Your Loan is Coming Due... Now What?

By Tony Petosa and Nick Bertino

As the credit crunch continues, lending options for commercial real estate, including manufactured home communities, have become increasingly scarce.  Conduit loans are still not being originated, life companies are lending on a highly selective basis, traditional banks are experiencing financial challenges causing them to pursue new loans only at lower leverage levels, if at all, and the agencies (Fannie Mae and Freddie Mac) have become more selective.  Adding to this problem of lack of available capital is one sobering fact:  a lot of commercial real estate loans will be maturing in the coming years. 

Over the past decade commercial real estate owners enjoyed some of the most favorable lending programs ever experienced.  Aggressive underwriting parameters, low interest rates, and a bounty of lenders hungry for volume all factored in to borrowers being able to obtain attractive loans on their properties.  In today's credit market, many of these lenders and loan structures simply don't exist, and many borrowers will face difficulties in refinancing their properties in the coming years.  Examples of properties that will face financing challenges include properties located in secondary and tertiary markets; properties that have experienced flat or declining occupancy and cash flow streams in recent years; and properties financed at high leverage levels with minimal amortization and loan terms of 5 years or less.  Properties that will mirror the problems suffered by the local and regional economies present corresponding problems for refinancing.  Does your property fit any of the characteristics described above?   The answer may bring you to another question: "What happens if I can't refinance or pay off my loan when it comes due?" 

Even if you are current on your loan payments, you will be in "monetary default" if you cannot pay off your loan balance when the loan matures.  As a first step, we recommend that you dust off and review the loan documents (particularly the promissory note, deed of trust/mortgage and guaranty) from your current loan.  At the outset, you should at a minimum have a clear understanding of the following topics:

1. Is Your Loan a Conduit Loan?  This is a vital fact that must be determined at the outset.  Conduit loans have typical features, and are much more difficult to modify.  Balance sheet (non-conduit) loans potentially present greater flexibility as your loan approaches maturity. 
2. Maturity and Default.  Do you have a specific "balloon" maturity date versus a fully amortizing loan term that may have periodic interest rate adjustments?  If your loan was a conduit loan, it is possible that it has "hyperamortizing" features that essentially provide an automatic "workout" once the "anticipated repayment date" (essentially what would have been the maturity date if this feature was not added) has passed.   However, in any event, if your loan has matured, it is likely to be accelerated unless you can work something out with your lender.  
3. What is Your "Default Interest Rate"?  Most commonly, when a loan goes into default, the current interest rate will adjust to the "default" interest rate.  This is typically the lesser of the current interest rate plus an additional margin (often 4%-5%) or the maximum interest rate allowable by law.  The bottom line is that the interest rate you will be charged when your loan is in default will be substantially higher than what your rate had been throughout the loan term.  To put this in perspective, imagine that five years ago you obtained a $5 million conduit loan at 80% loan-to-value amortized over 30 years with a 6% fixed interest rate.  During those five years, the cash flow of your property was flat.  You try to refinance your property at loan maturity, but because underwriting parameters are now more conservative and because your property has not increased in value, you are unable to obtain a new loan for your property, and the loan goes into monetary default.  Your interest rate would then adjust to 11%.  If the lender doesn't accelerate the loan balance, and you are permitted to continue monthly payments, in this particular circumstance the default rate alone would increase your monthly loan payment by more than $17,000.  As you can see, the purpose of implementing the default interest rate is to motivate the property owner to refinance or pay off the loan.
4. Personal Liability.  This issue may strongly shape your course of action.  Was your loan made on a recourse or non-recourse basis?  Are you a carveout guarantor or fully or partially responsible for repayment of the loan indebtedness?  These are extremely important facts to ascertain.  Recourse loans (for which the guarantors are fully liable for repayment of the entire loan) are typically non-conduit and made by banks when the loan is to be held on its balance sheet.  Nonrecourse loans are made with limited and specific "carveouts", and virtually all conduit loans follow this pattern.  For a nonrecourse loan, the lender agrees to look only to your property for repayment, except: (i) for losses it may sustain for certain "bad boy" acts, such as fraud, diversion of rents or insurance proceeds, waste and environmental conditions; and (ii) for your full liability for the entire loan in the event of bankruptcy, an unpermitted transfer of the property or equity interests in the borrower, or violations of loan covenants that assure the lender that your borrowing entity will remain a "single purpose, bankruptcy remote entity".  If you are only a "carveout" guarantor on a nonrecourse loan, be absolutely certain that you don't do anything (unless you determine that to be the best course of action, on balance) that will trigger that full (springing) personal liability and be aware of what the scope of your "carveout" liability will be for losses and damages as well.
5. Is There a Prepayment Penalty/Premium?  Payment of your loan prior to maturity almost always carries with it a prepayment penalty or premium (there is no practical difference in the term used).  For conduit loans, this typically takes the form of "defeasance" or "yield maintenance."  Defeasance is a complicated and costly process that involves assembly of a basket of U.S. Treasury securities to replace your property as security, and for which you will require an expert to put the pieces together.  Yield maintenance premiums (measuring the loss of yield over a U.S. Treasury security, as if your prepayment proceeds were to only be invested in such a security, but typically never less than 1% of your prepayment) are determined by your lender, are far less complicated, and don't require outside experts and their related fees.  Other loans (most often bank balance sheet loans) may require a "stepped prepayment premium" or a fixed percentage of the prepaid amount.  In short, know what is required, and determine the impact against your available capital and refinancing proceeds.
6. Is There an Open Prepayment Window?  If you do decide you are going to pay your existing loan off prior to its maturity, check your loan documents in further detail to determine whether there is an open prepay window, as well as whether there are any restrictions pertaining to what day of the month you will need to pay off your loan.  For conduit loans, as well as many bank balance sheet loans, the "window" is the last 3 months (some longer, some shorter) prior to maturity when the loan can be prepaid without a prepayment penalty.  In additional, some loan documents may require that the loan be paid off on the first or last day of the month, or you will be charged the full month of interest for the month in which the loan is paid off.  If you are processing a new loan, you will want your new lender to be aware of this so that you avoid paying double interest during that month.  Additionally, your existing loan documents may require that you give the existing lender written notice of at least 30-60 days prior to paying off you loan.  Again, this is a point you should be aware of if you are processing a new loan.

Even if your existing loan does not mature for another 12-24 months, it is only prudent, and strongly recommended, to start exploring your options for refinancing now.   Remember, lenders hate surprises, so you should manage the expectations of your current lender.  If your loan is a balance sheet (not a conduit) loan, you may have greater flexibility in working directly with that lender to extend the term of your loan prior to hitting the wall at maturity, although this will most likely require full personal liability if that is not already the case.  If you have a conduit loan, be aware that loan modifications cannot typically be made unless the loan is in default.  This presents material issues to working something out and virtually assures that you'll have to be on the "brink" in order to do so.  Thus, for a conduit loan in this environment, you cannot begin looking too soon for refinancing alternatives and setting realistic goals in that regard.

If an extension is offered to your loan, request a written outline of any additional items the lender may require to grant the loan extension.  You may find, for example, that the lender will require a partial pay down, shorter amortization, full recourse, an extension fee and/or re-setting of the interest rate as part of the loan extension.

In this economic environment it is critical to understand your specific loan terms and any default risks they may pose so you can plan accordingly.  The "friendly banker" you knew five years ago may not be the one you will be dealing with tomorrow.  Please feel free to give us a call to discuss your particular situation.

Tony Petosa is Senior Vice President and Nick Bertino is Vice President of Wells Fargo Commercial Mortgage.  They specialize in arranging financing on manufactured home communities, offering both direct and correspondent lending programs.  If you would like to receive future newsletters from Petosa and Bertino, or would like to receive a copy of their Manufactured Home Community Financing Handbook, they can be reached at 760/438-2153; 760/438-8710 fax; and via email:  tpetosa@wellsfargo.com and nick.bertino@wellsfargo.com.  You can also visit their website at www.wellsfargo.com/mhc.  Special thanks to Jim Simpson, Principal with the law firm of Miller Canfield, for his contribution to this article.