November 19, 2013
Judging from the cranes now dotting the horizon, it’s tempting to believe that things are back to normal—at least in the real estate world.
But in reality, developers, investors and lenders are living in a “new normal” of challenging and tough new real estate regulations and practices. For real estate players, this new normal creates as many pitfalls as possibilities.
While the market continues to improve, lenders are still cautious and are easing credit for certain types of projects and borrowers. For example, lenders are still aggressively seeking to finance good projects in primary markets or trophy buildings. At the same time, low cost of capital borrowers, Real Estate Investment Trusts and Master Limited Partnerships have been able to obtain financing because they have significant equity to invest in the financing.
Somewhat surprisingly, multifamily is heating up again, with lenders showing a willingness to fund if occupancies are good and the projects are in the “right” locations. Owner occupied office/warehouses can get financed—provided that the owner is in good financial condition, with good financials and with a good “business story” of increasing rather than decreasing business. And, of course, retail projects with strong rent rolls and national tenants are still attractive.
But on the other hand, many borrowers and projects continue to face difficulty in obtaining financing. Generally speaking, properties in secondary and tertiary markets, and properties out of the central business districts still cause underwriters concern because they believe that values in those areas will fall first in any downturn. Office continues to be challenged because of flat or low business growth, which calls into doubt the availability of new tenants. And certainly, unstabilized retail projects or mom-and-pop retail projects are unlikely to obtain financing because they lack anchor or national-brand tenants.
In the “new normal,” lenders are feeling squeezed because of regulatory pressure and they are seeking to minimize time in documenting loans. Because money is tight, lenders are often just denying borrowers’ requests for changes in loan documents terms. Loan documents are almost [but not quite] a “take it or leave it” offer. Borrowers must be prudent and ask for what they must have and give up the hope of negotiating the perfect loan documents. Those days are over.
Loan documents acceptable to lenders now contain stricter requirements for real cash equity in projects. Any issue, question or problem with the rent roll or any lease is typically “cured” by another cash reserve to minimize risk for the lender. Lenders often want to see real and meaningful cash equity in projects as opposed to “imputed cash” from appreciation, valuation, or a discounted payoff. Likewise, more extensive financial covenants are required in loan documents, such as debt service coverage, net-worth requirements for borrower and guarantors, and other financial covenants as early “default triggers” or “triggers” to spring various remedies.
Lenders are seeking to yield less control over property income to borrowers. It’s more common to see an immediate lock box from the beginning of the loan whereby 100 percent of the rent is trapped, any excess cash is deposited in various reserves to secure the loan, and a “springing lock box” is also used, which permits the borrower to use excess cash until a triggering event—such as a default, or a violation of a financial covenant. These deposit control agreements are entered into with the depository bank to perfect the lender’s security interest in the accounts under the UCC. Practically speaking, this means that borrowers may not have the ability to accumulate a “war chest” to fight the lender or file a Chapter 11 bankruptcy case if the project develops cash flow problems.
In addition, the “non-recourse” loan will typically have a “bad boy” guaranty that will include 100 percent liability for the guarantors on the loan if the borrower files bankruptcy. The “bad boy” guaranty may include various “risk shifting” liabilities, such as the failure to maintain insurance or pay taxes, which go beyond the traditional “bad conduct” liabilities. And finally, some lenders will require the borrower to amend their organizational documents and require the appointment of an independent director to be added to its manager or general partner so that the decision of an independent person will be required before the borrower is permitted to file for bankruptcy protection.
The coordinated combination of (i) very tight control of excess cash flow, (ii) bad boy liability on the guarantors if the borrower files bankruptcy and for other risks of the project, and (iii) an independent manager/general partner, severely restricts the options available to the borrower if the property develops cash flow problems.
Under the current market conditions, it seems this “new normal” is here to stay. While there are certainly many opportunities to be had, the conditions for seizing them have certainly become more challenging to meet.