How COVID-19 Will Transform Real Estate Loan Docs: Part 1

By Frederick Klein and Skyler Anderson
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Law360 (June 15, 2020, 6:00 PM EDT) --
Frederick Klein
Frederick Klein
Skyler Anderson
Skyler Anderson
In this two-part series, we will explore several provisions in loan documents that may be affected by the COVID-19 pandemic and provide observations on how borrowers and lenders may address them.

In part one, we will consider how the COVID-19 pandemic affects financial tests in loan documents, leasing covenants and prohibitions against additional debt. In part two, we will focus on the COVID-19 pandemic's impact on disbursement requirements in construction and other loans with a future funding component and on recourse carveouts.

While the real estate finance community (and everyone else) tries to cope with the unprecedented challenges caused by the COVID-19 pandemic, a few lessons we have already learned will be relevant as documents are negotiated for new originations. 

At least as of now, and from a macro standpoint, we can assume the following:

1. The ripple effects of the COVID-19 pandemic are still unsettled and it will take several months, if not years, and perhaps a second wave of infections, before a new normal becomes clear.

2. The real estate legal world, as we knew it, is experiencing rapid change. For example, consider how owners and occupiers will use space in the future, how courts (and public policy) will address the legal battles that will result from pandemic issues, and how due diligence and overall property underwriting will be affected.

3. Lenders will want to add new covenants, obligations and, potentially, liabilities, to loan documents in response to the COVID-19 pandemic and the lessons already learned.

4. Borrowers will respond to such new covenants, obligations and liabilities and respond — perhaps aggressively — to new provisions that appear in loan documents on account of the COVID-19 pandemic.  

In this series, we will focus on the fourth item. We will consider several key provisions in loan documents that we expect to be affected by the COVID-19 pandemic and provide observations on how borrowers and lenders will deal with them. While this article will focus primarily on issues related to the COVID-19 pandemic, many of the principles should apply equally to other short-term, uncontrollable and unanticipated challenges that might arise in the future — but that we cannot predict. 

Satisfying Financial Tests

One area that borrowers and lenders may need to address, and that has already become a contested issue, is whether there are implications for the loan if a particular tenant has gone dark, is operating or is open for business. While this comes up in a variety of contexts — for example, cash trap triggers, debt service coverage ratio, or DSCR, or loan-to-value, or LTV, tests, and, in some cases, defaults — let's consider the following example:

Net operating income, or NOI, a component in calculating DSCR or LTV, is based on revenues received from qualifying leases, which means, for our example, a lease that meets all of the following characteristics:

  • The tenant has taken (and is then in) occupancy;

  • The tenant has commenced business operations in the premises (which may include installation of tenant improvements and fixtures); and

  • The tenant is open for business and has not gone dark.

A borrower will argue that so long as the tenant is paying rent, why should the revenues generated under a lease be excluded from calculating NOI — especially when tests tied to NOI, when not achieved, can result in serious consequences, including failing to satisfy loan extension conditions and triggering cash traps or defaults. On the other hand, a lender will argue that a tenant ceasing operations or vacating its premises is a warning sign for potential bad news.  

There are certain exceptions to the operating requirement — e.g., sometimes lenders will exclude creditworthy tenants — and we acknowledge that this requirement is more important in retail properties where foot traffic is key to the success of the business.

Revisiting our example, consider how this type of requirement may have unexpectedly affected borrowers during the COVID-19 pandemic. Suppose that in a mixed-use property, most tenants were required by state or local law to suspend business operations for two months or longer, but that those tenants continued to pay rent. 

Under the loan documents, the borrower would likely fail an NOI test because the tenants are not open for business. This does not seem like the right outcome, for either lender or borrower. 

We believe this supports a borrower's argument that the mere fact a tenant is paying rent should count toward calculating NOI and satisfying other operating covenants and tests. A fair compromise, between the lender and borrower, could be to modify the language to provide that tenants have gone dark or ceased operations permanently.

One more aspect of this deserves some attention, due to laws or directives now in place in various states and cities: How should lenders account for deferred, as opposed to forgiven, rent? Should the deferred amounts count toward calculating NOI, even though there is no revenue at the time the calculation is being made?

While this may be a more challenging issue for a lender, it's fair to ask whether the borrower should be punished because the tenant was complying with applicable law. Allowing a borrower to recognize those revenues when they are due — and not when they are received — would help avoid the anomalous result of inflated NOI in the future when the tenant repays the deferred rent.

Leasing Covenants; Compliance With Applicable Law

Loan documents almost always allow the lender to establish leasing controls, particularly in the office and retail contexts. These provisions take many different forms, and typically, borrowers have less flexibility with major leases — i.e., leases that have a material impact on the property's operations, often based on square footage, and in some cases, related to specified credit tenants. 

The borrower is often required to obtain the lender's consent to execute, amend or terminate a major lease. Even aside from covenants limited to major leases, there are often general covenants relating to any type of leasing that, prior to the COVID-19 pandemic, did not generally worry borrowers. Examples are covenants requiring the borrower to continually enforce the tenant's lease covenants or prohibitions against amending any lease as to "change the amount of or payment date for rent due under the lease."

Borrowers are also separately required to comply with legal requirements applicable both to the property owner and to the property.

Now consider those covenants in the COVID-19 pandemic context, where tenants are not only asking for rent deferrals, but are being granted the legal right to defer rental payments for a specified time period — and in many cases, tenants are unilaterally deferring rent without their landlords' acquiescence. There are also numerous state and local ordinances that restrict a landlord's right to exercise remedies against tenants who do not pay rent. 

This unprecedented situation creates friction between what the law allows and what the loan documents require. We think there is a reasonable argument that complying with applicable law should prevail over other contractual covenants related to leasing, and we are unaware of any pandemic-inspired ordinances that prohibit lenders from notifying tenants of literal defaults under the loan documents. We will be watching for this as state and local governments continue to enact legislation and issue executive orders.

We would be surprised to see courts sympathize with opportunistic lenders and we hope that public policy and common sense prevail over the black letter of the contract. Nevertheless, because we are in uncharted waters, borrowers may consider requesting exceptions to leasing covenants if compliance would conflict with local or state law or directives.   

Additional Indebtedness

Lenders typically prohibit borrowers from incurring additional indebtedness, even if the security for that indebtedness is subordinate to the lender's mortgage. Violations of these restrictions typically have severe consequences — such as automatic defaults (with no notice or cure periods) and recourse to guarantors. Prohibitions against additional indebtedness are often camouflaged in single purpose entity covenants, sometimes as an indirect recourse event that may not be apparent to even the most careful borrowers and their attorneys.

Restrictions on additional indebtedness make good business sense, and also mitigate certain legal risks, so we are not going to try to argue against this very settled convention, at least in principle.

Lenders sometimes permit borrowers to incur a small amount of unsecured debt without the lender's consent, subject to certain restrictions — e.g., amounts not to exceed a small percentage of the existing lender's loan amount, not evidenced by a promissory note, not outstanding for more than 60-90 days. In light of current events, borrowers are encouraged to ask for greater flexibility, and preapproval, for certain additional indebtedness, in certain scenarios.

Congress enacted the Coronavirus Aid, Relief and Economic Security Act in response to the COVID-19 pandemic. The CARES Act established the Payroll Protection Program to help small businesses maintain their levels of employment through the pandemic. A few relevant features of the PPP loans include:

  • PPP loans are potentially forgivable if used for certain permitted purposes;

  • PPP loans were made available on a first-come, first-served basis and many applications were denied, at least in the first round, when the businesses delayed completing the applications, even for a few days; and

  • No collateral was given, no liens were created and no personal guarantees were required as security.

Apart from the question of whether a borrower is eligible for a PPP loan (and we acknowledge many real estate companies may not qualify), we encourage borrowers to ask lenders to allow these types of loans without the need for the lender to consent. Because the funds available under the PPP were depleted soon after the CARES Act was enacted, many borrowers could not risk waiting for lender consent before submitting applications.

We therefore encourage borrowers to ask lenders for a new exclusion for loans that do not require any security, and if either (1) the loans are forgivable by their terms or (2) the program will expire within a short time. If a lender is unwilling to add these or similar exclusions, then at least the lender may agree that obtaining loans of this type, without the lender's consent, would not result in recourse liability or a default.


While both borrowers and lenders are coping with unique issues that the COVID-19 pandemic has presented, everyone is encouraged to apply the lessons we are learning to seemingly routine language in loan documents. 

Correction: A previous version of this article misspelled author Frederick Klein's first name in the byline. The error has been corrected.

Frederick Klein is a partner and Skyler Anderson is an attorney at DLA Piper.

The opinions expressed above are those of the authors only and do not necessarily reflect the views of the firm or any of partners or other lawyers. This article is for general information purposes and is not intended to be and should not be taken as any form of legal advice.

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