The Terms and Conditions for a Construction Loan, Coursework Example

Attached is a Term Sheet that outlines the terms and conditions for a construction loan.  This Term Sheet was prepared by counsel to the lender (but has not yet been reviewed by the lender).  Please provide commentary (and a brief explanation of any commentary, where necessary) on the Term Sheet from the perspective of the borrower and, where appropriate, the lender.

The terms regarding interest rates are questionable as the borrower might perceive them to be too open ended. The law states that the interest rate is LIBOR plus 500 bps (5.00%), which is clearly defined, but then the term states that the Default rate shall be Agent’s then prevailing rate plus 10%. This implies that the interest rate is not set in stone and can be modified based on the lender’s preference. In addition to the term breaks down the fees that will be applied when rent is late. noting that “a late fee equal to 10% of the amount of any payment that is not paid when due will be assessed”. Another questionable aspect of the term sheet is the obligation to pay a construction consultant for an administrative fee.  The terms note that the fee is open ended in that it can be determined by the agent and then becomes payable annually but that there must be monthly fees paid to a construction consultant provided by the agent. The open ended nature of this is questionable and could possibly be an issue for the borrower, as it serves to create a variable cost that could in the future grow out of control, based primarily on the agent or the selected counselor’s preferences.

Satisfying Stays Inc. and its subsidiaries (the “Company”) are the owners, lessors and operators of hotels throughout the United States.  The Company is privately held by the wealthy Frank family.  The Company started out with one hotel and, through acquisitions, has grown over the years.  The Company now owns and operates 400 hotels and is looking to refinance the majority of its long-term debt with a new first lien mortgage loan in the amount of $1,000,000,000, new second lien debt in the amount of $300,000,000 and new unsecured bonds in the amount of $200,000,000.  As part of the refinancing, the Company is willing to make changes to its corporate and organizational structure to accommodate the requests of the lenders.

You will be the majority lender under the mortgage loan. 

How will your mortgage loan be structured and incurred by the Company and what are some of the operational changes you will require for the Company in order to protect your interests if the Company becomes financially distressed and/or insolvent?

As a borrower, the controlling company, Satisfying Stays Inc. is a single purpose, bankruptcy remote entity (SPE) with all 400 of the company’s properties included within the second lien mortgage refinancing remote agreement. At all times the lender owns 100% of the Borrower. The mortgage loan will be structured in such a way as to isolate financial or other assets available to support the loan, specifically in respect to securing the unsecured bonds. SPE’s parent and affiliates. SPEs have been structured to be “bankruptcy remote” in an attempt to protect lenders from becoming entangled in a bankruptcy case caused by financial difficulties of other members of the corporate family. SPEs typically incorporate carefully crafted impediments to a bankruptcy f filing in their organizational documents and loan agreements.

Market participant

As a borrower, the controlling company, Satisfying Stays Inc. is a single purpose, bankruptcy remote entity (SPE) with all 400 of the company’s properties included within the second lien mortgage refinancing remote agreement. At all times the lender owns 100% of the Borrower. The mortgage loan will be structured in such a way as to isolate financial or other assets available to support the loan, specifically in respect to securing the unsecured bonds. SPEs are often already structured in a way that is “bankruptcy remote,” to protect lenders from being caught up in the bankruptcy case. Directors and officers in single purpose bankruptcy remote entities must also act fairly and honestly in an attempt to avoid acting for personal gain or their own personal self interests. In cases like this one where it’s possible that a company may become insolvent, duties of care, loyalty, and good faith remain set in place, to protect the interest of the creditors as well as the shareholders.

What other protections, agreements and undertakings will you require to safeguard your interests if faced with the threat of bankruptcy?

The most clear cut way to safeguard interest is to require that the interest be larger than normal, especially in the case of a second lien loan. This ensures that the principle is paid off on the more efficiently. The borrower must also be expected to at least pay the interest on the loan. Another way to safeguard the interest is to have the borrower secure the bonds by putting up collateral in the form of some of their hotels. Through restructuring the terms of the agreement, which they consented and stated they were willing to do. Securing the unsecured bonds. and other loan debt, in the form of collateral, as well as requiring that the borrower have a guarantor with a higher credit rating, are the most sound ways to safeguard against bankruptcy.

How would this impact the Company’s options in terms of placing and structuring the second lien debt and the unsecured bonds? 

Debts that are subordinate to the rights of other debts, such as previous loan agreements issued against the same collateral, or part of the same collateral. If a borrower defaults on their debt obligation, the second lien debts gets paid off after the first lien debt. Second lien debt is actually subordinate to the debt that was acquired prior to its drafting. It’s actually standard that when loans are issued to require some form of collateral against the principle of the loan. n the case of a real estate mortgage, the lender effectively places a lien on the asset so that if it is sold, the lender will be first in line to receive funds. If a second mortgage is taken out on the same property, the second loan is defined as the second lien debt to the first mortgage, and it’s subordinate to the first in terms of return of principal. For this reason, second lien debt is usually considered riskier than higher lien debt and often comes with a higher interest rate as a result.

In the case of a real estate mortgage, the lender effectively places a lien on the asset so that if it is sold, the lender will be first in line to receive funds. If a second mortgage is taken out on the same property, the second loan will be considered second lien debt to the first mortgage, and will be subordinate to the first in terms of return of principal. For this reason, second lien debt is usually considered riskier than higher lien debt and often comes with a higher interest rate as a result.

Despite best intentions and superior management, the Company is facing a liquidity crisis.  The current economic crisis has caused a general and substantial decline in the value of properties and business ventures and economic factors have also limited consumers’ ability to, and appetite for, travel.  As a result of the foregoing, the Company is unable to generate enough revenue to service operations and service its debts; the Company will not be able to make the upcoming interest payments on the mortgage debt due in two weeks.  This will result in defaults under the mortgage debt, the second lien debt and the unsecured bonds.  The Company is unable to incur additional debt to make the interest payments because of restrictive covenants in the existing debt documents.  In addition, although certain third party lenders have expressed interest in funding the business, no lender is willing to lend to the Company in its current distressed state.  The Company has engaged in discussions with its various lender groups in order to reach a consensual resolution with regards to the interest payment and outstanding debt.  At least a majority of the mortgage debt is willing to work with the company to modify the terms of its debt, including extending the maturity, modifying covenants and modifying the interest rate.  Likewise, lenders in the second lien debt and certain of the unsecured bondholders are willing to negotiate a consensual resolution.  However, the Company is unable to get cooperation from 100% of its lenders and the secured lenders are unwilling to enter into a forbearance agreement.  There is also a large group of bondholders that are insisting on payment in full in cash and are threatening to accelerate the debt and exercise remedies in the event of a default.

You are the CEO of the Company and it is your desire to rehabilitate the business so it may continue as a going-concern.

What do you believe is the best course of action for the Company and its creditors to address its current distressed situation both in the short term and the long term?  What are the pros and cons to your strategy?

When corporations go out of business or default on their debts, bondholders, in the form of creditors, are given priority as opposed to stockholders if and when the company goes to bankruptcy court. The terms of each bond, however, would dictate who has priority among the Bond holders. For example, those holding secured bonds would have priority over the ones holding unsecured bonds. In fact one of the most critical aspect of this situation is in respect to whether or not the bonds they are holding are secured or unsecured. For the owners of the secured bonds, certain assets have already been pledged to those holders as collateral, which they are entitled to collect if they are requesting payment in full. It is also more likely that the creditors currently asking for payment in full are those holding the unsecured bonds as the interest on secured bonds would be significantly lower and the creditors aware that they have collateral to support their loan would most likely be less eager to collect on the smaller interest that has accrued.

Based on the company’s current situation it appearers as though filing for bankruptcy might be their only option, as the the mortgage loan payment is due in the next two weeks. There are some potentially beneficial alternative options to bankruptcy that might work for the company to resolve some of their cash flow problems in-house, independent of their conflicts they are having with their creditors. While bankruptcy does seem like a convenient solution to the company’s problem, it comes with it’s own set of complications such as attorney court filing fees and the long lasting negative stigma for the business as well as the impact it has on the credit score of the business owner. Some alternative options include cutting unnecessary costs to free up capital and revisiting the budget to modify it in a way that more adequately represents the company’s current operations. While two weeks may not seem like a long enough time for the company to free up enough capital to cover the mortgage payment, there is no way to be sure unless the company reassess its budget to identify unnecessary or unrealistic expenditures. Most importantly revisiting the budget in an attempt to cut costs will allow the company the opportunity to identify the cause of the debt, so it can isolate the issue and present it in a possible reorganization plan if the company files for bankruptcy or re-enters negotiations with its creditors. There is also the possibility that the company hasn’t been making sound efforts to collect payments receivable. The act of increasing collections efforts could substantially change the company’s revenue streams dynamics. Selling off unused company material could also be another way of generating short term income. This is definitely something that should be considered if revisiting the budget reveals that the company has the ability to meet its debt requirements over the long term after it overcomes the hurdle of paying the two week mortgage payment. Another method for the the business to possibly get back on its feet and continue operations is to consolidate the loan debt. This way the debt can be organized in such a way that it doesn’t impact the main focus of operations or identifying additional funds and revenue within the company.

Please describe the steps that a lender should take before commencing discussions with a borrower in connection with a distressed loan, some typical work out structures that are frequently used in work out situations, the key characteristics of a forbearance agreement and the benefits and drawbacks of using a pre-packaged bankruptcy as a means to achieving a work out of a troubled loan.

Before commencing discussion with the borrower, it must be determined whether or not a workout would be beneficial. This entails assessing the details of the loan, specifically the disadvantages and advantages associated with a possible bankruptcy or forbearance filing by the borrower, the possibility of litigation, or other alternatives like refinancing the loan. This requires some due diligence on the behalf of both parties to identify the weaknesses and strengths of all options. As the lender, I base all information, acquired through a due diligence assessment, on current market conditions and what they mean for the ease of retrieving the lended funds, as well as available collateral, and the genuine financial condition of the borrower. The due diligence process, prior to sitting down with the borrower, may reveal missing documents on my end or a problem with the perfection of the security associated with the loan. Taking the time to uncover potential deficiencies will better prepare the lender for the workout process. If the borrower is aware of certain deficiencies on my end, they may attempt to use that as leverage in a litigation negotiation, so it’s better to be prepared and correct these issues prior to workout discussion as to not be caught off guard. A review of all loan affiliated collateral most also be carried out. This entails assessing the collateral for its current market value through a qualified third party appraisal. This assessment of the collateral will play a key role in both the workout negotiations as well as bankruptcy proceedings if the borrower plans to take that route. The financial conditions of the borrower must also be accounted for as any recent changes in their financial situation could significantly impact the outcome of the workout proceedings in such a way that it would be to the lender’s benefit to pursue a specific path towards recovery of the lended funds that the lender might otherwise overlook or avoid. When evaluating the financial conditions of the borrower, the lender must also take into account the liquidity of the guarantor. For example, the guarantor could have recently filed for bankruptcy revealing a decline in their credit.

Litigation is the next potential step after due diligence. If the due diligence process reveals the security to be worth more than the actual value of the loan, then it is likely the borrower will be more willing to go into litigation as opposed to going through the workout proceedings. A sound prediction on the potential outcome of a litigation proceeding is essential for both parties to have the possibility of engaging in workout negotiations outside of the court room. The outcome of the borrower filing for a Chapter 11 bankruptcy and their ability to draft a comprehensive plan of reorganization also impacts the nature of workout proceedings.

There are also some other alternatives to a workout agreement that must be considered before lenders and borrowers begin negotiations. These alternatives tend to be broken down into three categories all accessed with out of court actions when dealing with a distressed loan. One of these alternative options is instead of having a workout negotiation, the borrower just gets the loan refinanced by another lender. In this case, the lender could possibly agree to accepting a discounted payment in order to remove the debt from their balance sheet. The second alternative to a workout agreement is to permanently restructure the conditions and terms of the loan in a such a way that the borrower can comfortably repay the debt obligation. The third alternative is a forbearance agreement. This entails certain established conditions which the borrower agrees to follow in return for the lender agreeing not to exercising their right for a remedy of the loan. Refinancing the Loan is the most ideal alternative but entails complicated aspects like convincing a another lender to taking on a distressed loan, which is not the most appealing thing for a new investor to do. One way for the borrower to sell a new investor on the idea of taking on a distressed loan would be to free up some capital and put it down on the loan to encourage new lenders to take on the loan.

As the head of one of the City’s largest real estate development firms, you are interested in finding pieces of property with development potential. You have recently become aware that a vacant lot (Lot 1, as shown on the attached diagram) is available to purchase. Please describe the uses and floor area that you would be able to develop on Lot 1 as-of-right. Describe the other zoning constraints you would review for the development. Finally, please explain what steps you would take to increase the value of the property and how those steps would affect the value.

As lot 1 is located directly in between the zoning district boundary, with lot 4 to the left of it and lot 5 to the right, there are zoning regulations that may impact how the land is used and these factors may impact the nature of development. Zoning and the building ordinances play a substantial role in how this lot will be utilized for a development project. It should be noted that depending on government regulations as they relate to boundary limits this property may be substantially limited in its possible use. The following will assess how zoning considerations and will impact the development process and how the the property value can be increased.

Zoning Constraints

A variety of factors influence the private sector’s ability to construct housing or other forms of development. Certain zoning constraints are applied in respect to the development, improvement and maintenance for all regions and all economic groups. Constraints, for the most part entail added costs to development, and are classified within two main categories non-governmental constraints and governmental constraints. Governmental constraints entail standards, requirements or actions imposed on a particular region. For this project the governmental constraints that apply entail Land Use Controls, which involve the minimum standards in respect to Subdivision Ordinances and City’s Zoning. Zoning ensures that land use within a particular community is efficiently and optimally utilized in a way that allows for adequate space between all types of developments. Zoning regulations implement the controls  necessary to maintain this assurance by regulating the lot area boundaries, the height of a particular building, its dimensions, bulk and yardage. When zoning standards are too strict, like in this case with the lot 1 development, sufficient land use flexibility will be denied and it could result in an increase in the cost of development which could diminish interest in the property. This is especially true if the property is a commercial or public property to be erupted for the benefit of the community. In the case of housing projects, the rigid zoning policies applied to lot 1 can negatively impact the affordability of near by housing. The Subdivision Ordinance regulated the process through which raw land is transitioned into building developments. Subdivision Ordinance can be see used in the Lot 1 blueprint in respect to how all of the lots are broken down into respective sections but they appear to all be attached to, or compressed within, the main core unit. Lot 1 has the added disadvantage of neighboring the zoning boundary, which could pose a potentially significant cost if there is a misconstruction and the building expands over into the zoning boundary. Subdivision Ordinances also dictate  how the internal aspect of buildings will be developed to ensure that  City designs follow a certain pattern relative to City streets, public utilities, safety, and to ensure the property is affordable to maintenance.

Again, overly restrictive standards will result in greater land development costs and potentially a lack in development interest. The blueprint suggests that the land use controls associated with the lot 1 development are, for the most part, consistent with those put in place by other regions and cities, except for the fact that they zoning boundary significantly restricts the erection of a building much more so than if the development were to be constructed in any of the other lots. Lack of control can also lead to quality issues in development which could be a plus for the lot 1 development project.

Some major considerations that must be taken into account in respect to developing the construction while staying compliant with zoning regulations and subdivision ordinances is that the development process and finished product must account for the construction and seamless integration of curbs, storm drains, and gutters. The construction must also account for building codes, which regulated that design and physical aspects of the building itself. Building codes also entail proper compliance with electrical, mechanical and plumbing codes. The enforcement of building codes happens through inspections as a direct response to filing a building permit for a new development, a major renovation, or remodeling. Inspections can also occur as a result of public inquiries about the questionable quality of a particular building or its construction made by members of the community.

Improving Property value

One key way to increase the property value would be to invite an interior designer Realtor or interior designer to check the property for valued improvements that could be implemented as an aspect of remodeling the property. This form of professional consultation could substantially improve the value of the property. Minor changes, like paint use could make a major difference. If the property is for public use, adding art to the property or a form of artistic design that increases the property value of other nearby developments through enhancing tourism is another way the value could be increased.

An intelligent or cost effective way to increase the property’s value is to cut the actual cost of maintenance or upkeep through cutting energy costs through having a local energy company do an energy audit on the property. Other forms of being energy efficient is to install solar panels or enable the property to run on alternative energy in addition to being an environmentally responsible way of saving money over the long run, some local governments provide subsidies for individual and commercial use of alternative energy in construction or transportation. By making the building energy efficient it will allows for additional funds that can be allocated to other aspects of building maintenance, as well as new building updates.

Landscaping is also another additive that can improve the quality of the property, of course any trees, sculptures, or other forms of decorative accessories to supplement the building’s presence within the community that might be added to the exterior of the construction must comply with all zoning and subdivision regulations. For example, planting a tree is something that increases the value of the property over time. Another advantage of having a fully grown tree near a property is that the shade it provides from the sun can cut cooling costs substantially.

Congratulations! You have just been appointed by New York City Mayor Bill Delusion to be his new Deputy Mayor for Development.  You’vie been tasked to evaluate three potential major public/private development  projects and advise the Mayor-elect:

What are the major risks inherent in each project? 

As previously stated some of the major risk involved in constructing new buildings involve zoning and building code violations in respect to the property diminishing the value of properties e community. Governmental constraints entail standards, requirements or actions imposed on a particular region. For this project the governmental constraints that apply entail Land Use Controls, which involve the minimum standards in respect to Subdivision Ordinances and City’s Zoning. Zoning ensures that land use within a particular community is efficiently and optimally utilized in a way that allows for adequate space between all types of developments. Zoning regulations implement the controls necessary to maintain this assurance by regulating the lot area boundaries, the height of a particular building, its dimensions, bulk and yardage.

What is most likely to delay the accomplishment of the project within the Mayor’s first term?

The main thing that is most likely to delay the accomplishment of projects within the Mayor’s term are the regulations such as zoning, and building policies and the acquiring the necessary permits for construction. Likewise, the cost of redirecting roadways, setting up utilities, and building gutters in the right locations are all important factors that must be taken into account and could potentially set the project back. Zoning is also an issue, as it can prolong development.

Why or why not is this project a good use of governmental incentives?

The project is a good use of governmental incentives because it’s increasing the value of the city, and thus resulting in increased revenues for the government in the form of a wide range of taxes. The most direct increase the government will see in its revenues comes in the form of local taxes on products in response to the increased purchases, as well as new businesses coming in response to the newly developed construction.

How can the project best be sold to the public?

The best way for the project to be sold to the public is through marketing the benefits the construction will bring to the city, specifically the jobs, increased tourism, and increased spending.

What sort of binding commitments and penalties should the City demand to ensure the project happens as promised?

The main binding agreement that needs to be established is an agreement for compensation in the amount that the city will have spent plus the cost of the city’s time. Projects that don’t see their way to completion often result in the loss of similar projects to other cities that could have brought significant revenue to the city. Half built developments need to be torn down and cleared, and that can often take longer the the initial plan to develop the building itself, which just results in more time wasted. An effective contract would account for such costs and compensate the city thoroughly.

Finally, which of the projects would you recommend receive the top priority and why?

Project #2:

After close evaluation, I believe project 2 should receive top priority, simply for the fact that the company J.P. Stanley is a long running and respected brand. The company also has substantially more capital available to it than the company in project 1 and it’s much more stable than the proposed project 3. This makes the project as a whole less of a risk. The company also agreed to sign an agreement preventing it form leaving New Jersey for 20 years, or they will have to pay a fine. As long as that fine is reflective of the amount of money that it will cost for development as well as the amount of money that would have been gained if the company had not departed, I believe project 2 is positioned to be the safest deal and priority project. Also the zoning issue compared to project 1 seems significantly minor.

Project #1:

As the case for project 1 notes Pear will only agree to setup their building in the city if the following terms are met”(a) the City and the MTA agree to build a new subway station below its office tower (which is expected to cost about $350 million); (b) an agreement by the City not to levy any taxes on the project for 20 years (valued at about $225 million); and (c) a change to the zoning resolution to allow for 2 million square feet of office use on a lot that only allow 500,000 square feet”. This creates a situation where the economic benefit really comes out to be about $100 million to $150 million over the course of the first ten years and then the project starts to show the city profit. There zoning code violation issue, and the impact overriding it will have aesthetically on the surrounding area should be taken into account.

Project #3:

The consortium of universities and corporations, eager to build the nanotechnology center faces financial challenges. They also face the challenge of being in an emerging market without a track record of success. This places them at a significantly high risk of being unsustainable. That said since they do have associates familiar with crowd funding and seeding startups, there is no reason to assume the project can’t acquire funding, especially since it has ethically sound goals in further technology. The problem is that since this is truly a mega start-up, the consortium has neither funds nor a track record, which means the city itself would be taking on substantial risk for an unsure bet. The case notes that the city would have to come up with $500 million to fund the project in anticipation of over $2 billion in investment of the research. This is $2 billion in investment that is not guaranteed. The fact that the city has to amend zoning regulations exposing them to the authority of the Uniform Land Use Review Process, creates more diplomatic complexity as it forces officials to find alternative political routes to get around the process. This is just more bureaucracy that takes time to resolve and results in the project taking up more time to complete. The final complexity of the project is that the consortium placed a 3 year limit on the deadline. This is a time frame that is not realistic for the level of political complexity involved in the project.