Navigating Market Challenges: Loan Workouts and Debt Restructurings (Article)

 Max Riffin

Introduction:

Tightening liquidity and increased borrowing costs are changing the

global financial landscape. This alert will explore the implications of these shifts on debt restructurings and loan workouts, with a particular focus on the commercial real estate sector.

 Tightening of Liquidity and Its Impact on Financing:

 The financial markets in the United States and the European Union are experiencing a tightening of liquidity, primarily driven by actions of central banks, including the Federal Reserve, in their efforts to combat inflation. This situation is becoming increasingly challenging for businesses, particularly in securing access to financing, which is becoming more restricted and costly. The commercial real estate sector is especially vulnerable in this climate, with an estimated $2.75 trillion out of the $5.67 trillion in loans set to mature in the next three years. These loans, originating in a low-interest-rate environment, now face refinancing challenges amid higher rates and market illiquidity.

Credit tightening in both the US and EU is evident as banks, especially smaller ones, grapple with the challenges posed by a higher interest rate environment and asset pressure.  This has led to a slowdown in US bank lending and an expected further tightening of lending standards. The current reduction in credit supply, equating to 25 to 100 basis points of policy tightening, suggests a Federal Funds rate of 5.25-6% by the end of Q1 2023. Financial conditions are likely to continue tightening, with real estate lending being particularly vulnerable due to the stress on smaller banks.

The shifting landscape has also led to changes in the banking sector, with bank deposits becoming less attractive compared to money market funds. This shift, coupled with a decrease in the quality of asset collateral due to higher rates and slower growth, is impacting smaller banks significantly, especially those heavily involved in real estate lending.

Although the current tightening falls short of a full-fledged credit crunch, it signals a cautious approach by policymakers who are monitoring the situation closely. Should small bank stress spread more broadly, sharply reducing credit availability, it could substantially impact US GDP growth in 2024. This scenario might lead to an earlier policy rate cut by the Federal Reserve.  The situation, while challenging, especially for the real estate sector, remains under close surveillance by central banks to prevent a severe economic downturn.

 Rising Borrowing Costs and the Effects of Interest Rate Hikes:

 Borrowing costs have escalated significantly due to recent interest rate hikes, putting additional pressure on businesses. The Federal Reserve's indication of nearing the end of its interest rate hike cycle suggests a possible stabilization of borrowing costs, yet the current high levels remain a challenge for debt servicing. This situation is particularly highlighted in the commercial real estate sector. In the second quarter of 2023, a marked retreat was observed in commercial-real-estate lending by smaller U.S. banks. The regional and local banks, which had previously accounted for a record 34.2% of all commercial mortgage originations in the first quarter of 2023, saw their market share plummet to just 25.1% in the following quarter. This 9 percentage point drop is notable, as it represents the most significant single-quarter decline ever recorded for this sector.

 The downturn in lending by these smaller banks is further highlighted by a year-over-year decline of 53% in commercial-mortgage originations in the second quarter of 2023, as reported by MSCI Mortgage Debt Intelligence. This decline is especially clear given the typical seasonal pattern where lending by smaller banks usually increases in the second quarter: an average rise of 14% was observed from 2012 to 2022. However, in 2023, there was an unusual 4% decrease into the second quarter.

This shift in lending behavior can be partly attributed to the failures of notable banks such as Silicon Valley Bank, Signature Bank, and First Republic early in 2023.  These events have exerted a significant impact on the lending practices of other regional and local banks, contributing to the sharp decline in their commercial mortgage originations.

Meanwhile, the banking industry, particularly regional and midsize banks, is facing increased funding costs due to the pace and steepness of the current rate cycles. This has significantly heightened the cost of interest-bearing deposits, squeezing the margins of these institutions.

Headwinds in the Capital Markets:

Capital markets are facing headwinds, especially in the real estate sector, exacerbated by the stress on small banks. The contraction in lending, particularly in the real estate domain, is indicative of a broader tightening in financial conditions, which could have ripple effects across various sectors.

The banking industry, benefiting from higher interest rates, saw an increase in net interest income post COVID. However, this trend has led to heightened funding costs and squeezed margins, particularly affecting regional and midsize banks due to higher deposit costs. 

Despite potential interest rate drops, banks globally may struggle to reduce these high deposit costs because of customer expectations and competitive pressures. European banks might decrease deposit costs more effectively due to less competition from money market funds compared to their U.S. counterparts.

Loan growth is expected to be modest, influenced by macroeconomic conditions and high borrowing costs. Banks are likely to maintain restrictive credit lending policies, as indicated by recent surveys from the Federal Reserve and the ECB, pointing to tightened credit standards due to economic uncertainties and potential deterioration in collateral values and credit quality.

The commercial real estate (CRE) sector in the U.S. is particularly stressed, affecting regional and midsize banks with significant exposures to office spaces. High uncertainty, inflated property prices, and debt repayment concerns have led to increased selectivity in new CRE originations and refinancing. CRE loan delinquencies are on the rise, signaling potential challenges in this sector. In contrast, the European CRE market appears more resilient, with larger, well-capitalized banks handling most CRE loans. The APAC region is expected to have a steadier trajectory, supported by demand from the hospitality sector and growth in multifamily residential mortgages.

Climate risks are also influencing loan demand and credit availability. Banks are tightening credit standards for loans to firms with higher climate risks, while easing conditions for green firms and those transitioning to decarbonization. This shift in credit disbursement policies is poised to significantly impact banking strategies.

Overall, the combination of higher deposit costs, variable policy rates, and constrained loan growth is impacting banks’ ability to generate strong net interest margins. This environment calls for banks to reassess their deposit costs and deployment strategies to navigate these challenging times effectively.

The State of Corporate Credit Quality and Bank Lending Policies.

The market is also witnessing a noticeable deterioration in corporate credit quality. This trend is primarily driven by persistently high official rates, which are likely to remain elevated as inflation in the eurozone may only return to its 2% target by late 2025. This situation will continue to impact growth negatively and maintain tight financing conditions, exacerbating the focus on aspects like cash flows, debt service, and sustainability.

Several risks are at play, including the potential for a stagnating European economy teetering on the brink of a shallow recession and the consequent exposure of financial vulnerabilities. This could see the default rate gradually inching toward 3.75% in upcoming quarters. 

Additionally, geopolitical tensions, such as Russia’s invasion of Ukraine and heightened trade tensions, especially involving China, pose significant threats.  These factors, along with rising refinancing costs and lower valuations, are putting substantial pressure on real estate credit quality.

For corporates, especially speculative-grade issuers, the trend in credit quality is turning negative as financing conditions tighten. The real estate sector remains particularly vulnerable. Although European banks are likely to experience some asset quality deterioration, credit losses are expected to only normalize. The ratings on speculative-grade companies have shown an increased negative outlook bias since summer 2022, with marked shifts in net outlook bias at the sector level, notably in real estate and technology sectors.

The CRE market is showing signs of strain, with a notable increase in loan delinquencies. This trend is concerning, given the CRE market's size and its role in the broader financial system. Increased regulatory scrutiny on banks with high CRE exposure adds another layer of complexity to this issue. For instance, the commercial real estate loan delinquency rate at U.S. banks climbed to 0.77% at the end of March 2023, the highest since the third quarter of 2021.  This increase is accompanied by a growth in total CRE loans to $2.436 trillion as of March 31, 2023.

The delinquency rate on nonowner-occupied nonresidential property loans has been on an upward trend for three consecutive quarters. This has led to increased scrutiny on loans, particularly those tied to office buildings. Banks, in response, are exercising heightened caution over CRE loans, potentially escalating stress on borrowers. This situation is further complicated by the growing number of U.S. banks exceeding regulatory guidance on CRE loan concentration, which has surged by over 30% compared to the previous year. These dynamics underline the need for careful monitoring and potential policy intervention to navigate the challenges in the CRE market.

Recommendations and Strategies for Debt Servicing:

For businesses struggling with debt servicing, a proactive approach is key. This includes not only identifying current challenges but also anticipating potential future challenges. A successful strategy is dependent on several critical elements:

First, central to any effective debt servicing strategy is the establishment of effective communication and collaboration between borrowers and lenders. This relationship is the basis for exploring and negotiating viable solutions. When borrowers and lenders engage in a dialogue grounded in mutual understanding, it lays the groundwork for creative problem-solving. In this context, borrowers should be prepared to present a clear and honest picture of their financial situation, fostering an environment conducive to effective negotiation and collaborative solution-finding.

Further, in navigating the complexities of debt restructuring, the role of professional legal and financial counsel is essential. These experts bring a wealth of knowledge and expertise, guiding both borrowers and lenders through the complexities of restructuring agreements while ensuring that solutions are viable and mutually agreeable.

Businesses should also consider all available restructuring options. The key is to align these options with the company’s current financial health, making sure that the restructured debt is manageable and sustainable.

Finally, businesses should build a support network of other business owners, industry experts, and legal and financial advisors who can provide valuable insights and support, offering practical advice based on various scenarios.

A partner in the business transactions practice group at prince Lobel Tye LLP.  Max Riffin primarily focuses on representing businesses, investment funds, and investment advisers, helping them navigate complex transactional and regulatory matters. His email address is mriffin@princelobel.com.

 

 

 

 

 

 

 

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Ten Things to Know About the Essex South District Registry of Deeds (Article)

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• Registered land and recorded land recordings. This feature permits automatic recording of documents in both registered and recorded land, and is done directly through registered land. This functionality is available for walk-in, mail and electronic recordings.

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• Electronic recording for government agencies. Supports submission of documents from government agencies remotely. The Recorder can re-route documents from Recorded Land to Registered Land or visa-versa, as needed. Fees (if any) may be allocated to an agency account. Accessed from the “SalemDeeds” website.

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• Public eRecording. Allows “Mom and Pops” to submit select (non-excise) documents remotely directly from their home or office. Paid by credit card, and accessible from the “SalemDeeds” website.

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• Cities & Towns e-Recording. This allows a City or Town to submit documents for recordings. This extended feature is through the “SalemDeeds” website.

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• Up to date scanning of all documents and certificates. Engineering plans, atlas and assessors’ records that are available at the Registry of Deeds are available for customer convenience.

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• Up to date records available online from 1640 to present.

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• Recording of Plans online.

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• Registry Staff does Outreach Training Seminars throughout the Essex South District Cities and Towns regarding property fraud watch and homesteads for the community residents. They also do in-house training with Realtors, and City and Town Employees on how to use the Registry of Deeds user-friendly system to research documents, plans, etc.

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• The Registry is open to the public for researching records and closings, and the Essex County Bar Association has their offices within the Registry of Deeds for legal referral assistance.

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• To kick off the Holidays, the employees of the Registry of Deeds may come to work dressed in costume on Halloween and they also do their Toys for Tots Drive and Aspire Coat Drive.

      

Editor's Note:

The above is the first installment of a series of “10 Things to Know About the Registries of Deeds” presented by the REBA Registries Section.  This month’s installment is from Dorothy Hersey, who has been appointed as acting Register of Deeds of the Essex South Registry as of January 1, 2024.  REBA would like to congratulate Ms. Hersey on her appointment, and we wish retiring Registrar John O’Brien all the best in his retirement! 

An Introduction to the Changing World of Residential Broker Commissions (Article)

 Christopher J. Mercurio

REBA is monitoring certain class-action lawsuits against the National Association of Realtors (“NAR”), various multiple listing services, and other brokerages and industry participants concerning how real estate brokers are compensated. As most readers of REBA News are aware, last October, a federal jury in the case of Burnett v. NAR (W.D. Mo.) found NAR (and other industry defendants) liable in a case challenging some longstanding practices that, according to the plaintiffs’ arguments, violate antitrust laws and artificially inflate broker commissions.

  Burnett is one of several similar cases making their way through the courts, including Nosalek v. MLS PIN (D. Mass), and Moehrl v. NAR (N.D. Ill.), the latter of which is not expected to go to trial until the end of 2024 at the earliest. 

While each case is unique, they all challenge the requirement (enforced by NAR and other industry groups) that sellers must offer to compensate a buyer’s broker in order to list a property on an MLS listing service, or other similar databases.  As the plaintiffs in Moehrl argue, this arrangement is anticompetitive and inflates commissions because, among other reasons, (i) it creates a system wherein sellers are shouldered with an extra cost that would normally be borne by buyers in a competitive market, (ii) it compels sellers to offer the same compensation to every buyer-broker, regardless of their experience or the services they provide, (iii) it creates an incentive for sellers to offer the (arguably high) industry-standard commission rates out of fear that buyers brokers will “steer” their clients away from listings that offer a lower commission.  As the plaintiffs in Burnett summarize, the foregoing factors result in the perpetuation of inflated commissions for buyer-brokers in a world where recent technological and social changes (e.g., the rise of the internet) should have led to savings in transaction costs being passed on to consumers like in other industries (e.g., travel booking, insurance and banking). 

While the implications of these lawsuits on the real estate industry will not be clear for some time, recent settlement agreements may offer some clues as to where the industry is going. In a recent proposed settlement in Nosalek, MLS PIN agreed to amend its rules by, in pertinent part:

(1) eliminating the requirement that a seller must offer compensation to a buyer-broker; (2) requiring the broker for the seller to provide notice to the seller that (a) the seller is not required to offer compensation to the buyer-broker and (b) if the buyer-broker requests compensation from the seller, the seller can decline; and (3) if the seller elects to make an initial offer to the buyer-broker and the buyer makes a counter offer (effectively rejecting the seller’s offer), then any commission to be paid to the buyer-broker is negotiated among the seller, the buyer, the seller-broker and the buyer-broker.

In a similar settlement in Burnett and Moehrl, RE/MAX agreed to several business practice changes, including (i) not requiring its agents to be members of NAR, (iii) encouraging franchisees to be “very clear that commissions are negotiable and not set by law or . . . corporate policy”, and (iii) not providing software that allows franchisees to filter listings by the amount of compensation offered to buyer-brokers.  It should be noted that the foregoing settlements are limited to certain defendants, and both the Nosalek and Moehrl cases are continuing.    

NAR has yet to participate in a settlement, and despite the setback in Burnett, former NAR President Tracy Kasper stated in October of 2023 that the matter “is not close to being final”, arguing that:

[c]onsumers are better off and business competition is able to thrive because of our rules and how well local MLS broker marketplaces function. In fact, the NAR cooperative compensation rule for local MLS broker marketplaces ensures efficient, transparent and equitable marketplaces where sellers can sell their home for more and have their home seen by more buyers while buyers have more choices of homes and can afford representation.

Given that these cases are being heard in different courts and include different participants and unique arguments, industry professionals who are advising clients should pay close attention to both the substantive rulings of the courts and the reactions (and potential rule changes) that follow from local trade groups and market participants.  If you are advising residential buyers or sellers, it would be prudent to advise them that the traditional commission structure is the subject of multiple lawsuits and, depending on their location and how the property in question is being marketed, they may have additional options for the way in which commissions are paid in their transaction. REBA will continue to monitor developments in these cases, including NAR’s appeal in Burnett.  

A member of REBA’s Title Insurance and National Affairs Section, Chris is an associate at the international law firm of Proskauer Rose LLP. He represents and advises businesses and organizations in all aspects of real estate transactions, commercial leasing, and land use and development.  Chris has experience in drafting and negotiating purchase sale agreements and managing due diligence for commercial real estate transactions involving industrial, office, multi-family residential and retail properties.  Chris’s email address is CMercurio@proskauer.com.

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Will Transferring Title to an Estate Planning Trust Terminate a Title Insurance Owners Policy?

Rhonda L. Duddy

Does an owner policy of title insurance terminate when title is transferred to a trust for estate planning purposes?  That is the question

title insurance underwriters are frequently asked by insured owners and/or their estate planning attorneys. 

The answer to this inquiry is both yes and no, based on the policy issued because the covered risks, terms, conditions and exclusions vary depending on the kind and version of policy issued.  For instance, a 1992 ALTA owner policy differs from a 2006 and a 2021 ALTA owner policy. Additionally, the 1998 ALTA homeowner policy (sometimes referred to as an enhanced policy) differs from a 2008, 2010, 2013 and 2021 ALTA homeowner policy.

A typical scenario is subsequent to the purchase of the property, the named insured conveys the property to trustee(s) of a trust for estate planning purposes.  Depending on the policy form issued at the time of purchase, if the named insured on the policy is no longer the owner of the real estate as a result of the transfer, under the terms of the policy coverage may have terminated due to the fact that the property is no longer owned by the named insured.  In that instance, the current owner no longer has the benefit of the title insurance policy. Therefore, it is important that terms and conditions of the policy be reviewed, particularly the policy’s continuation of coverage section and the definition of insured section in order to determine whether coverage under the policy might be impacted prior to transferring title from a named insured. 

For example, looking at the 1992 ALTA owner policy, the continuation of coverage section contains the following or similar language:

The coverage of this policy shall continue in force as of the Date of Policy in favor of an insured only so long as the insured retains an estate or interest in the land, or holds an indebtedness secured by a purchase money mortgage given by a purchaser from the insured, or only so long as the insured shall have liability by reason of covenants of warranty made by the insured in any transfer or conveyance of the estate or interest.  This policy shall not continue in force in favor of any purchaser from the insured of either (i) an estate or interest in the land, or (ii) an indebtedness secured by a purchase money mortgage given to the insured.

If the policy that was issued includes this or similar language and subsequently the insured conveys the property, the insured would no longer have an estate or interest in the land.  Depending on the terms of the trust and how the beneficial interest is allocated, an owner might have a personal property interest in the trust, but they would no longer have an individual interest in the land and would no longer have coverage under the policy. 

Other owner and homeowner policies may contain continuation of coverage language that includes language that the policy also insures the trustee or successor trustee of the insured’s trust or any estate planning entity to whom the insured transfers their title after the policy date.  In these instances, no further action may be required since the terms specifically state that policy coverage is continued under these specific circumstances, so long as it was an insured’s trust or a trust or entity created for estate planning purposes.    

It is also important to review the policy’s “definition of insured” section in order to determine whether there are any other parties or entities that are included falling under the term, other than the named insured.  In certain circumstances, a transfer to a third party or entity might not terminate coverage if that party or entity is included in the definition of insured.  It is important to note that the definition of insured varies depending on the version and type of policy issued.   

For example, looking again at the 1992 ALTA owner policy that contains the following or similar definition of an insured:

“Insured”:  The insured named in Schedule A, and, subject to any rights or defenses the Company would have had against the named insured, those who succeed to the interest of the named insured by operation of law as distinguished from purchase including, but not limited to, heirs, distributees, devisees, survivors, personal representatives, next of kin, or corporate or fiduciary successors.

Some policies expand the list of successor insureds to include certain parties who obtain title other than by operation of law, including a spouse who receives title upon dissolution of marriage and the trustee of a trust to whom title is transferred.  If the policy recognizes a transfer to a person or entity falling under the definition of an “Insured” then no further action may be required in order to continue coverage. 

 

Due to these nuances in the various title insurance policy forms, it is important to confirm continuation of coverage before transferring real estate so that the title insurance policy purchased at the time you purchased the property is not terminated upon transfer. As discussed, some policies have strict and limiting language relative to when coverage terminates while others have broader continuation of coverage language. 

 

What should you do if you would like to transfer your property and you have a current policy?  If it is determined that the existing policy does not cover transfers to trusts, you may have the option to either buy a new policy or obtain what is called an “additional insured” or “change” endorsement to the original policy.  A policy endorsement would then name the trustee(s) of the trust as an additional insured and coverage would continue.  Be aware that it is not an option to transfer the property out of the trustee(s) of the trust back to the named insured in order to regain coverage.  The first conveyance may terminate coverage so conveying it back would not reinstate the policy.

 

Please be sure to review your title insurance policy before transferring real estate into a trust.  You can always reach out to your attorney or title insurance underwriter to confirm whether coverage would continue or terminate on transfer to your trust for estate planning purposes.

 

Rhonda is Massachusetts and New Hampshire Underwriting Counsel for Steward Title Guaranty Company.  Her email address is rduddy@stewart.com.