Emerging Issues in Commercial Real Estate Financing, Contributed by Stuart M. Saft, Dewey & LeBoeuf

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Borrowers and lenders, having survived the Great Recession and now facing the possibility of another recession with both the federal government and real estate owners and lenders having significantly fewer tools with which to deal with it, are attempting to avoid the costly mistakes of the past. Among the victims of the Great Recession were many sophisticated lenders and investors whose deals collapsed because the structure and documentation did not anticipate events. Between the continued absence of the securitization market, the moribund recovery, the limited available assistance from the federal government, debt stacks with multiple levels of senior and mezzanine debt, and the cost and complexity of new governmental laws, regulations, and mandates emanating from Dodd-Frank, there are tremendous hurdles facing anyone involved with commercial real estate financing. Moreover, a major obstacle in commercial real estate financing is structuring a transaction to contain a mechanism to deal with an unpredictable economy and constantly changing laws and regulations. The following are issues that need addressing to ensure the viability and availability of commercial real estate financing.


Certainly one of the biggest problem facing commercial real estate finance as well as the economy in general is the effect of the new legislation and regulations that change the rules after the loans have been made. The ability of Congress to enact legislation that attempts to solve a specific problem without considering the effect of the legislation on the economy repeatedly triggers the law of unintended consequences and creates uncertainty for lenders.

In a way, an antecedent to the Great Recession was The Tax Reform Act of 1986,1 which was intended to eliminate tax shelters that were costing the federal government several billion dollars a year in deferred income taxes. However, the retroactive application of the law, which was required to make it revenue neutral, resulted in a disincentive for investors to continue paying for real estate investments, thereby leaving the savings and loan associations (S&Ls) that financed much of the real estate development on the hook for the loans they had already committed to make. The S&L crisis led Congress to enact the Financial Institutions Reform and Recovery Act2(FIRREA), which changed the appraisal standards and created the requirement for mark-to-market regulations that further undermined the banking industry, leading to a federal bailout costing a half trillion dollars and the Resolution Trust Company dumping real estate on the market, which eroded property values. When banks and S&Ls stopped making loans, the securitization market was born to fill the vacuum. In addition, Congress reacted to fraud by five companies,3 by enacting the Sarbanes-Oxley Act,4 which increased the accounting cost to business by multiples, made business less efficient, and chased the capital market abroad. In addition, who can forget that prior to Fannie Mae and Freddie Mac being taken over by the federal government, it was Congress who put pressure on them to buy non-conforming and no-income verification loans and, when the subprime market began to implode, it was Congress who insisted that Fannie Mae and Freddie Mac step in and buy the loans. This all led to the Dodd-Frank Act,5 which has just begun to stifle lending and the recovery.

In a global economy where the United States is no longer the only global economic superpower, business needs to be flexible in order to compete and Congress has to consider the unintended consequences of the actions it takes. For that reason, just as no real estate development occurs without an environmental impact statement, no legislation should be enacted without an Economic Impact Statement (EIS). Rather than just examining the revenue cost to the government of the legislation, the EIS would examine the economic impact on the country’s economy. If Congress then wants to enact the legislation and the president wants to sign it, that is fine, but at least they will understand the cost in money and jobs. Hopefully, this will also demonstrate to investors and lenders that the playing field is going to be stable for a while and therefore the risk of change abated.


In the event the borrower defaults in paying the senior debt, some or all of the mezzanine lenders will be required to structure a workout. Under those circumstances, the less senior mezzanine lender would be forced to find a solution for the property’s problems, which could include: (i) refinancing the senior debt and several of the mezzanine tranches, (ii) purchasing the tranche owned by the more senior mezzanine lender and restructuring the senior debt, or (iii) contributing more capital to prevent the default. Conversely, the junior mezzanine lender’s position may be so far beneath the then-current value of the property that it may make more economic sense for the mezzanine lender to absorb the loss and move on.

A great deal of concern has been expressed by lenders holding the junior tranche regarding “loan to own” scenarios in which a third party purchases either the senior debt or a senior mezzanine position at a discount and forecloses on the borrower and the subordinate mezzanine lenders in order to obtain the property with little or no debt. In these situations, hundreds of millions of dollars of mezzanine debt suddenly disappear and a property in which one owner had negative equity is held by someone else with positive equity. During this time when the senior lenders are requiring higher levels of equity, thereby necessitating additional mezzanine debt, the result of the increased risk to the mezzanine lenders is that the junior tranches are getting increasingly more expensive to fill, which increases the likelihood of default.

One way for mezzanine lenders to be protected in the future (at no cost to the borrower or the holders of the more senior debt) is for the intercreditor agreement or the pooling and servicing agreement to provide a right of first refusal (i) from the holder of the senior debt to the mezzanine lenders and (ii) from the holders of more senior mezzanine debt to the holders of the subordinate mezzanine debt, in each case allowing them to purchase a higher tranche of debt for the price being offered to a third party. Since the higher tranches benefited from the existence of the lower tranche, there is no reason why new money should wipe out the lower tranches before the lower tranches have an opportunity to salvage some value from their investment. Of course, this would still require an additional investment by the holders of the mezzanine debt, but it does so at a discount, and it provides an additional incentive for those investors considering buying the junior position.


Loan participants play an important role in commercial real estate finance, but they usually have limited rights to negotiate the participation agreement and are exposed to the loss of their entire investment in a default. Frequently, this happens without warning. In order for the debt stack to work and for each loan in the debt stack to have participants, the participants need to be protected from the actions of the lead participant acting solely in its own best interest. This is not to suggest that the lead participant owes a fiduciary duty to the participants, which would change the entire nature of these loan participations, but rather that the participants should have the ability to protect themselves from actions that the lead participant is prepared to take.

These protections would include a tag along provision, in which the participant would be bought out by a third party on the same terms as the lead participant if the lead participation is going to be sold. In addition, the participation agreement among the creditors should provide a right of first offer, which would give both the lead participant and the participants the right to bid for the other’s position before it is offered to a third party. Unlike a right of first refusal, it would not have an adverse impact on the participant wishing to liquidate its position, but would treat all the participants the same. Finally, under the typical participation agreements, the participants are given limited information on potential problems as they develop. It is therefore incumbent on the lead participant to make certain that the participants receive copies of all notices that could indicate a potential problem and participants should certainly receive copies of any correspondence relating to a request that the lead participant waive any of the provisions of the loan documents or the intercreditor agreement.


One of the lessons learned from the Great Recession was that it was impossible to work out or restructure securitized commercial real estate loans because no one had the authority to do so. Notwithstanding exhortations from the President of the United States to do something, neither servicers, special servicers, master servicers, nor anyone else had the authority to do anything without unanimous consent of all the debt holders who frequently could not even be identified. In many ways, it resembled Humpty Dumpty because all the king’s horses and all the king’s men couldn’t put Humpty Dumpty together again.

There is little doubt that, at some point the economic problems will be behind us and the commercial securitization market or something akin to it will be resuscitated, if only because real estate finance has become so large and complex that securitization is required for the industry to function properly. Like it or not, the days of the local bank making loans for a house, mall, or office building in the bank’s home town are over and the loans will again have to be sliced and diced into different tranches for deals to be financed. Hopefully, the structure will have a stronger foundation than stretched appraisals and credit default insurance, but regardless of how the transactions are structured, there has to be a method built into the structure for the entire debt stack to be restructured without the need to obtain the consent of every participant in the stack. In the current environment, the lender holding the smallest interest can hold the entire restructuring hostage until the smallest lender is bought out at par. The proverbial tail wagging the dog.

Therefore, in the future, both pooling and servicing agreements and intercreditor agreements must include a workout structure that is devised when the loans are being negotiated (when every participant has the choice of participating) and not after the loan goes into default. Trying to put Humpty Dumpty back together again is not something that should be attempted under the pressure of a default or the threat of a bankruptcy filing. One way of doing this is to (i) formulate a system similar to a Chapter 11 proceeding with two twists—(a) permit the special servicer to take any actions necessary in the event of a default, and (b) grant either the senior lender and a majority (or two thirds) of the mezzanine lenders (all based on size of their loans) the right to reject the debt restructuring unless they are not being adversely affected, (ii) indemnify the special servicer as long as it complies with the provisions of the pooling and servicing agreement or the intercreditor agreement, as the case may be, and (iii) amend the Bankruptcy Code to allow the restructuring to be enforced in bankruptcy court without the necessity of commencing a Chapter 11 proceeding.


In order to obtain protection from a borrower’s bankruptcy filing or any bad behavior by the borrower, lenders have typically required the borrower to provide a non-recourse carveout guaranty from one or more of its principals or another creditworthy individual. The guaranty usually shields the lender from any losses or expenses resulting from fraud, material misrepresentation, misapplication of insurance proceeds or condemnation awards, misapplication of security deposits, violations of the special purpose entity (SPE) covenants and representations, violations of transfer or subordinate mortgage or other debt restrictions, filing of any bankruptcy petition, and certain other borrower actions. These guaranties became full loan guaranties if breached.

As it turned out the non-recourse carveouts had an unintended consequence, in that the borrower could not turn to bankruptcy courts to help with problems thereby leaving the holders of the senior debt free to foreclose, which wiped out the equity as well as the mezzanine debt unless the mezzanine lender acquired the senior debt. This was the basis of the fight in Bank of America, N.A. v. PSW NYC LLC6 (PSW) between the holders of the senior debt and the mezzanine debt in Stuyvesant Town/Peter Cooper Village (ST/PCV). The interesting, but as yet unanswered question, is whether the mezzanine lender who forecloses and becomes the owner of the property, may then file a petition in Chapter 11 to obtain the benefit of the automatic stay to stop the holder of the senior debt from foreclosing and cramming down the mezzanine lender. Another question is whether a mezzanine lender such as PSW, after acquiring title to the property, could have filed a Chapter 11 petition and argued that the prohibition or restriction in the intercreditor agreement was against public policy and voidable. Alternatively, could an affiliate of PSW have acquired claims from three creditors other than the mezzanine lenders and filed an involuntary bankruptcy proceeding to prevent the senior lender from foreclosing? If so, could the holders of the senior debt have proceeded against the original guarantors by arguing that they violated the non-recourse carveout by creating a debt stack in which a bankruptcy filing could result? Prior to utilizing this structure for future loans, these issues must be resolved and the loan documents must provide a mechanism for dealing with it.


The commercial real estate market is facing uncertainty as a result of recent events, which is impeding the recovery and could result in another recession. In order to avoid this consequence, unintended risks to lenders and investors must be eliminated.

Stuart M. Saft is a partner and chairman of Dewey & LeBoeuf’s global real estate practice and is the author of thirty books including “Commercial Real Estate Workouts” and over fifty published articles on real estate, economics and finance. In the last year, Mr. Saft has represented borrowers or lenders in over $1 billion of commercial real estate debt restructurings as well as over $1 billion of financing on hotels, malls and mixed use property as well as representing the developers of hotels, resorts and multi family housing.  


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