms of the loan documents, the lender should require that the borrower execute and deliver a general release in connection with such modification. For instance, if a borrower asks a lender to partially release the lender’s security interest in certain personal property so that the borrower can convey or grant a first priority security interest in that property to a third party, and the lender is willing to do so, the lender should require the borrower to release the lender from any claims that the borrower may have under the loan documents through the date of the release. This should help limit potential claims or counterclaims that may be asserted by the borrower against the lender in a foreclosure action if the loan goes into default thereafter.
Conclusion
Given the recent volatility in today’s capital markets, and the uncertainty in the Asian and Russian economies, many lenders (particularly conduit lenders) have ceased making new loans or have significantly increased their lending requirements on new real estate projects. Thus, it appears that some members of the lending community are already taking a conservative view about the stability of the current real estate market. Accordingly, even though the real estate market still is relatively strong in many parts of the country, lenders should consider taking some or all of the foregoing steps to better position themselves if the market slows down in the near future and, consequently, borrowers have trouble repaying their loans. While these preventive measures may be time consuming and somewhat costly, they could help lenders save considerable time and money if and when this good cycle comes to an end. Of course, most of us hope that history will not repeat itself, and that the real estate markets continue to remain healthy for many years to come.
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Lawrence J. Diamond is a partner in the West Palm Beach law firm of Ackerman, Link & Sartory, P.A., where he concentrates in real estate finance and a variety of other real estate matters. He received a B.S. from New York University and a J.D. from Fordham University School of Law.
This column is submitted on behalf of the Business Law Section, Stephen D. Busey, chair, and T.A. Borowski, Jr., editor.
© 1999, Lawrence J. Diamond.
