(Adapted from the October 30, 2009 Policy Statement on Prudent Commercial Real Estate Loan Workouts)
Introduction
In response to the residential mortgage crisis, and in anticipation of the looming commercial mortgage crisis of much greater potential magnitude, the federal banking regulators got together and issued a policy statement to encourage lenders to modify commercial mortgages and other loans secured by commercial real estate. Attachment 1 to the Policy Statement featured six example scenarios to help lenders to understand that the question isn't whether you modify a loan, but rather how you modify a loan, that may result in regulatory penalization.
From the statement: "[t]he regulators have found that prudent CRE loan workouts are often in the best interest of the financial institution and the borrower. Examiners are expected to take a balanced approach in assessing the adequacy of an institution’s risk management practices for loan workout activity. Financial institutions that implement prudent CRE loan workout arrangements after performing a comprehensive review of a borrower’s financial condition will not be subject to criticism for engaging in these efforts even if the restructured loans have weaknesses that result in adverse credit classification. 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. "
What follows is the regulator's example of modifying a land acquisition, Condominium Construction and Conversion Mortgage.
Note: - The financial regulators consist of the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), the Office of the Comptroller of the Currency (OCC), the Office of Thrift Supervision (OTS), and the Federal Financial Institutions Examination Council (FFIEC) State Liaison Committee (collectively, the regulators).
BASE CASE: The lender originally extended a $50 million loan for the purchase of vacant land and the construction of a condominium project. The loan was interest-only and included an interest reserve to cover the monthly payments. The developer bought the land and began construction after obtaining purchase commitments for about a third of the planned units. Many of these pending sales were with speculative buyers who committed to buy multiple units with minimal down payments. As the real estate market softened, most of the speculative buyers failed to perform on their purchase contracts and only a limited number of the other planned units have been pre-sold. The developer subsequently determined it was in the best interest to halt construction with the property 80 percent complete. The loan balance was drawn to $44 million to pay construction costs (including cost overruns) and interest and the borrower estimates another $10 million is needed to complete construction. Current financial information reflects that the developer does not have sufficient cash flow to service the debt; and while the developer does have equity in other assets, there is a question about the borrower’s ability to complete the project.
SCENARIO 1: The borrower agrees to grant the lender a second lien on certain assets, which provides about $5 million in additional collateral support. In return, the lender advanced the borrower $10 million to finish construction and the condominium was completed. The lender also agreed to extend the $54 million loan for 12 months at a market rate of interest that provides for the incremental credit risk to give the borrower time to market the property. The borrower agreed to pay interest whenever a unit was sold with any outstanding balance due at maturity. The lender obtained a recent appraisal on the condominium building that reported a prospective "as complete" market value of $65 million, reflecting a 24-month sell-out period and projected selling costs of 15 percent. The $65 million prospective "as complete" market value plus the $5 million in other collateral results in a LTV of 77 percent. The lender used the prospective "as complete" market value in its analysis and decision to fund the completion and sale of the units, and to maximize its recovery on the loan.
SCENARIO 2: A recent appraisal of the property reflects that the highest and best use would be conversion to an apartment building. The appraisal reports a prospective "as complete" market value of $60 million upon conversion to an apartment building and a $67 million prospective "as stabilized" market value upon the property reaching stabilized occupancy. The borrower agrees to grant the lender a second lien on certain assets, which provides about $5 million in additional collateral support. In return, the lender advanced the borrower $10 million, which is needed to convert the project to an apartment complex and finish construction. The lender also agreed to extend the $54 million loan for 12 months at a market rate of interest that provides for the incremental credit risk to give the borrower time to lease the apartments. The $60 million "as complete" market value plus the $5 million in other collateral results in a LTV of 83 percent. The prospective "as complete" market value is used because the loan is funding the construction of the apartment building. The lender may utilize the prospective "as stabilized" market value when funding is provided for the lease-up period.