We recently discussed the importance of due diligence when acquiring distressed commercial mortgages, providing a due diligence checklist for the process. Since any foreclosure mezzanine lender can come “into ownership” if they foreclose their mezzanine loan, perhaps more caution should be exercised when considering buying a mezzanine loan. distressed real estate. As with a mortgage loan, diligence is required!
Before describing the due diligence that must be done before purchasing a distressed mezzanine loan (or, really, any mezzanine loan), let’s quickly describe a mezzanine loan.
A mezzanine loan is a loan to direct or indirect owners of a real estate owner.
As can be seen from the chart above, a mezzanine loan is a loan to an entity (the mezzanine borrower) that directly (or in some cases indirectly) owns the property owner. A mezzanine loan is not secured by a lien on real estate collateral. Instead, a mezzanine loan is secured by a pledge of equity interests in the property owner. So that the mezzanine lender’s loan is worthless if the mortgage lender forecloses its mortgage or accepts a deed in lieu thereof – and so that the mezzanine loan is structurally subordinate to any mortgage and liens on the property (such as real estate tax liens, mechanic’s liens or judgment liens).
Because the loan collateral includes pledged equity (i.e. personal property), the Uniform Commercial Code (UCC) and not the Real Property Act applies when the mezzanine lender enforces its appeal.
We have outlined the due diligence to be performed when acquiring a distressed mortgage. When a potential mezzanine loan buyer is considering acquiring a mezzanine loan, even greater scrutiny is required, as any foreclosed mezzanine lender could be “stepping into the shoes” of the homeowner. Diligence is essential!
To illustrate, in addition to the things we’ve discussed in relation to acquiring a distressed mortgage, any buyer should also focus (as any property owner would) on the following:
- The status of the mortgage loan, in particular any defaults. Are they curable? What does it entail to remedy these faults, and what is the cost of these faults?
- Property taxes and other arrears;
- Mortgage liens and mechanic’s and judgment liens (thus state of title, in general);
- Environmental issues and liabilities, and the condition of the property;
- Income streams from property, rentals and obligations to tenants (such as tenant allowances and constructions);
- Unpaid and potential debts under co-ownership documents, reciprocal easement agreements, or similar documents (and are there any liens for unpaid common charges or assessments?);
- Current and potential liabilities under any management agreements and service contracts (and are these agreements terminable?);
- Current and potential liabilities under union contracts, including unfunded pension liabilities;
- If the mezzanine lender is “behind” a construction loan, the status of construction, including the status of payments to contractors, design professionals and others, defaults, terms of construction contracts and design, lien waivers, potential mechanic liens – and what is needed to achieve completion (and when); and
- If the business operating in the property is a hotel, any management or franchise agreements (are these agreements terminable?) – and any cross defaults or transfer restrictions in these agreements.
Remember that if the mezzanine lender seizes and acquires ownership of the property themselves, they are responsible for all such matters – so due diligence at the property level is essential!
It is also essential to do due diligence and assess the terms of the Intercreditors Agreement (ICA), also shown in the table above. The ICA is the agreement usually entered into between the mortgage lender and the mezzanine lender and governs the relationship between the mortgage loan (on the one hand) and the mezzanine loan (on the other hand), granting the mezzanine lender more (or less ) protections.
As a preliminary, what does the CIA foresee with regard to mezzanine loan transfers? Many ICAs provide that transfers of majority or control interest in mezzanine loans and foreclosures (and related transfers) of mezzanine loans cannot take place without the approval of the rating agency or the mortgage borrower ( if the mortgage loan has not been securitized) if they involve transfers to some of the predefined “qualified transferees” who satisfy certain essentially financial (and generally negotiated) “eligibility conditions”. So a preliminary question is: is the buyer a “qualified transferee” – or will the purchase require mortgage lender (or rating agency) approval?
Note that ICAs generally prevent a lender from selling its loan to the borrower or affiliates of the borrower and contain “break-through” provisions such as a loan held by a borrower or an affiliate of the borrower n are not entitled to the many protections afforded to mezzanine lenders under the ICAs. (or not having the right to buy the mezzanine loan at all!)
The next due diligence issue in the ICA is the healing rights granted to the mezzanine lender. Recall that the mezzanine loan is in distress and that, presumably, the mortgage loan is also in “distress” or potentially in distress. In this regard, many ICAs grant mezzanine lenders certain rights to remedy both monetary and non-monetary events of default under the mortgage loan. But does the ICA cap the number of monetary remedies that may be available? What does the CIA require as part of the repair (by the mezzanine lender) of non-monetary defaults in the mortgage loan? Is there an external time frame for such cures – and what are the requirements? What would that imply, concretely?
ICAs often also address execution by mezzanine lender— and impose requirements on any such application). What are these restrictions? Many ICAs require, for example, that:
- the collateral assignee is either the mezzanine lender or a “qualified assignee” (or otherwise approved);
- the foreclosure mezzanine lender, or a third-party buyer, provides “replacement guarantees and environmental indemnities” concurrently with (or shortly after) the foreclosure. These replacement guarantees and indemnities generally cover actions that are taken after the date the foreclosure occurs and must generally be delivered whether or not the original guarantors and indemnities are released. But does the ICA require that all guarantees be put in place by the garnishing lender (including payment guarantees)? Or does it “modify” the forms of existing guarantees to better “fit” the new guarantor and reflect the specified guaranteed obligations?
- the property must be managed by a pre-qualified or mortgage lender-approved property manager – and cash management may be required.
In addition, CIAs generally grant the mezzanine lender the
right to purchase the mortgage upon the occurrence of certain triggers – generally including (i) events of default or acceleration of mortgage loans; or (ii) a securitized mortgage becoming a “specialized” loan. What is the purchase price in such a case? What is the time limit within which this right must be exercised? Is it expired?
Similarly, ICAs generally grant a brief moratorium to mezzanine lenders before the mortgage lender agrees to a deed in lieu. (For a more in-depth discussion of these provisions, see The Role of ICAs Between Mortgage and Mezzanine Lenders and Mezzanine and Construction Lending – ICA Considerations and Provisions.)
As we have demonstrated, due diligence when acquiring any form of distressed debt is essential, but an understanding of enforcement under the Uniform Commercial Code (UCC) is
too critical. So what Is the buyer of a distressed mezzanine loan might face? Next, we’ll take a closer look at the UCC.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.