While much attention has been paid to the struggles of businesses, such as restaurants and retail establishments, to survive the economic downturn wrought by the COVID-19 pandemic, those who lend to such businesses for the purchase of real estate are also dealing with the fallout.
Every real estate loan payment missed by a borrower puts lenders in a more precarious financial position. Even borrowers who remain current on their loan payment obligations may find themselves in default, as lower property valuations result in borrowers failing to meet debt yield, loan-to-value or similar financial covenants.
While the economy in Michigan and across the country is reopening in fits and starts, it’s by no means “business as usual.” Economic woes are likely to continue, which means that lenders will be forced to deal with more financially distressed borrowers. In some instances, this means the possibility of foreclosure. In others, this means dealing with debtors in bankruptcy, as evidenced by a recent surge in bankruptcy filings. According to data from Epiq Systems, commercial Chapter 11 filings were up 48% in May as compared to May 2019.
However, more often, loan defaults by borrowers, and the possibility of future defaults due to financial distress, are dealt with outside of foreclosure or bankruptcy. In many cases, a lender is better off working out a deal that keeps a debtor in the property and running its business, so that it can work through the distress and remain solvent. The potential for recovery via foreclosure or bankruptcy is often limited—not to mention the costs associated with such processes are often steep, and with widespread court closures, any judicial action may be curtailed.
One of the primary tools lenders can use to accommodate distressed borrowers, while preserving their own rights and remedies, is a forbearance agreement.
In a typical forbearance agreement, the borrower acknowledges that it has defaulted on its obligations, and the lender agrees that it will refrain from exercising its remedies for such defaults as long as the borrower performs or observes the new conditions set out in the forbearance agreement, and, by a certain date, cures the defaults. A lender who forbears from enforcing remedies does not waive defaults, but rather grants a borrower time to work through its issues.
A forbearance agreement is best suited for situations where the lender has assessed that the borrower’s struggles are short term and will improve. Given that conditions for many borrowers will improve as the economy reopens, forbearance agreements will likely be widely used by lenders in the coming months.
While every forbearance agreement is customized to address a specific scenario, most contain common provisions, including:
- Forbearance Period: The forbearance period is the period within which the lender will agree to forbear from exercising its default remedies under the loan agreement. The forbearance period typically lasts for a specified period of time (e.g., 120 days), subject to early termination by the lender if the borrower defaults in its obligations under the forbearance agreement.
- Borrower Acknowledgements, Reaffirmations, and Waivers: Borrowers are commonly required to acknowledge and affirm key terms, representations and warranties from the existing loan agreement in the forbearance agreement. These may include waiving defenses, acknowledging amounts due under the loan, and affirming the validity of the lender’s lien, among other things. Lenders also typically condition their agreement to forbear on the borrower waiving claims against the lender based on the loan documents and dealings between the parties taking place prior to the execution of the forbearance agreement in order to avoid lender liability claims.
- Agreements as to the Financial Terms of the Forbearance: A forbearance agreement will address financial terms, such as the interest rate the borrower will pay during the forbearance period, which may be different from the original interest rate under the loan documents. Additional terms may include the amount of any forbearance fee payable by the borrower, a reduction to the lender’s commitment to extend additional credit, reduction of overadvance or overformula balances, and any deferral or modification to the debt service payment schedule.
- Additional Reporting: During the forbearance period, a lender may request reporting information in addition to what is required by the existing loan agreement. Such information may include the borrower’s cash flow status and expenses, weekly business updates from the borrower, and access to the property for inspection.
A forbearance agreement can benefit both a borrower and lender. A borrower is given time to work out its business issues or attempt to sell or refinance the property, and a lender can shore up its position by addressing deficiencies in the original loan documents and negotiating more favorable terms as described above, and hopefully avoid having to exercise foreclosure or other default remedies under the loan agreement. For some borrowers, foreclosure and/or bankruptcy may be inevitable. But commercial real estate lenders are often well-served by pursuing a forbearance agreement in order to better align the interests of lender and borrower during the borrower’s recovery period.