Due to the negative market forces caused by COVID-19, we anticipate an increasing number of nonperforming commercial real estate loans. Therefore, the secondary loan market in the United States is likely to become a pipeline of opportunity for well-prepared sellers and buyers alike. Lenders interested in selling one or more loans (the sellers) may find that this market presents opportunity to offload risk and better leverage balance sheets in an environment where scheduled or accelerated principal repayments, early discounted payoffs, and even current monthly payments may not be feasible for many borrowers. For those seeking to acquire loans in the secondary market (the buyers), this environment provides an avenue to invest in debt in amounts, at yields/asset cycles and with associated risks that may be more aligned with their investment strategies. Further, acquisition of distressed debt can also serve as a vehicle to acquire real estate.
Before commencing a commercial real estate loan purchase and sale transaction, each party should (1) identify its specific short- and long-term objectives; (2) consider the nature of the loan and underlying collateral and realistically evaluate its ability to administer the loan or, following foreclosure, the collateral; (3) identify the key opportunities, obstacles and risks in light of market realities; and (4) consider pricing factors.
This Legal Update provides a guide for commercial real estate loan purchase transactions and some practical considerations that parties should bear in mind during the course of such transactions. In addition to the considerations set forth below, the parties should engage professionals experienced with the type of debt under consideration, as it is critical at each stage that the parties consider and understand key distinctions relative to the kind and source of debt at issue and tailor the transaction accordingly. Some key distinctions in types of debt include:
- Nonperforming Loans vs. Performing Loans
- Commercial Loans vs. Residential Loans
- Senior Loans vs. Junior/Mezzanine Loans
- Construction Loans vs. Permanent Loans
- Loan Portfolios vs. Individual Loans
- Whole Loans vs. Partial Interests1
- Term Sheet/Letter of
Intent. The term sheet or letter of intent will establish
the baseline terms for the loan purchase transaction. Loan purchase
transactions can look like a property acquisition, with a purchase
agreement pursuant to which a deposit is made and due diligence
period occurs, or they can be structured as a "sign and
close" transaction in which the loan purchase agreement is
signed at the closing of the acquisition. In a "sign and
close" scenario, the term sheet will effectively govern the
transaction until closing, which may affect the level of detail the
parties wish to include. Some of the key points to be covered in
the term sheet include:
- Price, Deposit and Other Financial Allocations. The term sheet should identify the purchase price (or at least the manner in which it will be calculated). Some considerations in pricing the loan include: whether the debt is fully secured, oversecured or undersecured given the current market value of the underlying collateral, the borrower's overall financial status (including the likelihood of a bankruptcy), the priority of the debt and other outstanding financing, and the direction in which the market/economy or the borrower's business is trending. In addition to the purchase price of the loan, the parties will need to consider the allocation of payments and advances from the time the purchase price is established through the closing date (and possibly beyond if a transfer of servicing occurs after the closing date). If the transaction is not a "sign and close," the buyer will likely be required to put up a deposit to serve as the seller's liquidated damages in the event of a buyer breach.
- Scope and Priority of Purchase. Loans may be purchased individually or in groups or pools. If more than one loan is the subject of the transaction, the term sheet should specify whether, based on diligence or other specified events, the buyer may remove one or more loans from the transaction and continue with the acquisition of others. If there is active litigation in connection with the loan such as a foreclosure or a suit on a guaranty, the buyer will need the seller's interest in such litigation to be expressly assigned to the buyer and such assignment to be filed with the applicable court. For distressed loans, the buyer should verify whether there is any other lender or competing interest holder with a stake in the underlying asset, regardless of the seniority of the loan being purchased and/or the buyer's business plan for the loan. A junior or mezzanine lender may have a right to purchase a senior or mortgage loan or to approve material modifications of the debt which could forestall workout plans. A senior loan foreclosure process might be affected by a junior or mezzanine lender making a competing bid to protect its investment, and conversely could wipe out a junior lien and/or the value of any mezzanine collateral. Any other creditor of borrower or its major constituents could potentially create a bankruptcy situation that would be problematic for the buyer. Any of these outcomes may result in a buyer claim against the seller if the existence of other known interest holders was not been disclosed, based upon a breach of representation or warranty. Accordingly, it may behoove both the seller and the buyer to spell out how the parties contemplate handling the contractual rights/relationships of any third parties that may have competing interests in the proposed purchase.
- Diligence considerations are covered in more detail below, but should include loan documents and servicing files, as well as borrower and property diligence. As the diligence period is typically short or concurrent with document negotiation and, in either case, usually 30 days or less, prospective purchasers are wise to condition the commencement of the diligence period upon the seller's delivery of the complete loan/diligence file. Key diligence items which a buyer requires should be called out in the term sheet. The term sheet/LOI should specify the means by (and the timing within) which the seller will make diligence in its possession available, and as well as the scope of the buyer's rights to terminate the agreement (or to remove loans from the transaction) on the basis of diligence. Depending on the size, type and number of loans in the transaction, the basis for transaction termination/removal of loans may vary widely, from a buyer's sole discretion based on its opinion of diligence to the limited instances where there is a material defect in loan documents or a deficiency causing the seller's representations to be materially untrue. If the purchase agreement will have an escrow period, provisions regarding a deposit and diligence period should be included in the term sheet, although certain details regarding diligence objections and post-diligence period/pre-closing discoveries or events may not be negotiated until the purchase agreement is prepared. Other key provisions regarding diligence may be drawn from "Diligence" below for incorporation as well.
- The parties should specify in the term sheet whether the loan is being transferred on a servicing-released basis or whether the seller or the existing servicer will continue to service the loan. If the seller or an affiliate is servicing the loan pre-sale, the seller may wish to try and retain the servicing function for the ongoing revenue. Retaining the loan servicer in a loan purchase transaction simplifies the interface with the borrower, as the borrower will continue to deal with the same party on a day-to-day basis, and may result in fewer other logistical tasks (such as transferring accounts, etc.). However, engaging a servicer will come at a cost to the buyer, and the buyer should consider whether it is capable of servicing the loan, whether it has other servicing options it wishes to pursue, and whether it has confidence in the seller performing such role.
- Confidentiality and Exclusivity. Loan document confidentiality requirements may create a corresponding need for the seller to include a confidentiality provision in the term sheet. The buyer should ensure that the scope of representatives and consultants with whom the buyer is permitted to share the diligence information covers with those whose expertise it will need to evaluate the loan, the borrower and the property, and should consider corresponding confidentiality commitments from such representatives and consultants. While the seller may be reluctant to provide, the buyer should push for the inclusion of an exclusivity provision— providing protection from potential dead deal costs in the event that the seller shops for, and signs with, an alternate loan purchaser.
- Other Key Provisions. The term sheet should also address issues such as the anticipated closing date, termination rights and remedies, key representations, governing law, and allocation of transaction costs (legal fees, title updates, title endorsements, servicing release costs, and costs of obtaining tenant estoppels and/or the consent of any necessary counterparties, in each case as applicable). Many of these subjects are discussed in more detail below under "Diligence" and "Transaction Documents."
Originally published 16 July, 2020
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