Think Like a Lender — 8 Ways Lenders Protect Downside Risk

Huber Bongolan
August 17, 2020

In last month’s blog “8 Ways CRE Lenders have Adjusted to COVID”, we focused on how lenders’ adjustments affected the structure and protections built into loans today, and how that would affect a borrower’s financing options. I ended by saying “the world is changing so fast! We are learning new things about lenders every single day. Next month, I might have a whole new list for you.” That remains true today, after receiving devastating economic loss numbers from Q2, facing sustained quarantine-fueled unemployment, and facing a cliff of government spending programs that may or may not be renewed.

For this blog I collaborated with my StackSource teammate, Omar Sobhy, to provide you with another list of eight. These are more tailored to the lender’s perspective for how to mitigate risk across in new originations and across their book of loans.

For the borrowers in the room: not all loans will use these additional 8 risk mitigation strategies. Lenders will want them, but that does not mean you have to give them up. An experienced Capital Advisor can help you navigate these waters.

8 ways to mitigate commercial mortgage risk

Here is a lender's playbook to mitigating risk in today's market:

1. Plan for the worst

Underwrite for an uncertain future and put more protective measures in place to avoid foreclosure, which is more expensive than you think.

As a lender, consider a scenario where this loan won’t be paid back. And when your loan is not paid back, you as the lender will have to pay the transfer taxes and eat all of the other costs associated with servicing the loan that the borrower was expected to pay.

What can you do to help increase the likelihood of payment throughout and payback at the end of the term? Consider lowering the LTV/LTC, increasing the borrower reserve requirement, underwriting to a higher DSCR or Debt Yield, and underwriting more conservative rents and rent growth due to the level of uncertainty in a post-COVID world.

2. Don’t throw good money after bad

Include frequent covenant testing to remedy your loan well in advance of it going bad.

As a lender, you don’t want to be in a situation where your borrower is making late payments or asking for certain concessions and you’re bending over backwards to avoid foreclosing. Save yourself the wasted time and money that could come from poorly structured, aggressively underwritten loans.

Closely monitor your borrowers and the asset you’re lending on. Monthly DSCR, debt yield, and interest reserve balance requirements should be put in place and strictly enforced.

3. Make the cash management system watertight

Establish hard lockboxes and reserves with distributions only after property-level expenses, holdbacks, and reserves are funded.

Structure your loan terms from the beginning to provide iron-clad lender protection where the lender always gets paid first and foremost. Structure a lockbox, where property operating cash flows go to the lender first before the borrower. Structure a cash sweep, where cash flows in the lender lockbox are “swept” before going to the borrower in order to make debt service payments and fund the interest reserve safely above the minimum threshold.

4. Bankruptcy remote is not bankruptcy proof

Don’t bank on bankruptcy remote entities saving the day from the borrower entity declaring bankruptcy.

A bankruptcy remote entity is a special-purpose vehicle (“SPV”) that’s formed to hold a defined group of assets and to protect them from being administered as property of a bankruptcy estate.

However, bankruptcy remote does not necessarily mean bankruptcy proof. Lenders should recognize the bankruptcy risks that cannot be eliminated, even if the borrower is using a bankruptcy remote entity.

5. The intercreditor agreement is like a prenuptial agreement

Clarify lien positions and subordination agreements well in advance of any situations where lenders will need to clarify seniority.

Ensure that all loan documents, yours and any subordinate lender(s), clearly articulate that you as the senior lender have the right the senior lien position.

It is crucial that all lenders involved in a transaction clarify their rights and priorities in case a borrower defaults so there is no confusion if the time to foreclose comes.

6. The recourse carve-outs may save the day

Get a “warm body guarantor” and beef up the carve-outs list.

“Warm body” individual guarantors are of much greater value to lenders than entity guarantors, even where the creditworthiness initially appears to be similar. Having a “warm body” guarantor gets the borrower on the hook for the loan significantly more than the case where recourse can only be had to an entity guarantor.

Therefore, individual sponsors tend to be much more cooperative and motivated to avoid foreclosure with warm body vs entity guarantors.

7. Maturing loans may need long term care issuance

Lenders should add loan extension options for a fee as well as incentivize borrowers to avoid exit fees when refinancing with the existing lender.

Construction and bridge loans are typically 12–36 months. One way that lenders protect themselves is by writing into the loan terms that the borrower can extend this term for an additional six months to a year for a fee to the borrower (usually 1%).

Lenders also offer to waive the exit fee when a borrower chooses to refinance the loan with the existing lender. Underwriting borrowers and assets is cumbersome, so why not try to get longer term yield from borrowers and assets you trust when possible.

8. Deal with “self dealing”

Keep a list of borrower affiliates to ensure borrowers are not siphoning off cash from their project before it comes to the bottom line.

One of my mentors once told me “pretty much everyone in real estate is an entrepreneur”. Entrepreneurially-minded borrowers might try to get cash from all aspects of their project. These could include: affiliate agreements with the property manager, contractor, investment sales broker, loan broker, and more.

Include covenants that all contracts will be disclosed and at arms-length terms unless approved in advance by the lender. Also be sure to include provisions which cut off payments to borrower affiliates and other insiders following a default under the loan documents and covenants.

The post-COVID world we live in is filled with uncertainty. Underwriting assumptions now have a huge spread and lenders must double down on risk mitigation while still putting money to work.

If you’re a commercial real estate lender, use the 8 ways listed above to protect yourself when sending out your next term sheet.

If you’re a borrower, consider these 8 points when underwriting deals and looking for financing.

Good luck out there friends.

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