In an environment where real estate values are fluctuating and cash flows are difficult to predict, it is more important than ever to apply a comprehensive perspective when considering the purchase of real estate loans. Indeed, we believe it is essential for buyers to consider the following threshold questions before buying:
- What is the nature of the collateral? Is it, for
example, a mortgage on a hotel or a pledge of the equity of an
entity that owns a mixed-use project?
The answer to this question is important for numerous reasons, and involves analysis of potentially competing claims for the underlying asset and understanding the remedies available in the event of a borrower default. The loan buyer also needs to be comfortable with the realities of operating the underlying real estate if that buyer ends up controlling the property. Finally, COVID-19 may create opportunities for distressed investors, but it also will impact entire asset classes in ways that are still unfolding.
- Who are the relevant parties in
In addition to the borrower and guarantor (if any), relevant parties may include other lenders, the property manager, a cash management bank, major tenants, etc. Proper diligence will uncover the relative priorities of the various interest holders in the underlying asset. For example, does a major tenant have a right of first refusal on any transfer of the property, and if so, is there a carve-out for a foreclosure sale?
- What is the purpose of the loan purchase - loan-to-own
The answer to this question may impact, among other things, the lens through which the loan buyer's diligence is conducted and structuring considerations. For example, in an investment context, a creditworthy guarantor will give the investor comfort that funds are available to make the loan payments. By the same token, in a loan-to-own scenario, the existence of a creditworthy guarantor may decrease the likelihood that the loan buyer will complete a foreclosure process before the guarantor steps up and cures the loan default. From a tax perspective, mortgage and mezzanine foreclosures may create tax issues for offshore holders (who are subject to U.S. tax and filing obligations in connection with the ownership of U.S. real property), and consideration should be given to transfer taxes and other taxes payable in connection with a UCC or real estate foreclosure, conversion of debt to equity or other disposition.
- Is the loan distressed, and if so, to what extent is
borrower/guarantor cooperation in connection with the lender's
exercise of remedies to be expected?
Lack of borrower/guarantor cooperation will likely result in significant costs and delays in obtaining title to the underlying real estate asset. Even with a so-called "bad boy" guaranty and other sophisticated mechanisms in place, our lending clients have faced various defensive maneuvers by borrowers, including attempting to enjoin foreclosure, filing a voluntary bankruptcy, taking measures to destroy the bankruptcy-remoteness of the borrower entity and co-opting or ignoring the rights of independent directors. While these measures may ultimately prove to be catastrophic to a guarantor, they inflict considerable cost and delay, which can erode lender profits and prevent a lender from controlling its collateral until a later, and perhaps less desirable, phase of the market cycle.
- What is the extent of the legal and nonlegal diligence
to be performed?
The answer to this question depends on, among other things, the buyer's appetite for risk, the contemplated timing of the loan sale closing and the buyer's business plan. In many cases, there is not enough time to perform asset-level diligence to verify the current physical and operational condition of the property, and loan purchasers may end up relying on third-party reports from the loan origination. Some risk can be mitigated if the loan seller is providing representations in the loan purchase agreement, but many loan sales are on an "as is" basis, as described below. The question above, of investment versus loan-to-own, also affects the approach to diligence. Furtherore, a buyer may need to consider zoning and land use issues, for example, if the buyer is contemplating a redevelopment or change of use of the property after gaining control.
- Will the loan sale be on an as-is basis?
In an as-is sale, the loan seller is making very few, if any, representations. This means that information about the property, and many times about the loan itself, can be obtained only through independent verification. Loan buyers may "price in" this risk when bidding on a loan, but we note that loans may be offered for sale without a sufficient discount to account for the (still evolving) impact of COVID-19 or the general diligence risk of the investment. Another consideration in an as-is sale (in fact, in any loan sale) is whether the loan seller is retaining any interest in the loan as a co-lender, as a lender in another layer of the capital stack, as a participant or otherwise. A loan buyer may take some comfort in an as-is sale where the seller retains an interest.
- Is the loan fully advanced?
It is a very different situation to take on loan funding obligations, particularly in a construction loan context, as compared to the purchase of a fully funded loan. The loan documents must be reviewed to determine the extent of any funding obligations. Moreover, from a tax perspective, if the loan is not fully funded, future funding obligations may cause an offshore holder to be engaged in a loan origination business, which could subject the holder to U.S. federal, and possibly state, income tax on the investment, as well as to U.S. tax filing obligations.
- Is the loan nonrecourse, partially recourse or fully
In addition to the note above regarding whether a guarantor is likely to step in to cure a borrower default, the true value of a loan guaranty is dependent on the current creditworthiness of the guarantor. This issue can be mitigated if the loan seller is able to provide recent financial statements of the guarantor.
- What is the governing law of the loan
This is particularly important in determining how long it will take to secure title to the collateral underlying a distressed loan and what remedies can be pursued. We recently represented a client, which held both the mezzanine and mortgage positions, in its successful UCC foreclosure, overcoming the borrower's claim that the foreclosure clogged the equity of redemption. Loan buyers also need to be mindful of loan documents that provide for a different governing law, specifically with respect to the exercise of remedies. Finally, in situations where the exercise of remedies is imminent or ongoing, prospective buyers should seek counsel on the impact of COVID-19 on the exercise of remedies.
- Is a restructuring of the loan
A restructuring or modification of the loan could have material income tax consequences for the buyer of the loan. Regardless of whether the loan was originally issued with original issue discount (OID), the buyer of the loan at a discount could be required to include all or a portion of the discount in taxable income (i.e., pay tax without the receipt of cash) following a restructuring or modification of the loan to the extent the face amount of the restructured loan remains in excess of the buyer's cost. Alternatively, the buyer may be required to include such portion of the discount in income as OID as it accrues over the term of the restructured instrument. In addition, a restructuring could cause the loan to be recharacterized as equity for tax purposes. As noted above, that could be detrimental for offshore holders, and it would have significant tax consequences for domestic holders as well.
An overview of the considerations real estate loan buyers should keep in mind before finalizing a deal can be seen in this infographic.
Originally published JUNE 15, 2020
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.