Loan to Own, Real Estate Intelligence
As a result of recent regulatory changes, lenders have been forced to contract their balance sheets by divesting capital-intensive real estate loans. To date, attention has been focused on the sale of large non-performing loan portfolios by banks to private equity and hedge fund investors. Whilst it is predicted that €13.83bn of real estate loan portfolios will be sold in the UK during 2013, lenders are also increasingly taking a more granular approach and selling individual loans with outstanding balances of between €10m and €150m.
Individual loan sales appeal to a wider group of potential purchasers, including traditional real estate investors who more commonly favour direct investment in real estate assets.
From the perspective of a real estate investor, acquiring real estate via a 'loan to own' strategy can be a riskier and more time consuming process when compared to direct investment. In this article we will discuss some of the key considerations for investors. For the purposes of this discussion, we have assumed that the approach to be taken will involve the acquisition of a whole loan and the appointment of a receiver to dispose of real estate assets that are subject to a priority mortgage. Except where indicated, we have not considered issues that arise in respect of syndicated loans, intercreditor issues, or alternative methods of enforcement, such as the appropriation of shares or the appointment of an administrator.
Loan documentation: In addition to conducting diligence on the underlying property, investors will also need to review the loan documentation (including security documents, intercreditor agreements and any hedging arrangements). Fundamental diligence items will include: (1) reviewing the loan transfer provisions, including any specific requirements relevant to the status of the lender (e.g. with respect to withholding tax), (2) confirming that there is a subsisting event of default under the terms of the loan agreement which will enable the investor to accelerate the loan, (3) reviewing the provisions in the loan documentation relating to acceleration and enforcement to ensure that the lender can control the enforcement process which, in the context of a syndicated facility, will also involve verifying that the lender has the ability to direct the agent and security trustee to act on its instructions and (4) verifying that the security package is valid, enforceable and has been perfected.
Property: The availability of property information will be more limited where the investor is acquiring a loan. Investors will be reliant on information provided by the selling bank (typically official copies and historic reports and valuations) together with information which is publicly available at the Land Registry. Property diligence typically includes a review of office copies for the underlying property to confirm that the relevant borrower is the proprietor and that the security has been registered and is first ranking. Depending on the time available and the investor's budget, investors may also conduct drive-by valuations/boundary checks on the underlying property. However, neither the underlying borrower nor the selling bank is likely to provide replies to enquiries and investors will need to decide how comfortable they are with the quality of the information available. Investors will also need to consider the quality and availability of information in view of their proposed funding arrangements. If the investor is proposing to fund the acquisition with new bank debt – commonly referred to as a "loan on loan", it will need to ensure that the incoming lender is also comfortable with the quality of the information.
Acquisition structure: In view of restrictions on self dealing (Williams v Wellingborough BC [1975] 1 WLR 1327), the investor will need to establish two separate entities. One vehicle will be established to acquire the loan from the lender ("LoanCo") and a second entity will be established to take legal title to the property upon enforcement ("Propco"). The loan documentation will need to be reviewed to check whether there are any other criteria which LoanCo needs to satisfy in order to become a lender, for example, there may be a requirement that LoanCo is a Qualifying Lender for withholding tax purposes.
Loan transfer documentation: The transfer of the loan will be documented pursuant to a loan sale agreement. A separate transfer certificate may also be required where the loan is a syndicated loan. In syndicated loan documentation, it is also customary for the investor (as new lender) to pay a transfer fee to the agent. Such fee is usually a relatively de minimus amount, but this does represent an additional cost to the investor. Lenders often suggest using the Loan Market Association ("LMA") secondary trading documents as the template for the loan sale agreement. However, from an investor's perspective, this may not always be advisable as the LMA secondary trading documents: (i) do not easily work in conjunction with non-LMA loan documents (which includes most bilateral loans) and (ii) contain quite limited representations and warranties about the loan. An investor should therefore consider proposing an alternative form of loan sale agreement (including a more appropriate warranty package) at the outset. The scope of the warranty package available to the investor will largely depend on the identity of the seller. Whilst most banks are prepared to negotiate the inclusion of some warranties relating to the loan, government sponsored "bad banks" such as NAMA are not generally prepared to give any warranties at all.
Enforcement process: We have assumed that the investor will enforce the security by appointing a receiver. The additional time and costs that will be incurred in drafting appointment documentation, getting the receiver comfortable with the validity of its appointment and negotiating any indemnities that it requires , should be factored in. If the borrower is located in a jurisdiction outside England and Wales, the investor will also need to consider whether an insolvency process could be commenced by the borrower or its officers in that jurisdiction which could impede the enforcement process.
Fair value: A receiver has duties to all of the borrower’s creditors when disposing of the property. Fair dealing rules (Tse Kwong Lam v Wong Chit Sen [1983] 1 WLR) require that the property must be transferred to Propco in good faith and for the best price reasonably obtainable in the market at that time. In assessing what constitutes the best price, the receiver is likely to market the property and obtain a third party valuation. The length of the marketing period will depend on the type of property and the level of interest in the open market. From the investor's perspective, the marketing process will have an impact on the timing of enforcement and may also increase the risk of a competing bid for the property.
Competing bids: Depending on the circumstances of sale, there is a risk that Propco may not be the preferred purchaser. The likelihood of Propco being the preferred bidder will depend on the relative values of the property and the outstanding debt claim under the loan. Propco can effectively credit bid the face value of the debt. Where the property is worth less than the amount of the outstanding loan, Propco stands a greater chance of being the highest bidder. The receiver is not obliged to take the highest bid, however, and can also give weight to other factors. So if, for example, a competing bidder does not have committed funding in place, the receiver may choose to go with a lower bid that looks more solid. It should be noted that, until the receiver is actually appointed, the borrower has the right to sell the property provided that it is able to repay all amounts owed under the loan documentation. This is the borrower’s 'equity of redemption'.
Purchase price: The investor will need to have sufficient funds to finance both the acquisition of the loan by LoanCo and the purchase of the property by Propco or will need an agreement between LoanCo and Propco, whereby Propco agrees to acquire the property in consideration for LoanCo discharging the loan. If the latter option is used, this will need to be agreed with the receiver. Whilst no SDLT is payable by LoanCo on the acquisition of the loan, SDLT will be payable by Propco upon purchase of the property.
Lawyer Contacts
For further information, please contact your principal Firm representative or one of the lawyers listed below. General email messages may be sent using our "Contact Us" form, which can be found at www.jonesday.com.
Andrew Barker
London
adbarker@jonesday.com
+44.20.7039.5135
Emily Firn
London
efirn@jonesday.com
+44.20.7039.5211
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