As hotel owners begin to address the short-, intermediate- and long-term cash flow and operational challenges brought on by the COVID-19 pandemic, modifications to their existing financing arrangements will be critical. This article provides guidance to owners of hospitality and leisure assets as they prepare to approach their lenders for relief in connection with mortgage loans secured by such assets and related mezzanine loans.
Before approaching its lender with a request to modify a mortgage or mezzanine loan, a hospitality asset owner should take the following initial steps:
1. Assess Loan Documents Carefully: Conduct a thorough assessment of the existing loan documents. Most notably, review the recourse carve-outs in any guaranties provided in connection with the loan to determine what actions or inactions may give rise to recourse liability. Recourse carve-outs may include seemingly innocuous actions such as incurring additional indebtedness (like a loan under the Paycheck Protection Program), amending a management or franchise agreement without the lender’s prior written consent, or stating in writing that the borrower cannot or will not pay some or all of its debts (including the subject loan). Also review the representations, warranties and covenants in the loan documents and identify any provisions that may need updates in light of changed circumstances.
2. Prepare a list of specific requests: Lenders are more likely to respond to specific, relatively reasonable requests for loan modifications than a general request for forbearance or waiver of defaults. However, be aware that the modification process presents an opportunity for the lender also to request changes to the loan documents. In order to maximize the likelihood of getting and keeping the lender’s attention and cooperation, and to minimize the likelihood of extensive lender changes, keep requested modifications to only essential items.
3. Third-party engagement: Consider if any third-party approval is required for the proposed loan modifications and consult the relevant documentation to understand such third party’s notice and consent rights. Is there a ground lessor on the real property? Is franchisor or manager approval necessary for any of the proposed modifications (e.g., allowing use of funds in a FF&E reserve for other expenses)? What internal Borrower approvals are necessary (e.g., is the modification a major decision)?
The following are potential modifications hospitality asset owners may want to consider:
1. Forbearance request: If the loan is in default or a default is imminent while negotiations are pending, a threshold request should be made that the lender forbear while the parties are in active negotiations from taking any action in connection with such defaults, including demands upon or collections of any guarantor’s obligations and exercising remedies (including foreclosure) under any security instrument. Be aware, however, that lenders often are reluctant to agree to anything that will delay their ability to exercise remedies in the event a mutually acceptable modification agreement cannot be reached; accordingly, we recommend approaching the lender prior to any defaults, if possible. If a modification agreement is agreed upon, such agreement should include continued forbearance from the lender’s exercise of remedies and, potentially, rescission of remedies previously exercised by the lender, such as imposition of default interest or any cash management restrictions.
2. Deferral of principal and interest: Deferral of interest (and, if applicable, principal) payments will free up cash to use for other operating expenses. In requesting any such deferral, a borrower should consider how long of a deferral period to request and how to propose such deferred charges eventually will be repaid (e.g., whether the deferred amount will be added to the principal of the loan or paid in monthly installments, in addition to regularly scheduled payments, following the deferral period).
3. Reserves: The borrower may want to request a waiver of required deposits into any reserve(s) during a specified period. Such requests with respect to FF&E or capital expenditure reserves should be relatively uncontroversial since deposit requirements are typically based upon revenue, so current deposits will likely be minimal given the limited revenue being generated by hotels during this pandemic. Borrower may also desire the use of existing reserves for FF&E or capital expenditures to provide liquidity to pay for ongoing operating expenses, including debt service. When requesting re-purposing reserves, be aware the lender may require the reserve to be replenished in a single deposit or incremental deposits after a certain period. If replenishment is required, lenders may also impose consequences for failure to do so, including the addition of recourse liability for the guarantor.
4. Financial covenants: If the loan includes financial covenants that must be met by certain dates, such as debt service coverage ratio or debt yield requirements, a temporary or even permanent waiver or adjustment of these covenants may be necessary due to decreases in revenue. Be aware that lenders may be reluctant to adjust any such covenants which are not imminently applicable (e.g., within the next 3-6 months) while waiting to see how long the current circumstances last. If not already included in the loan documents, addition of an option to make a cash payment to apply to principal in order to satisfy a covenant would be advisable.
5. Incurring additional debt: Most loans will prohibit borrowers from taking on debt outside of the ordinary course (such as trade payables) and may include a non-recourse carve out if any such debt is incurred. If additional financing is desired, such as a Paycheck Protection Program loan, lender approval will be required.
6. Amendments to management or franchise agreements: Lender’s consent may be required prior to modifying the terms of any management or franchise agreement, including any changes in fees, modification of the competitive set or adjustment to reserve requirements. Before any potential changes with the manager and/or franchisor are finalized and agreed to, be sure to obtain the lender’s consent.
7. Closures and re-opening: If any temporary hotel closure may trigger a covenant default, we advise obtaining the lender’s consent before doing so and also addressing any requirements for re-opening a hotel once closed.
8. Renovations and capital expenditures: Consider modifications to any required renovation or capital expenditure requirements mandated by the loan, including any property improvement plan required in accordance with any franchise agreement. Time periods for completion may need to be extended and budgets in connection with their completion may need to be re-visited.
9. Construction loans: Extensive and complex issues will be implicated if the debt is a construction loan in the funding or pre-funding stage. Potential modifications include waivers of covenant defaults due to work stoppages and extensions of milestone and completion dates. Also consider whether any revisions to the plans and specifications for the project and/or budgets may be required given the pandemic may make certain materials more expensive or hard to acquire.
10. Closures of governmental offices: Shutdown of government offices may make it difficult to obtain or renew licenses and permits within the timeframe required under the loan, including a certificate of completion for any construction project, and thus also may need to be addressed.
The lender may also take a modification request as an opportunity to strengthen its collateral (particularly in light of any changes favorable to borrower) or address deficiencies in the loan documents. These may include:
1. Requiring partial paydown of the loan;
2. Termination of future funding obligations or enhanced conditions precedent to such future funding;
3. Expansion of the lender’s collateral, such as an equity pledge, additional cash reserves and/or a letter of credit;
4. Deposit of proceeds from any additional financing (such as a Payroll Protection Program loan) into a lender-controlled account;
5. Additional recourse liability to the guarantor, possible addition of new guarantors, or new repayment guaranties, which may take the form of interest and carry guaranties;
6. Additional or enhanced financial covenants/tests;
7. Accrual or termination of affiliate management fees;
8. Advanced consent to the appointment of a receiver or foreclosure or a confession of judgment upon an additional default; and
9. Updates to the lender’s form of loan documents. For example, a lender may seek to make revisions to LIBOR replacement provisions to give the lender unilateral rights to set a LIBOR replacement.
The type of lender involved also should be considered when approaching a loan modification. A balance sheet lender will have the greatest flexibility to make modifications to the loan. With a CMBS loan, the borrower will have go to a master servicer and, depending on the nature of the modifications sought, the loan may be transferred to a special servicer (which will result in incurring substantial special servicing fees). While a special servicer can agree to certain loan modifications, the standards required in order to make such modifications will be different than a balance sheet lender and several layers of approval may be required.
The myriad considerations involved in the loan modification process require careful analysis in light of numerous factors, including the hotel market segment and location of the asset, franchise/brand involvement and the financial position of the borrower. The Goodwin Real Estate Industry team possesses the depth of experience necessary to guide hotel owners through these deliberations and to successfully partner with owners in navigating these challenging times.
Chauncey M. SwalwellPartner