SELECTED ISSUES IN THE NEGOTIATION OF REAL ESTATE FINANCING DOCUMENTS By Alan Wayte Dewey Ballantine LLP Los Angeles, California I. Mortgage loans are being made again, and the documents look familiar although the underwriting may be more conservative. A. New underwriting approaches - some from experience; some from change in law and regulations. 1. More conservative loan-to-value and debt coverage ratios. a. The days of 100% financing are over for now. b. Debt service ratios at 1.20 and higher. 2. More emphasis on personal liability. 3. More conservative appraisals. 4. More interest in additional collateral. pre-leasing. 5. Requirements for greater borrower equity and/or greater amount of 6. Relationship lending with smaller developers is still more difficult. It is much easier for major owners and developers. B. Lenders may have a new interest in impound accounts especially if securitization is contemplated. 1. Taxes, insurance and ground lease payments. 2. Security deposits, leasing commissions and other lease-up costs. - 1-1
3. Capital improvements reserves. C. Financial covenants are now seen in real estate loan documents. 1. Limits on distributions to partners. 2. Maintenance of loan-to-value ratios. 3. Better and more frequent financial statements required. methods: 4. Enforcement of the financial covenants may be through several - 2- a. Higher interest rate b. No extensions c. No more advances d. Foreclosure? May not be helpful to the lender. II. It is still critical to negotiate major issues at the pre-commitment stage. When the loan documents have been prepared it may be too late to raise issues which could have been anticipated by experienced counsel. A. Many lenders use loan application forms which contain most of the major covenants and provisions which are to be included in the loan documents. B. Major issues to be raised early include: a. Exceptions to prepayment clause b. Exceptions to non-recourse clause c. Exceptions to due on sale clause d. Exceptions to due on encumbrance clause e. Exceptions to full environmental indemnity f. Form of borrower s counsel opinion g. Use of insurance and condemnation proceeds for rebuilding 2
h. Restrictions on leasing activity i. Relationship with tenants and use of subordination and non disturbance agreements C. Effect of securitization is to require conformity. D. Most lenders strongly resist rewriting of post default language or anything which would slow down the foreclosure process. III. Non-recourse protection for the borrower is still common although many exceptions to non-recourse are included. See Exhibit A for a sample non-recourse clause. A. The maker desires no liability as a credit matter, desiring to limit its losses to the property and not to prejudice its other developments or its personal assets. B. If the borrower is a limited partnership, where none of the partners has any personal liability, then all parties, including limited partners, may include a portion of such debt in the basis of their interest in the partnership. Such basis is important for purposes of determining the extent to which deductions, including depreciation deductions, may be taken by each partner. See Internal Revenue Code of 1986, 704(d) and 752(a). C. Lenders have had confidence in their underwriting practices and have been willing to grant non-recourse protection because they are relying upon the value of the security. D. Lenders have been hurt by the widespread use of the clause. 1. Many lenders believe that the lack of personal liability has encouraged borrowers to be reckless in workout negotiations. 2. The use of the non-recourse clause has allowed some borrowers to take the cash flow from the property or expose the lender to significant unanticipated liabilities. E. Lenders have been adding significant exceptions to non-recourse language in order to discourage certain practices by borrowers and may be expected to continue this practice. Some typical carve-outs, designed to reimburse lenders for any losses caused by certain conduct, are as follows: 1. Fraud or misrepresentation in the making of the loan. - 3-3
a. Restrict to intentional misrepresentations? b. Restrict to statements made in writing? 2. Misapplication of loan proceeds or insurance or condemnation funds released to the borrower for restoration. 3. Misapplication of tenant security deposits or prepaid rents (but did the lender have security deposits included as collateral?). 4. Misapplication of revenues from the improvements by not paying expenses of operation and maintenance or the indebtedness occurring after default or a period prior to default. 5. Liability under hazardous waste indemnities. In California, it should not release a borrower from a personal action under Cal. Code Civ. Proc. 726.5. 6. Failure to pay mechanics' liens, perhaps including subordinate liens. 7. Failure to pay taxes, assessments and/or utility charges. F. Some lenders provide for total recourse in the event certain covenants are breached as a method to control undesirable borrower conduct. 1. Violation of the due on sale and due on encumbrance clause. 2. Violation of the covenants regarding use of hazardous materials. 3. Resisting enforcement of the documents by the lender. 4. Filing for protection under bankruptcy laws. G. Drafting the non-recourse clause raises several issues. 1. Include the exculpatory language in the note and the mortgage or deed of trust. Many borrowers also want it referred to or quoted in the other loan documents. 2. Is the obligor released from liability for obligations in the mortgage other than the debt? See Smart v. Tower Land & Investment Co., 597 S.W.2d 333 (Tex. 1980); Heim v. Kirkland, 356 So. 2d 850 (Fla. 1978); Berks Title Ins. Co. v. Haendiges, 772 F.2d 278 (6th Cir. 1985). - 4-4
3. The lender should not be restricted from pursuing remedies such as obtaining a receiver. It may be necessary to name all parties in a lawsuit to do so. H. As borrower's counsel, should you object to any of these clauses? I. These matters should be negotiated at the commitment stage. It may be prudent to include in the commitment the entire non-recourse paragraph that will appear in the loan documents. J. The increased use of LLCs may make the clause less common. IV. Lenders usually restrict second mortgages and borrowers should consider requesting exceptions. A. Why do lenders wish to prohibit further encumbrances? 1. Increased risk of default by over-encumbering the property. unpaid. 2. Borrower may make payments on junior lien while senior lien goes 3. Makes modification and workout problems more difficult by requiring consent of junior lien holder to optional advances, term changes, interest rate modifications and other remedies. a. Language in a senior deed of trust securing any future advances probably will not give such advances priority over existing junior liens unless senior lender is obligated to make such advances. The issue should be addressed directly in a Subordination or Intercreditor Agreement whereby the junior lender agrees to the priority of optional advances and agrees to confirm such subordination from time to time upon the making of any such optional advance. b. Junior lender may argue that conditional advance is optional if senior lender makes the advance without requiring satisfaction of all conditions or during default. c. However, a junior encumbrance often provides an interested party willing to cure a default under the first mortgage. 4. The automatic stay of the Bankruptcy Code may prohibit a senior lender from foreclosing its lien if a junior lender files for bankruptcy. - 5-5