Agencies of the Federal Financial Institutions Examination Council have weighed in on the “extend and pretend” debate, and it appears they are willing to extend―given the right circumstances. The term refers to the practice of a lender extending the term of a maturing loan for a short period of time rather than forcing the borrower to pay it off or to right size it, given the pressure on commercial real estate valuations. Essentially, “extend and pretend” pushes the valuation issue off to a future date.
In October, the Council issued a policy statement on Prudent Commercial Real Estate Loan Workouts. The statement presented guidelines to lenders on how to address troubled commercial real estate loans and encouraged them to work with strong borrowers. The guidelines indicated:
While commercial real estate borrowers may experience deterioration in their financial condition, many continue to be creditworthy customers who have the willingness and capacity to repay their debts. In such cases, financial institutions and borrowers may find it mutually beneficial to work constructively together. 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.
So what does this mean to self-storage owners facing maturing loans? Assuming you have sufficient cash flow to service the loan’s debt, the guidelines are good news. Regulators made it clear that modified loans can continue to be classified as “performing” even if the property is worth less than the loan amount. Regulators are encouraging lenders to go beyond the property’s current value and cash flow to consider a borrower’s entire financial picture when determining whether to extend a loan.
These new guidelines also provide examples of loan modifications considered prudent by regulators. Lenders can bridge the difference between a property’s loan amount and current market value by demonstrating there’s enough cash flow being generated from the property and the sponsor’s other assets (global cash flow) to service the modified loan. The guidelines also indicate the modified loan’s interest rate must be at a prevailing market level to compensate the lender for the additional risk. If not, the lender will have to classify the loan as “non-accrual” or “non-performing.”
Given these guidelines and the overall market environment, lenders will consider several criteria when determining which loans to extend. One of the terms cited frequently in the new guidelines is “borrower’s repayment capacity.” This refers to the borrower’s character, overall financial strength, and historical payment record on this and other loans. Lenders are also closely examining the historical basis and market conditions affecting the property’s cash flow and value, the borrower’s other contingent liabilities, and the ability to support repayment through personal guarantees.
In a nutshell, what this indicates is lenders will readily extend loans to well-capitalized borrowers demonstrating a strong payment history and with the ability to supplement the property cash flow with out-of-pocket funds to service any debt-service shortfall. Earth-shattering news? No. Common sense? Absolutely!
All of this sounds great for storage owners who meet the new guidelines. But what about poorly capitalized borrowers with less than sufficient global cash flow? Well, there’s a structure that might work in these situations as well.
The regulatory guidelines present an “A note/B note” structure allows lenders to keep current the portion of the note whose market interest-rate debt service can be supported by the property’s cash flow (the A note). Additionally, the A note’s principal amount must be within a prudent loan-to-value ratio based on current market conditions.
The lender would classify the B note as non-accrual and structure it with a below-market interest rate and other terms not characteristic of prudent lending practice. This A/B structure allows the borrower to remain in good standing with the lender, and minimizes the lender’s non-performing assets with the potential to recapture part of the write-off (the B note). If lenders did not break the loan into A and B notes, the alternatives of simply reducing the principal amount or adjusting the interest rate to below-market levels would require them to classify the entire loan amount as non-performing.
The guidelines issued in late October clearly demonstrate regulatory support for lenders and borrowers to collaborate on finding solutions to today’s valuation issues. Remember, the above examples may apply to your situation, but each loan will most likely have unique attributes which will need to be negotiated and worked through with the lender. This highlights the need for borrowers to be proactive about approaching their lenders with potential solutions as opposed to waiting for lenders to raise the issue.
There is still tremendous pressure on commercial real estate valuations, inevitably resulting in foreclosure and losses.
Devin Huber is a principal at Chicago-based The BSC Group, where he provides mortgage brokerage and financial consulting to commercial real estate owners nationwide. He can be reached at 312.207.8232. To receive a copy of the Federal Financial Institutions Examination Council policy statement, e-mail [email protected], or visit www.fdic.gov.