Modifying a Shopping Mall 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 shopping mall mortgage.

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 36-month $10 million loan for the construction of a shopping mall to occur over 24 months with a 12-month lease-up period to allow the borrower time to achieve stabilized occupancy before obtaining permanent financing. The loan had an interest reserve to cover interest payments over the three-year term of the credit. At the end of the third year, there is $10 million outstanding on the loan, as the shopping mall has been built and the interest reserve, which has been covering interest payments, has been fully drawn.

At the time of origination, the appraisal reported an “as stabilized” market value of $13.5 million for the property. In addition, the borrower had a take-out commitment that would provide permanent financing at maturity. A condition of the take-out lender was that the shopping mall had to achieve a 75 percent occupancy level. Due to weak economic conditions, the property only reached a 55 percent occupancy level at the end of the12-month lease up period and the original takeout commitment became void. Mainly due to a tightening of credit for these types of loans, the borrower is unable to obtain permanent financing elsewhere when the loan matured in February (i.e., due to market factors and not due to the borrower’s financial condition).

SCENARIO 1: The lender renewed the loan for an additional year to allow for a higher lease-up rate and for the borrower to seek permanent financing. The extension is at a market rate that provides for the incremental credit risk and on an interest-only basis. While the property’s historical cash flow was insufficient at 0.92x debt service ratio, recent improvements in the occupancy level now provides adequate coverage. Recent improvements include the signing of several new leases with other leases currently being negotiated.

In addition, current financial statements reflect that the builder, who personally guarantees the debt, has sufficient cash on deposit at the lender plus other liquid assets. These assets provide sufficient cash flow to service the borrower’s global debt service requirements on a principal and interest basis, if necessary. The guarantor covered the initial cash flow shortfalls from the project and provided a good faith principal curtailment of $200,000 at renewal. A recent appraisal on the shopping mall reports an “as is” market value of $10 million and an “as stabilized” market value $11 million.

Classification: The lender internally graded the loan as a pass and is monitoring the credit. The examiner agreed with the lender’s internal loan grade. The examiner concluded that the project continues to progress and now cash flows the interest payments. The guarantor currently has the ability and demonstrated willingness to supplement the project’s cash flow and service the borrower’s global debt service requirements. The examiner concurred that the interest-only terms were reasonable because the renewal was short-term and the project and the guarantor have demonstrated repayment capacity. In addition, this type of loan structure is commonly used to allow a project to achieve stabilized occupancy, but any subsequent loan terms should likely have a principal amortization component. The examiner also agreed that the LTV should be based on the “as stabilized” market value as the lender is financing the project through the lease-up period.

Nonaccrual Treatment: The lender maintained the loan on accrual status as the guarantor has sufficient funds to cover the borrower’s global debt service requirements over the one-year period of the renewed loan. Full repayment of principal and interest is reasonably assured from the project’s and guarantor’s cash flow despite a decline in the collateral margin. The examiner concurred with the lender’s accrual treatment.

TDR Treatment: The lender concluded that while the borrower has been affected by declining economic conditions, the level of deterioration does not warrant TDR treatment. The borrower was not experiencing financial difficulties because the borrower and guarantor have the ability to service the renewed loan, which was prudently underwritten at a market rate of interest, plus the borrower’s other obligations on a timely basis, and the lender’s expectation to collect the full amount of principal and interest from the borrower’s or guarantor’s sources (i.e., not from interest reserves). The examiner concurred with the lender’s rationale and TDR treatment.

SCENARIO 2: The lender restructured the loan on an interest-only basis at a below market rate for one year to provide additional time to increase the occupancy level and thereby enable the borrower to arrange permanent financing. The level of lease-up remains relatively unchanged at 55 percent and the shopping mall projects a debt service coverage ratio of 1.02x based on the preferential loan terms. At the time of the restructuring, the lender inappropriately based the selection of the below market interest rate on outdated financial information, which resulted in a positive cash flow projection even though file documentation available at the time of the restructuring reflected that the borrower anticipates the shopping mall’s income stream will decline due to rent concessions, the loss of a tenant, and limited prospects for finding new tenants. Current financial statements indicate the builder, who personally guarantees the debt, is highly leveraged, has limited cash or liquid assets, and has other projects with delinquent payments. A recent appraisal on the shopping mall reports an “as is” market value of $9 million, which results in a LTV ratio of 111 percent.

Classification: The lender internally graded the loan as substandard. The examiner disagreed with the internal grade and classified the amount not protected by the collateral value, $1 million, as loss and required the lender to charge-off this amount. The examiner did not factor costs to sell into the loss classification analysis, as the source of repayment is not reliant on the sale of the collateral at this time. The examiner classified the remaining loan balance, based on the property’s “as is” market value of $9 million, as substandard given the borrower’s uncertain repayment capacity and weak financial support.

Nonaccrual Treatment: The lender determined the loan did not warrant being placed on nonaccrual status. The examiner did not concur with this treatment because the partial charge-off is indicative that full collection of principal is not anticipated and the lender has continued exposure to additional loss due to the project’s insufficient cash flow and reduced collateral margin, and the guarantor’s limited ability to provide further support.

TDR Treatment: The lender reported the restructured loan as a TDR because (a) the borrower is experiencing financial difficulties as evidenced by the high leverage, delinquent payments on other projects, and inability to meet the proposed exit strategy because of the inability to lease the property in a reasonable timeframe; and (b) the lender granted a concession as evidenced by the reduction in the interest rate to a below market rate. The examiner concurred with the lender’s TDR treatment.

SCENARIO 3: Current financial statements indicate the borrower and the guarantor have minimal other resources available to support this credit. The lender chose not to restructure the $10 million loan into a new single amortizing note of $10 million at a market rate of interest because the project’s projected cash flow would only provide a 0.88x debt service coverage ratio as the borrower has been unable to lease space. A recent appraisal on the shopping mall reported an “as is” market value of $9 million, which results in a LTV of 111 percent. Therefore, at the original loan’s maturity in February, the lender restructured the $10 million debt into two notes. The lender placed the first note of $7.2 million (i.e., the A note) on monthly payments that amortize the debt over 20 years at a market rate of interest that provides for the incremental credit risk. The project’s debt service coverage ratio equals 1.20x for the $7.2 million loan based on the shopping mall’s projected net operating income. The lender placed the second note of the remaining principal balance of $2.8 million (i.e., the B note) into a 2 percent interest-only loan that is scheduled to reset in five years to an amortizing payment. The lender then charged-off the $2.8 million note due to the project’s lack of repayment capacity and to provide reasonable collateral protection for the remaining on-book loan of $7.2 million. Since the restructuring, the borrower has made payments on both loans for more than six consecutive months.

Classification: The lender internally graded the on-book loan of $7.2 million as a pass credit due to the fact that the borrower has demonstrated the ability to perform under the modified terms. The examiner agreed with the lender’s grade as the lender restructured the original obligation into A and B notes, the lender charged off the B note, and the borrower has demonstrated the ability to repay the A note. Using this multiple note structure with the charge-off of the B note enables the lender to recognize interest income and limit the amount reported as a TDR in future periods. If the lender had restructured the loan into a single note, the credit classification and the nonaccrual and TDR treatments would have been different.

Nonaccrual Treatment: The lender restored the on-book loan of $7.2 million to accrual status as the borrower has the ability to repay the loan, has a record of performing at the revised terms for more than six months, and full repayment of principal and interest is expected. The examiner concurred with the lender’s accrual treatment. Interest payments received on the off-book loan have been recorded as recoveries because, in this case, full recovery of principal and interest on this loan was not reasonably assured.

TDR Treatment: The lender reported the restructured on-book loan of $7.2 million as a TDR. The lender determined that the on-book loan should be reported as a TDR, consistent with the regulatory reporting guidance because (a) the borrower is experiencing financial difficulties as evidenced by the borrower’s high leverage, delinquent payments on other projects, and failure to meet the proposed exit strategy because of the inability to lease the property in a reasonable timeframe and the unlikely collectibility of the charged-off loan; and (b) the lender granted a concession. The concessions included a below market interest rate and protracted payment requirements on the charged-off portion of the debt and extending the on-book loan beyond expected timeframes.

If the borrower continues to perform according to the modified terms of the restructured loan, the lender plans to stop reporting the on-book loan as a TDR after the regulatory reporting defined time period expires because it was restructured with a market rate of interest. For example, since the restructuring occurred in February, the $7.2 million on-book loan should be reported as a TDR on the lender’s March, June, September, and December regulatory reports. The TDR reporting could cease on the lender’s following March regulatory report if the borrower continues to perform according to the modified terms. The examiner concurred with this planned treatment.

SCENARIO 4: Current financial statements indicate the borrower and the guarantor have minimal other resources available to support this credit. The lender restructured the $10 million loan into a new single note of $10 million at a market rate of interest that provides for the incremental credit risk and is on an amortizing basis. The project’s projected cash flow reflects a 0.88x debt service coverage ratio as the borrower has been unable to lease space. A recent appraisal on the shopping mall reports an “as is” market value of $9 million, which results in a LTV of 111 percent. Based on the property’s current market value of $9 million, the lender charged-off $1 million immediately after the renewal.

Classification: The lender internally graded the remaining $9 million on-book portion of the loan as a pass credit because the lender’s analysis of the project’s cash flow indicated a 1.05x debt service coverage ratio when just considering the on-book balance. The examiner disagreed with the internal grade and classified the $9 million on-book balance as substandard due to the borrower’s marginal financial condition, lack of guarantor support, and uncertainty over the source of repayment.

Nonaccrual Treatment: The lender maintained the remaining $9 million on-book portion of the loan on accrual, as the borrower has the ability to repay the principal and interest on this balance. The examiner did not concur with this treatment. The examiner instructed the lender to place the loan on nonaccrual status. Because the lender restructured the debt into a single note and had charged-off a portion of the restructured loan, the repayment of the interest and principal contractually due on the entire debt is not reasonably assured.

The loan can be returned to accrual status if the lender can document that subsequent improvement in the borrower’s financial condition has enabled the loan to be brought fully current with respect to principal and interest and the lender expects the contractual balance of the loan (including the partial charge-off) will be fully collected. In addition, interest income may be recognized on a cash basis for the partially charged-off portion of the loan when the remaining recorded balance is considered fully collectible. However, the partial charge-off cannot be reversed.

TDR Treatment: The lender reported the restructured loan as a TDR according to the requirements of its regulatory reports because (a) the borrower is experiencing financial difficulties as evidenced by the high leverage, delinquent payments on other projects, and inability to meet the original exit strategy because the borrower was unable to lease the property in a reasonable timeframe; and (b) the lender granted a concession as evidenced by deferring payment beyond the repayment ability of the borrower. The charge-off indicates that the lender does not expect full repayment of principal and interest, yet the borrower remains obligated for the full amount of the debt and payments, which is at a level that is not consistent with the borrower’s repayment capacity. Because the borrower is not expected to be able to comply with the loan’s restructured terms, the lender would likely continue to report the loan as a TDR. The examiner concurs with reporting the renewed loan as a TDR.

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