Modifying a Commercial Office Building Mortgage

9 Feb

Timothy McCandless Esq. and Associates
Offices Statewide

(909)890-9192
(925)957-9797
FAX (909) 382-9956
tim@Prodefenders.com

http://www.timothymccandless.com

(Adapted from the October 30, 2009 Policy Statement on Prudent Commercial Real Estate Loan Workouts)

Introduction

In response to the residential mortgage crisis, and in anticipation of the looming commercial mortgage crisis of much greater potential magnitude, the federal banking regulators got together and issued a policy statement to encourage lenders to modify commercial mortgages and other loans secured by commercial real estate. Attachment 1 to the Policy Statement featured six example scenarios to help lenders to understand that the question isn’t whether you modify a loan, but rather how you modify a loan, that may result in regulatory penalization.

From the statement: “[t]he regulators have found that prudent CRE loan workouts are often in the best interest of the financial institution and the borrower. Examiners are expected to take a balanced approach in assessing the adequacy of an institution’s risk management practices for loan workout activity. Financial institutions that implement prudent CRE loan workout arrangements after performing a comprehensive review of a borrower’s financial condition will not be subject to criticism for engaging in these efforts even if the restructured loans have weaknesses that result in adverse credit classification. In addition, renewed or restructured loans to borrowers who have the ability to repay their debts according to reasonable modified terms will not be subject to adverse classification solely because the value of the underlying collateral has declined to an amount that is less than the loan balance. ”

What follows is the regulator’s example of modifying a mortgage on a commercial office building.

Note:

* The financial regulators consist of the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), the Office of the Comptroller of the Currency (OCC), the Office of Thrift Supervision (OTS), and the Federal Financial Institutions Examination Council (FFIEC) State Liaison Committee (collectively, the regulators).

BASE CASE: A lender originated a $15 million loan for the purchase of an office building with monthly payments based on an amortization of 20 years and a balloon payment of $13.6 million at the end of year three. At origination, the loan had a 75 percent loan-to-value (LTV) based on an appraisal reflecting a $20 million market value on an “as stabilized” basis, a debt service coverage ratio of 1.35x, and a market interest rate. The lender expected to renew the loan when the balloon payment became due at the end of year three. The project’s cash flow has declined, as the borrower granted rental concessions to existing tenants in order to retain the tenants and compete with other landlords in a weak economy.

SCENARIO 1: At maturity, the lender renewed the $13.6 million loan at a market rate of interest that provides for the incremental credit risk and amortized the principal over the remaining 17 years. The borrower had not been delinquent on prior payments and has sufficient cash flow to service the market rate terms at a debt service coverage ratio of 1.12x. A review of the leases reflects the majority of tenants are now stable occupants with long-term leases and sufficient cash flow to pay their rent. A recent appraisal reported an “as stabilized” market value of $13.1 million for the property, reflecting an increase in market capitalization rates, which results in a 104 percent LTV.

Classification: The lender internally graded the loan pass and is monitoring the credit. The examiner agreed, as the borrower has the ability to continue making payments on reasonable terms despite a decline in cash flow and in the market value of the collateral.

Nonaccrual Treatment: The lender maintained the loan on an accrual status. The borrower has demonstrated the ability to make the regularly scheduled payments and, even with the decline in the borrower’s creditworthiness, cash flow appears sufficient to make these payments and full repayment of principal and interest is expected. The examiner concurred with the lender’s accrual treatment.

TDR Treatment: The lender determined that the renewed loan should not be reported as a TDR. While the borrower is experiencing some financial deterioration, the borrower has sufficient cash flow to service the debt and has no record of payment default; therefore, the borrower is not experiencing financial difficulties. The examiner concurred with the lender’s TDR treatment.

SCENARIO 2: At maturity, the lender renewed the $13.6 million loan at a market rate of interest that provides for the incremental risk and amortized the principal over the remaining 17 years. The borrower had not been delinquent on prior payments. The building’s net operating income has decreased and current cash flow to service the new loan has declined, resulting in a debt service coverage ratio of 1.12x. Some of the leases are coming up for renewal and additional rental concessions may be necessary to keep the existing tenants in a weak economy. However, the project’s debt service coverage is not expected to drop below 1.05x. A current valuation has not been ordered. The lender estimates the property’s current “as stabilized” market value is $14.5 million, which results in a 94 percent LTV. In addition, the lender has not asked the borrower to provide current financial statements to assess the borrower’s ability to service the debt with cash from other sources.

Classification: The lender internally graded the loan pass and is monitoring the credit. The examiner disagreed with the internal grade and listed the credit as special mention. While the borrower has the ability to continue to make payments, there has been a declining trend in the property’s income stream, continued potential rental concessions, and a reduced collateral margin. In addition, the lender’s failure to request current financial information and to obtain an updated collateral valuation represents administrative deficiencies.

Nonaccrual Treatment: The lender maintained the loan on an accrual status. The borrower has demonstrated the ability to make regularly scheduled payments and, even with the decline in the borrower’s creditworthiness, cash flow is sufficient at this time to make payments and full repayment of principal and interest are expected. The examiner concurred with the lender’s accrual treatment.

TDR Treatment: The lender determined that the renewed loan should not be reported as a TDR. While the borrower is experiencing some financial deterioration, the borrower is not experiencing financial difficulties as the borrower has sufficient cash flow to service the debt, and there was no history of default. The examiner concurred with the lender’s TDR treatment.

SCENARIO 3: At maturity, the lender restructured the $13.6 million loan on a 12-month interest-only basis at a below market rate of interest. The borrower has been sporadically delinquent on prior payments and projects a debt service coverage ratio of 1.12x based on the preferential terms. A review of the leases, which were available to the lender at the time of the restructuring, reflects the majority of tenants have short-term leases and that some were behind on their rental payments to the borrower. According to the lender, this situation has not improved since the restructuring. A recent appraisal reported a $14.5 million “as stabilized” market value for the property, which results in a 94 percent LTV.

Classification: The lender internally graded the loan pass and is monitoring the credit. The examiner disagreed with the internal grade due to the borrower’s limited ability to service a below market rate loan on an interest-only basis, sporadic delinquencies, and the reduced collateral position, and classified the loan substandard.

Nonaccrual Treatment: The lender maintained the loan on accrual status due to the positive cash flow and collateral margin. The examiner did not concur with this treatment because the loan was not restructured with reasonable repayment terms, the borrower has limited capacity to service a below market rate on an interest-only basis, and the reduced estimate of cash flow from the property indicates that full repayment of principal and interest is not reasonably assured.

TDR Treatment: The lender reported the restructured loan as a TDR because the borrower is experiencing financial difficulties: the project’s ability to generate sufficient cash flows to service the debt is questionable, the lease income from the tenants is declining, loan payments have been sporadic, and collateral values have declined. In addition, the lender granted a concession (i.e., reduced the interest rate to a below market level and deferred principal payments). The examiner concurred with the lender’s TDR treatment.

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