Please Mind The Gap – by John Darrow
I remember when I started my career, I would drive to the banks that were selling distressed loans, sit in their conference room, and literally read through mortgages for hours on end. While I quickly got good at knowing what to look for, over time several other things began to stick as well. I would argue spending five years reading through distressed mortgages should qualify me for an honorary JD, but I haven’t found a law school to buy that rationale yet. I digress.
I recently spent some time visiting with a longtime colleague turned good friend of mine, Brock Cannon, who is the head of national loan sales for Newmark. Our career paths have diverged somewhat since I moved over to mortgage originations and he remained in the loan sales space, but the perspective from where he sits and what he sees is invaluable. And sure enough, the intelligence he bestowed on me this time had me reading loan documents in the wee hours of the morning. Brock and I spent the better part of our conversation talking about UCC foreclosures by mezzanine lenders. While most clients would consider this information either idiosyncratic or benign, mainly because they don’t have mezzanine financing on their properties, anyone that has a commercial real estate collateralized loan obligation (CRE CLO) or debt fund loan may want to read on.
The CRE CLO space accounted for $50.3B of fundings in 2021, and by all accounts had a strong 1Q2022 before spreads started to widen according to Morningstar, of which 64.3% of fundings were apartments. Usually buried in between sections 10 – 15 of the loan agreement depending on the lender, is a section speaking to the lenders’ rights to transfer the loan into a securitization, or sell participating interests, etc. Fine, so what? Isn’t that industry standard for securitized products? If you keep reading, a subset paragraph in that section will speak to either, “Loan Bifurcation,” or restructuring into “the New Mezzanine Loan,” at no additional costs to the borrower, provided the new blended rate equals that of the current loan rate. Most loan agreements will put the option to exercise at the sole discretion of the lender, and once exercised, the borrower is compelled to provide, “including, without limitation, a promissory note evidencing the mezzanine loan and a pledge and security agreement pledging the equity collateral to Lender as security for the mezzanine loan,” (or similar wording to that extent). The borrower is compelled to provide this documentation usually within a number of days.
A default under a loan secured by a pledge of the borrower’s ownership interest would permit the lender to commence a Uniform Commercial Code (UCC) foreclosure proceeding, whereby they take ownership of the property by obtaining ownership of the entity that owns the property. “A UCC Foreclosure Sale streamlines the foreclosure process for lenders and ultimately allows them to take over the property(s) in 60 – 75 days. Obviously, this timeline is much faster than a traditional foreclosure in a judicial state,” said Brock. Further, “When a lender commences the UCC Foreclosure Sale while simultaneously marketing the loan for sale they are essentially condensing the foreclosure timeframe for whoever buys the non-performing loan. This is a strategy that we will see more and more of from lenders who do not want to own properties.” That pledge of the equity interest creates a “dual collateral” loan for the lender – a mortgage lien on the real property and a pledge of the ownership interest in the borrower. Astute borrowers and any savvy lender understand the significance of a judicial versus non-judicial foreclosure process, but a UCC sale is a non-judicial process lacking any equitable or judicial restraint or oversight. Think of a ballgame with no referees or umpires. Things just got a lot more interesting, that’s for sure. These lenders have come a long way from the RTC and even the Lehman Brothers days.
This brings me full circle to the title of this article. As a native New Yorker, I frequented the subway and train daily for at least 12 years while living in the city. You come to take for granted how often you would hear the prerecorded announcement, “please mind the gap between the train and the platform,” but the announcement is there to warn us about something most of us are unconsciously good at doing, walking. As real estate professionals, is it safe to say debt is something we can—and do—unconsciously take for granted? After all, both residential and commercial real estate would be completely different if we couldn’t get financing for it.
Our jobs as mortgage bankers to a large extent are synonymous with those of good real estate attorneys. We are looking for the best financial terms on behalf of our clients, while the attorneys are fighting for the best legal terms. But we also need to be reminding our clients to “mind the gap,” or think about not just the explicit, but also the implicit implications of the loan agreement, especially when repercussions aren’t yet even known. Your lender is typically your biggest financial partner in each deal, but as a wise colleague of mine would frequently say, “debt is your best friend—until it’s not.”
John Darrow
Principal
D: 949.335.7821
john.darrow@slatt.com
For more information on how to reach this week’s contributor:
Brock Cannon
Head of National Loan Sales
Newmark
125 Park Ave.
New York, NY 10017
t 212.372.2066
m 646.315.4785
brock.cannon@nmrk.com