April 10, 2020

MSW Q&A Series – Part 2: Real Estate Finance and COVID-19: Loan Modifications in a Global Pandemic

In Part 2 of this 4-part series, Charles J. Wilkes, Esq. answers questions related to financing challenges arising in the COVID-19 crisis. As a partner at Murphy Schiller & Wilkes LLP (MSW), Charles leads the firm’s Banking and Commercial Finance and Real Estate Finance practice groups.  He represents clients in a wide range of transactional and financing matters in New Jersey and New York and throughout the United States.

Q1: How have the COVID-19 pandemic and recent “stay-at-home” orders impacted commercial landlords and their mortgage lenders

A1: Legally speaking, the COVID-19 pandemic and the governmental orders shutting down business activities do not excuse a borrower’s obligation to make payments due under a commercial mortgage loan. They also do not excuse the obligation to pay both real estate taxes and operating expenses. Commercial mortgage loan documents provide that payment obligations due to a mortgage lender are absolute and unconditional, which means that the borrower must make payments, without regard to financial hardship or external events, including global pandemics and governmental orders. The legal principles governing lending transactions, however, do not make borrowers and lenders immune to the pressures imposed on our economy by COVID-19 and government action to limit its spread. Most commercial and industrial real estate tenants are either closed or facing major declines in business revenue. And many residential tenants have lost their jobs or have suffered pay cuts. As a consequence, tenants across the real estate spectrum are unable to make monthly rent payments due under their leases. They are also unable to reimburse their landlords for real estate taxes and operating expenses. In fact, brand name businesses, including Staples and The Cheesecake Factory, have announced publicly that they will not be making rent payments during the COVID-19 crisis. That reality leaves many landlords without the cash flow required to service their mortgage debt and operate their properties. Lenders are therefore facing a steep drop in monthly mortgage payments and a rising number of loan defaults.

Q2: What should commercial landlords do if a loan default is anticipated or occurs as a result of the COVID-19 pandemic?

A2: Commercial landlords should notify their mortgage lenders promptly upon receipt of non-payment notices from their tenants or upon any significant reduction in cash flow due to COVID-19. Although commercial mortgage lenders are not legally required to modify loan payment obligations and may not be able to accommodate every borrower who requests relief, banking regulators are encouraging lenders to offer forbearance to borrowers in order to mitigate the financial impact of COVID-19.  On April 7, 2020, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the National Credit Union Administration, the Office of the Comptroller of the Currency and the Consumer Financial Protection Bureau issued the “Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus”, which encourages lenders to “work prudently with borrowers who are or may be unable to meet their contractual payment obligations because of the effects of COVID-19”. Regulators have advised that they “will not criticize institutions for working with borrowers in a safe and sound manner”. Additionally, with court systems closed or operating on a limited basis and evictions and foreclosures halted by governmental order, lenders and borrowers must, for the time being at least, work through these issues on their own.

At this point in time, we have found that most borrowers and lenders are already taking very proactive approaches to the COVID-19 crisis, even with respect to loans that are not yet in default due to COVID-19. Commercial landlords are talking with their tenants, reviewing the status of their leases and analyzing their projected cash flow over the next several months. Commercial landlords are also actively discussing the possibilities for deferrals of principal and/or interest payments with their mortgage lenders. Commercial banks have articulated policies for granting payment deferrals to landlords in need of assistance. And, derivatives desks at major financial institutions are working to amend the terms of interest rate swap agreements to permit payment deferrals under such agreements.

Finally, it is important to remember that the relationship between a commercial mortgage lender and its borrower is often a complex one. Monthly payments of principal and interest are not the only consideration in that relationship. Loan documents include many terms and conditions that could be affected by the COVID-19 crisis, including debt service coverage ratios, debt yield covenants, leasing requirements, cash flow sweeps, reserves for lease rollover risk and personal guaranty obligations - just to name a few.  Borrowers and lenders must consider the impact that COVID-19 will have on all of their obligations and how such obligations can be modified to address Coronavirus-related impacts.

Q3: What effect will COVID-19 have on construction loans and what should construction lenders and borrowers do about it?

A3: Over the past several weeks, construction projects across the United States have been halted or slowed due to COVID-19.  Such work stoppages and slow downs have occurred for a variety of reasons, including but not limited to (1) executive orders shutting down construction activities (such as Governor Philip D. Murphy’s Executive Order 122 in New Jersey, which halts all non-essential construction as of April 10, 2020), (2) social distancing measures which reduce or slow construction activity at otherwise operational construction sites, (3) workforce reductions due to illness and concerns about the spread of COVID-19, (4) disruptions in the supply chain for construction materials due to COVID-19 and (5) an inability to obtain necessary permits and approvals or complete necessary inspections due to the closure of municipal offices.  Due to these constraints, contractors may not be able to complete projects within the timelines provided under their construction contracts. Contractors may invoke force majeure provisions under such contracts. As a result, many developers may not be able to meet completion deadlines under their construction loan agreements, creating events of default under such agreements. In the case of certain projects, developers may not be able to deliver space to tenants by the deadlines set forth in their lease agreements, which may result in cancelled leases. In turn, cancelled leases may result in the developers being unable to service or refinance construction loan debt. It is certainly difficult to understate the complex range of effects that COVID-19 could have on real estate development and construction.

As is the case with permanent mortgage loans on stabilized properties adversely impacted by COVID-19, borrowers and lenders must take a proactive approach. Borrowers should review their construction contracts, leases and construction loan agreements to assess the impact that construction delays will have on each of those contractual agreements.  Borrowers should then convene discussions with their contractors, tenants and lenders to negotiate the modifications necessary to extend project deadlines. Each borrower should seek flexible extension options under such agreements, including an extension of the construction loan maturity date under its construction loan agreement.  Lenders will likely need additional assurances that their borrowers will be able to fund additional carrying costs, construction costs and interest expenses arising from such extended timeframes for project completion.  Ultimately, mitigating the impacts of COVID-19 on a construction loan will require a collaborative mindset by all parties involved in the applicable project, including the developers, contractors, lenders and tenants, who will need to work together to ensure that the delayed construction project can ultimately be completed successfully.

Q4: What alternative financing options are available to a landlord if mortgage capital becomes unavailable due to the current crisis?

A4: Unfortunately, the recent federal and state government relief efforts do not provide direct relief to landlords.  Instead, federal and state relief is focused on funding payroll and business operating expenses to keep people employed during the pandemic.  The good news for landlords and their mortgage lenders is that tenants can use federal and state funding to pay their rent expenses, which in turn permits landlords to make their mortgage payments and pay for real estate taxes and operating expenses. Two sources of such relief are the Economic Injury Disaster Loan Program (EIDL) and the Paycheck Protection Program (PPP).

EIDL is a direct loan program administered by the Small Business Administration (SBA).  Applicants must submit their applications directly to the SBA and funds are disbursed directly by the United States Treasury.  Borrowers may borrow up to $2,000,000 at an interest rate of 3.75% for a term of 30 years. The loans may be used to pay rent, payroll and other operating expenses.  Businesses applying for such loans must meet certain size standards and be located within a declared disaster area.

PPP is a federally guaranteed forgivable loan program created under the Coronavirus Aid, Relief, and Economic Security (CARES) Act.  Loans under the program are originated by lenders approved by the SBA and funded by the federal government. A borrower may borrow 2.5 times its average monthly payroll cost, up to a maximum of $10,000,000.  All PPP loans will bear interest at 1% and have a term of 2 years. Loan payments will be deferred for 6 months. The loans may be used for payroll costs, rent, utilities and interest on debt obligations. Subject to certain terms and conditions, each PPP loan is forgivable. At least 75% of the loan proceeds must be used for payroll costs, but the other 25% may be used for rent and other qualifying expenses.  Businesses applying for such loans must meet certain size standards.

Landlords, tenants and mortgage lenders should work together to ensure that the proceeds of these loan programs are used to fund rent payments, to the extent permissible. Tenants’ use of the loan proceeds for rent payments will certainly reduce commercial mortgage loan defaults.

Q5: How can the attorneys at MSW assist both borrowers and lenders with COVID-19 loan modifications?

A5: MSW attorneys have deep experience in real estate finance transactions, representing national and local banks, non-bank lenders and borrowers in sophisticated lending transactions.  MSW attorneys are available to help borrowers and lenders structure and document loan modifications which will permit all parties to endure this current crisis. MSW attorneys are well-versed in the legal and business concerns that guide relationships between borrowers and lenders in commercial mortgage transactions.  Although different sectors of our economy have been affected differently by this crisis, everyone has been affected in some way and everyone stands to benefit by working collaboratively. We look forward to assisting you.

For more information, please feel free to contact:
Charles J. Wilkes, Esq.
(973) 705-7422

Murphy Schiller & Wilkes LLP (MSW) is a boutique law firm servicing the commercial real estate and construction industries. Headquartered in Newark, New Jersey, the firm services the commercial real estate and construction industries. Through the development of comprehensive legal strategies, our team works tirelessly to create a blueprint for success and advance our clients’ interests in every matter.