The Fed's plan to aid struggling borrowers with preferred equity

The current commercial real estate crisis brought on by the coronavirus disease 2019 (COVID-19) pandemic is unlikely to be solved with debt alone.  Preferred equity investment will likely prove an important component.

While the Federal Reserve has attempted to blunt the COVID-19 pandemic’s impact on the financial markets through a myriad of pandemic programs, including facilities such as the Term Asset-Backed Securities Loan Facility, the Paycheck Protection Program Loan Facility and the Main Street New Loan Facility, the Federal Reserve has generally overlooked the plight of commercial real estate owners, including Commercial Mortgage-Backed Securities (CMBS) and non-agency borrowers.

Unlike balance sheet and agency borrowers that have benefited from government action encouraging lenders to provide forbearance and other forms of relief, CMBS and certain non-agency borrowers have been hamstrung by (i) rigid servicing agreements that do not afford servicers much latitude in working with borrowers and (ii) loan documentation that restrict borrowers’ ability to incur additional debt.  This has resulted in many CMBS and non-agency borrowers failing to qualify for aid under the existing relief programs.

Not surprisingly, borrowers in the hospitality space have been amongst the hardest hit.  As we enter the fifth consecutive month of lockdowns, hotels, restaurants, bars and all things hospitality-related have been decimated, with these assets generating insufficient cash flow in order to cover debt service and other property operating expenses.  According to Trepp, overall CMBS delinquency rates in May 2020 hit 7.2 percent, with hospitality delinquency rates hovering around 19.1 percent.  Unless the federal government acts quickly and decisively to address distress at the commercial property level, it is possible that we could be witness to a tsunami of CMBS loan defaults and property foreclosures not seen since the 2008 financial crisis.

Enter the “Helping Open Properties Endeavor Act of 2020” or the “Hope Act of 2020” (Act), a draft bill recently circulated by Congressman Van Taylor (R-TX).  The bill would provide assistance to borrowers by guaranteeing the purchase by eligible financial institutions, administered by the Department of Treasury and guaranteed by the federal government, of preferred equity investments issued by certain eligible commercial real estate borrowers negatively impacted by the COVID-19 pandemic.  

Highlights of the Act include the following:

• a cap on the investment equal to 10 percent of the outstanding principal balance;
• the investment would be unsecured, with no right of foreclosure and no voting rights, clearly beneficial to the borrower;
• a low interest rate of 2.5 percent annually, fully amortizing over seven years;
• the investment would be freely prepayable at any time;
• the investment would allow up to 50 percent direct or indirect equity transfers in the borrower before triggering redemption; and
• use of the proceeds would be limited to payment of expenses pertaining to the property and the preferred equity interest, including principal, interest and operating expenses.

Annual servicing fees equal to one percent of the preferred equity investment and an origination fee would be paid to the financial institution making the preferred equity investment.

DLA is in regular contact with Congressman Van Taylor’s office regarding the status of the Act and will continue to provide updates.

If you have any questions regarding these new requirements and their implications, please contact the author or your DLA Piper relationship attorney.

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This information does not, and is not intended to, constitute legal advice.  All information, content, and materials are for general informational purposes only.  No reader should act, or refrain from acting, with respect to any particular legal matter on the basis of this information without first seeking legal advice from counsel in the relevant jurisdiction.