Given the sharp decline in property values over the past 12 months and upcoming wave of loan maturities in 2024, there are many borrowers and lenders currently working through loan modifications to extend the loan term for an additional 6 to 24 months.
I recently reached out to many borrowers and lenders to ask about loan modifications that were in process or they had completed recently.
There were 5 common themes in the responses:
1) Each loan modification is unique and there is not a "one size fits all" approach.
- Debt Fund - "My high level takeaway is that modification discussions are becoming more bespoke as we get deeper into the new normal. Borrowers and lenders are increasingly deliberate in evaluating what works on a case-by-case basis depending on the situation."
- Bank - "This is a tough question because it’s really deal dependent – who is the sponsor, how deep is our relationship, how long will it take to execute the business plan, which direction is the asset/market trending, is the loan syndicated, etc. So many layers to each modification."
- Debt Fund - "I would say in general, loan modifications are highly tailored to the specific loan, quality/experience of the sponsor, sub-market health and the risk/return profile of the lender."
2) Banks are focused on a loan's risk rating and want to prevent the loan from being downgraded, which would require a significant increase in reserves held by the bank.
- Bank - "We have our periodic exam with the OCC in early 2024 and our expectation is that regulatory agencies will be working harder to peel the layers of the onion and really dig to uncover potential distress to almost force downgrades on banks to ensure adequate capital reserves."
- Bank - "For a bank, it’s hard to accommodate too much because you end up with a lower credit quality rating. The worse the rating, the more reserves a bank must hold."
- Bank - "It depends on what type of loan (perm, construction, etc.) but in general RWA (risk weighted assets) increases to 150% for any 'Criticized' loan. A general rule of thumb for RWA on 'Pass' loans is 100% of the funded amount and 50% of the unfunded amount. If a bank has a 10% capital requirement, then the reserve formula for a fully funded Pass loan = Commitment x 100% x 10%. For a Criticized loan, it’s Commitment x 150% x 10%."
3) There's currently a larger focus on cash flow (DSCR and DY) than value. A common target is a 1.0x DSCR:
- Bank - "We need the loan to be paid down to at least a 1.0x DSCR on same payment as was in process (I/O or amortizing). It's all about DSCR right now, not LTV. Regulators are pushing for 1.0x DSCR amortizing or 1.10x DSCR I/O. The bank can’t afford to downgrade too many loans."
- Developer - "Ever since the failures of Silicon Valley Bank and Signature Bank, every loan modification conversation starts with DSCRs and how much cash-in is needed to get the loan to a satisfactory DSCR. The lowest we’ve been able to convince any lender to go is 1.0x. Depending on the magnitude of paydowns, there has been negotiating room for longer extensions (>1yr), or recourse burndown/eliminations in some situations."
- Bank - "We're looking at 12-24 month extensions with paydowns to 8% - 9% DY, or min 1.0x on I/O basis using actual pay rate."
4) Relationships matter and lenders are going to be more accommodating for borrowers they want to continue working with going forward.
- Bank - "We are asking some borrowers to pay off loans at maturity. Modifications/extensions are only being considered for clients with broad relationships, deposits, etc. Good sponsorship will likely be given the gift of additional time for us all to figure it out."
- Bank - "We're doing a ton of loan mods right now. The can is being kicked, but each one is different. If a borrower is being nice, proactive, and trying to solve the problem, then it's a better path compared to a borrower that's being rude and difficult."
- Debt Fund - "We've pushed a few borrowers to pay us off on deals that had issues, but no standard structure that we apply. Usually the decision is based on the borrower's performance to date, if they have been responsive we will be more willing to work with them."
5) Offering some flexibility on purchasing rate caps is common.
- Debt Fund - "To date, I would say most of our mods have been relief on rate caps (maybe 6 month terms instead of 1 year terms)."
- Agency - "The most common modification requests come from Sponsors who are on Agency floaters where their escrows for a replacement cap are sweeping all excess cash flows. The loan docs require that we escrow based on 125% of the estimated cost of a 2-year replacement cap (they allow you to actually buy a 1-year replacement cap, but escrows are based off of a 2-year replacement). In select circumstances, I've seen the master servicer agree to escrow at 100% rather than 125% of the estimated cost of the replacement cap, but there isn't much bend beyond that."
- Debt Fund - "We're allowing a borrower to post a debt service shortfall escrow and buy a higher rate cap (call it 6% cap) vs buying an expensive in the money cap as required in the documents to provide 1.20x DSC. The only test to meet the extension is buying a rate cap that provides 1.20x DSC for a one year period."
Thanks for reading! If you have any insight into how lenders are currently approaching loan mods, please share in the comments.
