Law360 (September 9, 2020, 5:13 PM EDT) -- In this edition of Coronavirus Q&A, Ervin Cohen's real estate co-chair discusses the challenges lenders face when it comes to underwriting loans amid the pandemic and also addresses the difficulty of staying on top of the numerous government regulations that vary by location in California.
Valencia shared his thoughts as part of a series of interviews Law360 is doing with lawyers to discuss the ways the pandemic has affected businesses and created new legal questions.
This interview has been edited for length and clarity.
Let's start by talking about the commercial real estate finance markets. What are you seeing right now in terms of access to financing?
Interest rates are low; that's the good. The bad is that underwriting is extremely conservative to a point that it's almost impossible to get financing put in place. What I've seen is, deals start, and then they basically stop while the lender runs through multiple layers of additional underwriting.
I have every reason to believe that these loans will get extended. Actually, a good number of them are refinancing. And so there's no technical deadline on them. Except there have been a couple where they're refinancing out a maturing loan, and so that's created more issues, but the lenders have been extremely conservative in their underwriting. So, if you can get the loan, I think you're in good shape because interest rates are pretty competitive. The hard part is actually getting over the underwriting hump, if you will.
Do you represent both borrowers and lenders on these discussions?
Usually borrowers now, but I used to represent a lot of lenders previously. I still end up on the lending side periodically. We will do a handful of those. I've done maybe two in the last six months on the lender side.
What are the biggest concerns that you're hearing from your borrower-side clients right now as they try to work out these disputes with their lenders?
I'll answer it in two different stages. One is if there's a new purchase — which are still happening, just happening much more slowly — and we intend to get financing, the concern is: How fast will the lender get comfortable with underwriting? So what we've been doing, and what I think is definitely a trend, is that we're ending up with much longer time frames for due diligence and closing. I have a couple of deals in process. Normally, in a standard deal, you have 30 days for due diligence and 30 days to close. Now I'm ending up with 60 days of due diligence and frequently 30 days to close, but an option to extend for an additional 30 days, usually with some additional extension payments or closing extension payments. And the reason for that is because everyone is recognizing that the lenders are taking longer to pull the trigger and say that they've signed off on the loans. So that's for a new purchase. That's the concern that the buyers and borrowers have, is that lenders are just taking a long time to get comfortable. That's one.
The other flavor is where you have an existing asset where a borrower owns a property and it already has a loan on it, but they're refinancing it. So they're paying off the existing loan to put a new loan in place, and even that's broken up into two pieces. One is where you're coming up on a maturity, which we've been dealing with. And then there's others where there's no real maturity coming, but the asset is in a position where you should be able to get better financing, right? Meaning that the initial financing was probably based on a lower-valued asset, probably because the leasing hadn't taken place. The property was purchased and there were renovations taking place, and the occupancy rate was lower. And then the natural procedures are you fix up the property and you let the asset, probably reletting it at higher rents. Now the property's worth more and you should be able to refinance it for lower rates.
And there's definitely a conservatism in the way that lenders are underwriting, too. They're being very deliberate and careful. And I'm not saying that that's wrong. I'm just saying that that's the reality of what's happening from a borrower and lender's standpoint. On the lender side, we've been in situations where we couldn't get appraisals because people wouldn't go out to the property [because of the pandemic]. One was a shopping center, and the appraisers — this was earlier, in the March-April time frame — we could not find an appraiser who was willing to go to the property, which is pretty astounding.
So is part of the cause for delay perhaps an understaffing on the lender side, too? I know that special servicers found that they were understaffed to handle the uptick in work, and so special servicers have been on a hiring spree. Do you think lenders are also understaffed and trying to hire more folks?
Yeah, probably. Even if they're not understaffed, let's say they have enough head count, it might be that the people they have are just not as available. It seems as if there's a lower responsiveness from the standard employees, the lender personnel. And, again, I think anecdotally, I'm obviously guessing here, but it probably stems from the fact that many people are working from home and they have split responsibilities, right? They're probably trying to take care of a bunch of stuff on the domestic front, including child care or taking care of elderly parents and what have you. And if they're doing that plus trying to do their job, it's not surprising that they're moving a little slower. And to your point about the special servicers, many lenders outsource a good portion of their operations to servicers, right? So I would agree with your point that the servicers don't have enough people. There's an uptick in work, not just in workouts, but actually in work like getting a payoff demand in a refinancing scenario, and those are taking forever too. And effectively, all they have to do is look to see what is the applicable interest rate and when do we expect the payoff to happen. Those normally don't take that long.
You mentioned changes in underwriting. What specifically are you seeing in terms of underwriting right now?
[Lenders are] definitely taking a smaller loan-to-value [ratio] because you're just trying to make sure that there's enough equity in the property, so they're being careful about that. But even if there's not an explicit reduction in LTV ratios, there's definitely a closer look at the underlying assumptions. So, I touched on this a little earlier. For example, underwriting is frequently based on the cash flow of the property. And it's not just cash flow, but cash flow plus some sort of factor that's applied based on the creditworthiness of those tenants, right? Which makes sense. It's like if you have a tenant who is paying a lot of rent, but is a brand-new company and is going through a huge expansion, they're probably going to fare less favorably in this environment than would a creditworthy tenant that's been there for a long time. I've been dealing with properties with creditworthy tenants in the health care space, which, as you can imagine, has been pretty resilient in this environment because health care is still very much useful. And in properties where this is their headquarters — meaning that the chances of that tenant going out is very low — lenders are looking very closely to understand those leases and making sure that those tenants are going to be there in the immediate and presumably the long term.
Let's broaden the conversation to your real estate practice as a whole. I'm curious to hear what sort of questions you're getting from clients these days.
We're full-service, so we represent clients in all aspects of real estate. Actually, for that matter, as a firm, in all aspects, pretty much. So we have many who are property owners, who are negotiating on two fronts. Workouts that are taking place both at the tenant level, because depending on what kind of asset we're talking about, it very much depends on what kind of tenants we're dealing with — many, almost all tenants are undergoing some degree of stress, right? Industrial is probably the safest, and then office is probably the next most attractive in terms of tenants, because they're continuing with operation. And then you have the other end of the spectrum where you have retail and, for example, gyms. We have clients who have fitness centers or gyms that are in their property, and normally [the gym] would be considered to be a strong anchor tenant. You know, you think about a gym, the great thing about them is they're just moneymakers, right? They sign people up, and then people don't even go to the gyms, statistically. Pre-COVID, the underwriting on a gym tenant, especially the name-brand ones, you would view that very positively. Now it's been completely inverted, because people can't open, and when they can open, patrons don't want to go. So there are a lot of issues there. So, broadly speaking, we're getting a lot of questions about what is a fair workout with a tenant. And, you know, what do you do with tenants who are experiencing financial duress and what's the best way to deal with that.
For those clients who own those properties, fortunately I think a lot of them are trying to be fair, but they also need to get justification from their tenants as to when they're giving various concessions. Because, let's face it, there are parties out there — including tenants — who are being opportunistic and seeing this as an opportunity to just try to get benefits that they may not even really need. And so there's a whole host of questions that fall within how you appropriately deal with tenant requests for some sort of concession and so forth. That's one big body of issues that we're dealing with, and what stems from that frequently are various lease amendments to accommodate, and workout deals with those tenants.
Then on the flip side, for those owners, they of course have to answer to their investors. They have to explain why they're giving various concessions and so forth. It's prudent for them to be methodical in the way that they review a request for rent concessions and so forth. But on top of that, besides their investors, of course, many have leverage, so they have lenders who are expecting to get paid on their loan. So there are workouts on that end when you're a property owner. The real pinch comes on properties where you have tenants who are largely and justifiably unable to pay their rent, because, to use that extreme example of a gym or a bar, in those situations those tenants are not able to pay their rents and they're not making that up. They're just not able to do it. And then you have lenders who are expecting to get their debt service payment. So, you have to go to the lenders and explain to them why. What's going on with the property and what you can do in order to reach some sort of equilibrium in the interim until these tenants get back on track and so forth. And so that's a whole separate and complicated negotiation as well.
What's been your reaction to the response and actions of lawmakers in California?
That's a big one. Our practice is national, so we've dealt with it on multiple fronts, but of course we're based here in California. I would say, generally speaking, it's been very difficult because the criteria differs from jurisdiction to jurisdiction, right? From city to city, definitely from county to county. Let's say we're speaking a little more specifically about Southern California. What you're seeing is that the criteria is different in each place. And so when the tenants come, like I was mentioning before, you're trying to understand what their situation is. It's not straightforward. It's frequently hard to understand what those tenants are able to do and what they're not able to do, and you feel for those tenants. But it's also hard on the property owners because you own your property in, let's say, LA proper, Santa Monica, El Segundo. And different rules apply in and all those places. And the overlapping criteria, the moratorium on evictions and so forth, I understand the motivation, but what would have been a lot easier I think for all parties would have been if there could have been some standardization as to what actually applied in those situations.
And then we represent business operators too who are tenants at these properties, and they have the flip-side concerns, where they can't pay their rent or various things happen as well. In those tenant situations, they have complications too because they can't generate revenue. In terms of COVID, they can't generate revenue because they can't operate. And then they have to answer to their landlord.
I have a restaurant that was mid-process, mid-construction. That was complicated because they have construction lending as well. So they have to answer to their lender and say, 'Look, we're doing our best here and we're being diligent and prudent. We're being good, right? But we're in a bad spot, because how do we pay our landlord and how do we pay to you, the lender, and how do we pay the contractors who are doing the work on the buildout?' It just messes up all of the projections on pro formas. Pro formas are imprecise to begin with. But think about a restaurant. It's hard right now. People don't know what they're going to be able to generate, and should they change their construction plans to make it so that it's outdoors, for example. A lot of considerations are going into that as well.
--Editing by Alanna Weissman.
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