In today’s ever changing economic landscape, many commercial real estate lenders and borrowers are feeling COVID-19’s impact, and strategic investors are realizing there are burgeoning opportunities to acquire both performing and distressed debt instruments. When purchasing a single or a small portfolio of commercial real estate loans (as distinguished from a large portfolio which has distinct considerations), the prospective purchaser must perform extensive due diligence on many aspects of the loan, including the loan documents, the borrower and its organizational structure, the sponsors, the guarantors and the underlying real estate and related personal property collateral for the loan. The period in which a prospective purchaser has to evaluate diligence matters is often short, with most if not all materials for evaluation coming from the selling lender (with little or no contact permitted with the borrower). The ability of a prospective purchaser, and its counsel, to efficiently evaluate such diligence information and to know what questions to ask and what information to look for is critical for the successful negotiation of the loan purchase for many reasons, including the identification of gaps in the diligence materials that need to be covered by seller representations, warranties and indemnities. As will be addressed further in a subsequent installment of this series, the breadth of the representations and warranties a seller may be willing to provide will also be dependent on whether the seller originated the loan and whether the loan is a distressed asset in, or in danger of, default.
If you are a prospective purchaser of a real estate loan, the following is a high-level overview of certain important diligence tasks and analyses that should be considered and evaluated, and about which a loan seller should expect you to inquire.
The Loan Documents:
- Thoroughly review the loan documents, including any amendments, modifications and side letters to develop a full and complete understanding of the agreed terms. Consider asking your counsel to abstract the documents to present a high-level view of important business and legal matters.
- Confirm that the business terms reflected in the loan documents, including the loan amount, interest rate, amortization schedule, prepayment restrictions, maturity date, ongoing financial covenants and other material terms are consistent with the representations made by the loan seller.
- There are numerous questions you should ask in connection with a complete due diligence review, including:
- In addition to the real property collateral, what other collateral secures the borrower’s obligations under the loan documents? Are there specified furnishings, equipment, accounts, rights under management agreements, condominium declarations, CC&Rs or other contracts, or if the borrower is a single-purpose entity, does the collateral encompass all of the borrower’s assets?
- Are there any unfunded holdbacks of loan proceeds that you will be liable for after closing and what are the conditions to the lender’s obligation to make disbursements of those proceeds?
- Are there any reserve or escrow account requirements, and if so, what is the amount and the status of such reserves and accounts and what are the conditions to lender’s obligation to make disbursements from these reserves?
- Is the loan recourse or non-recourse to the borrower, and if it is non-recourse, are there any “bad-boy” non-recourse carve-outs? What other guarantees, if any, have been provided by the guarantors (e.g., payment, debt service and carry, completion of construction and environmental)? Are there any custom guaranties to address deal specific risks with respect to the borrower or the property? What, if any, limitations such as liability caps or burn-offs are placed on the guarantor’s obligations?
- Is there any form of cash management in place? Is there any lockbox arrangement in place?
- What rights and remedies, if any, are held by co-lenders, senior lenders or subordinate lenders?
- Is the loan cross-collateralized or cross-defaulted with any other loans?
- Does the borrower have any rights to transfer the underlying collateral and is the loan assumable by the property purchaser? What rights do the people and entities owning a direct or indirect interest in the borrower have to transfer their interests?
- Was a typical enforceability opinion delivered to the originating lender at the closing of the loan by reputable legal counsel?
- Check the loan documents to confirm whether the borrower is required to deliver an estoppel certificate upon the lender’s request. If so, closing of the loan acquisition should be conditioned on receipt of a clean estoppel executed by the borrower in favor of the purchasing entity and its successors and assigns. A comprehensive estoppel prepared by experienced counsel can address a host of uncertainties, including potential defaults and borrower claims, status of the borrower, including any changes in its ownership structure since origination, property-related issues, and questions regarding litigation and bankruptcy risks.
- The loan payment history and loan file can also be a source of important information about the borrower. If not provided, be sure to request a detailed accounting of the borrower’s payment history and consider having the selling lender make representations and warranties as to the outstanding balance of the loan, the status and amounts of any holdbacks, reserves and escrow accounts, and whether any defaults or events of default have occurred in the past and/or currently exist. If there is any history of defaults (or current defaults), confirm whether the lender notified the borrower of the default, delivered a written acceptance of a cure and/or commenced the exercise of any remedies. If remedies have been commenced, all actions taken by the lender should be thoroughly evaluated by counsel, especially any pending litigation against the borrower or guarantor.
- Review copies of all organizational documents, including an organizational chart, of the borrower and its constituent entities that are located in the loan file to confirm that the ownership structure and control rights are as expected. Updated good standing certificates and certified copies of the formation documents filed with the applicable Secretary of State should also be obtained. Request a current organizational chart of the borrower to confirm whether there have been any changes in the borrower’s ownership structure since origination.
- If there is a single-purpose Delaware limited liability company structure, confirm whether the borrower’s operating agreement provides for springing members, and for larger loans, one or more independent directors.
- Is the borrower required to be a bankruptcy remote single-purpose entity, and if so, does its operating agreement contain single-purpose entity covenants that track those in the loan agreement?
- Request copies of all borrower financial statements, reports and tax returns from the loan file to assess the borrower’s financial health.
- Obtain current litigation, bankruptcy, judgment and lien searches with respect to the borrower to determine if there are any outstanding tax or UCC liens (other than in connection with the loan), open litigation matters, judgments or bankruptcy filings and consider obtaining credit searches.
- Check the loan file for legal opinion letters related to the borrower, including standard entity opinions, Delaware single-member limited liability company opinions, and for larger loans, a non-consolidation opinion.
- As with the borrower, if the guarantor is an entity, review copies of all organizational documents, including an organizational chart, of the guarantor and its constituent entities that are located in the loan file, and order updated good standing certificates and certified copies of the formation documents from the applicable Secretary of State. If the guarantor is an entity, request a current organizational chart of the guarantor to confirm whether there have been any changes in the guarantor’s ownership structure since origination.
- Request copies of each guarantor’s financial statements, compliance certificates and tax returns. A thorough analysis of these materials can confirm the status of the guarantor’s financial health and whether the guarantor is in compliance with any net worth, liquidity or other financial covenants contained in the loan documents.
- Obtain current litigation, bankruptcy, judgment and lien searches with respect to the guarantor to determine if there are any outstanding tax or UCC liens, open litigation matters, judgments or bankruptcy filings and consider obtaining credit searches.
- Check the loan file for typical entity opinions on each entity guarantor.
- Obtain a current appraisal of the property to verify that the value supports the proposed purchase price for the loan.
- Evaluate all of the property diligence materials provided by the loan seller, such as a property condition report, soils report, geotechnical report and Phase I (and if applicable, Phase II) environmental reports, and consider whether it is necessary, and if it is feasible, to obtain updates of such reports. If any issues were disclosed in reports delivered to the lender at origination, determine whether the resultant risks to the lender were adequately addressed (e.g., by environmental insurance requirements, covenants, reserves for replacements, immediate repairs, environmental remediation and/or other uses, additional non-recourse carveouts, etc.). Confirm whether third-party reports run to the selling lender’s successors and assigns. If not, consider updating reliance letters from the third-party report provider.
- Review the selling lender’s existing loan policy of title insurance, a recent title report and copies of all exception documents referenced therein. If the existing title coverage is acceptable, obtain a commitment from the title company to issue an endorsement that identifies the purchasing entity as the new insured. Alternatively, consider obtaining a title commitment for issuance of a new loan policy of title insurance.
- Review the existing survey of the property and confirm that the certification runs to the selling lender’s successors and assigns. If there have been changes to the footprint of the improvements located on the property since origination, and if feasible, consider obtaining a new survey.
- Review any zoning letters, opinions or reports contained in the loan file and consider whether it is necessary to have such materials updated.
- Review copies of all existing leases, including amendments, and consider asking your counsel to abstract them to confirm the business terms and highlight any problematic provisions, such as tenant purchase rights.
- Request a current rent roll, and subject to the borrower’s obligations under the loan documents, estoppel certificates from all commercial tenants at the property. Evaluate the financial condition of any major tenants and investigate whether there are any current or past lease defaults or tenant/landlord disputes and whether any major tenants have commenced or are at risk of bankruptcy.
- If the loan is secured by a ground leasehold interest, take particular care in reviewing the terms of the underlying ground lease, including the mortgagee protections, as well as any ground landlord estoppel delivered to the selling lender at origination. It is also essential to require a new, comprehensive estoppel certificate from the ground landlord as a condition to closing of the acquisition.
- With respect to any CC&Rs, REAs, condominium declaration, SLUR or similar document encumbering the property, consider requesting estoppel certificates from the relevant parties under each document to confirm that the property, the borrower and the other parties subject to such document are in compliance with their respective obligations.
- Evaluate the borrower’s insurance to determine whether it satisfies the requirements of the loan documents and is otherwise sufficient under current conditions.
This outline of key diligence matters is intended to give the prospective loan purchaser a framework for thinking about the myriad of issues and risks that must be investigated before proceeding with an acquisition, but each individual loan can have numerous additional nuanced issues that require thoughtful analysis by experienced legal counsel.