Publications & Resources

July/August 2010
Regulatory Changes & Restructuring

Prudent CRE Loan Workouts: A Best-Practice Approach

By Richard K. Hollowell

Financial regulators realize that banks face significant challenges when working with commercial real estate borrowers that are experiencing diminished operating cash flows, depreciated collateral values, or prolonged sales and rental absorption periods. They also understand that replacement loans may not be available for many months to come, and that well over $1 trillion of bank CRE loans are set to mature over the next four years. At the intersection of these issues is the banks’ need to prudently restructure loans in a manner which will enhance prospects for full repayment, through a re-underwriting process calling for extensive documentation and research.

On October 30, 2009, financial regulators adopted a Policy Statement on Prudent Commercial Real Estate Loan Workouts (the “Policy Statement”). Although intended to be a tool for bankers faced with loan restructuring challenges, many community banks have been slow to focus upon the loan management, documentation and re-underwriting guidelines discussed in the Policy Statement, a condition which will invite significant regulatory criticism during the bank examination process. In the Policy Statement, it is crystal-clear that banks are expected to back their workout decisions with a significantly higher level of underwriting documentation; most particularly, in the areas of collateral valuation, the financial condition of the borrowing entity and guarantors, and feasibility of forward-looking operating projections. This article will focus on “best practices” attendant to collecting and analyzing the information which will form the foundation for workout decisions.

Whether the bank is challenged with a maturing loan or a CRE loan default, the Policy Statement requires loan officers to painstakingly dig for information on the borrower, guarantors, and collateral property; thereafter, employing review techniques which will generate the documentation and facts upon which a well-documented workout plan is underwritten. Today’s “best practices” include:

Enhanced Data Collection

Personally interview the borrower’s general partner and/or appointed representative and all guarantors;
Personally interview the borrower’s/guarantor’s accountants to discuss the integrity of financial statements, and other bankers to discuss deposit accounts and borrowing relationships;
Personally interview property managers, leasing agents, or sales agents assigned to the collateral property;
Obtain and analyze asset and lien searches on all guarantors;
Obtain and analyze updated appraisals, review appraisals, and third-party broker’s opinions of value;
Obtain and analyze financial statements, annual sales statistics, and inventories of key tenants (low sales or inventory levels are early signs of a possible tenant default);
Research the market to determine if competing properties are financially suffering and/or faced with foreclosure;
Consider the standard of living and marital status of guarantors, remembering that lavish lifestyles and divorces drain assets;
Obtain current financial statements with full documentation as to cash accounts, brokerage accounts, and surrender values; also request third-party valuations of personal property, collectibles, and real estate;
Review sales and/or leasing records for the collateral property, examining historic performance and future sales/lease rollover risk;
Obtain re-certification of your Phase I Environmental report and commission a physical needs study if your site inspection reveals even the smallest level of deferred maintenance (require that all deferred maintenance be corrected as part of the loan workout);
Obtain borrower’s projection of property cash flow, making sure that cash flow is sufficient to validate the borrower’s loan-exit assumption.

Although the data collection and documentation practices outlined above may sound like “overkill”, avoiding examination criticism is of paramount importance in today’s environment. Remember, the cost associated with re-underwriting the loan should be borne by the borrower; so demand that the borrower pay for all new reports, including your underwriting fee.

Critical Documentation Review

As the borrower will feel burdened with the cost and time necessary to collect data sufficient to prudently underwrite the workout, so too should he feel burdened by the bank’s forensic review of documentation and testing of cash flows needed to ultimately repay the loan. Remember, the borrower failed to pay the loan as agreed, so don’t be soft in your analyses.

Critically assess the borrower’s ability to fund cash flow deficits; particularly, money needed for deferred maintenance, tenant finishes, leasing/sales commissions, physical needs, emergencies, and, of course, principal, interest and taxes. Demand that the borrower fund reserve accounts before closing the workout.
Be cautious of jointly-held properties and cash accounts; highly discount the value placed on properties where guarantors do not hold a majority interest.
Examine the financial viability of closely-held corporations and be sensitive to the level of debt burdening these companies.
Understand what property level and market changes have occurred since the loan was originated; make sure the borrower’s forward-looking projections are not reliant on positive changes to the national or local economy.
Tie representations made on financial statements to most recent tax returns.
Test every assumption contained in the borrower’s projections; if assumptions are not supported, make adjustments. Bank examiners regularly test and adjust assumptions, so make sure your workout is based on operating projections that are reasonably achievable.

Quick “Rules of Thumb”

In devising your workout with the borrower, remember:
Only close a loan workout that you are convinced has a very high chance for success; bank examination teams will identify flaws if you don’t.
Keep loan extensions as short as possible for non-institutional grade properties.
Re-margin the loan requiring cash, collateral, or additional guaranties; “sweep” cash during the extension period.
Beef up loan administration practices, testing operating budgets and debt service coverages monthly; monitor changes to borrower / guarantor financial condition not less than quarterly; don’t be afraid to declare “technical or monetary defaults” to keep the borrower’s attention.
Place the burden of all third-party appraisals and reports on the borrower, and charge a loan re-underwriting fee and appropriate discount points as part of the workout formula.

Above all, as discussed throughout the Policy Statement: Be Prudent.

Richard K. Hollowell is managing director – national real estate practice leader for BBK. He can be reached at 213-631-6116 or rhollowell@ee-bbk.com.