The outcome of the EU referendum has put valuers in an unenviable position. The RICS Red Book requires a valuer to identify a situation where a reduced level of certainty should be attached to their valuation (VPGA 9 – Valuations in markets susceptible to change: certainty and uncertainty). The effect of the general political and financial uncertainty generated by the leave vote as regards the UK property market is not yet fully clear. So far, at least one of the large valuers in the UK has made the decision to caveat its valuations finalised post-23 June with a note to the effect that the valuer has less confidence than usual in the probability of the valuation coinciding with the price achievable on a sale, as a result of the Brexit vote.
Absent other mitigating features, this may not be welcome for a lender basing its credit decision on a more risky loan to value, in particular, junior or mezzanine lenders, and we are already seeing caution in the market on this basis. Speculating on mitigating features, we note that U.S. lenders are used to relying on ‘bad boy’ guarantees. These guarantees (and the related loan agreements with the borrowers) typically alter the liability of the borrower and guarantor under the financing transaction in two respects once triggered. First, the guarantee of the borrower’s obligations, usually given by an owner or principal of the borrower, will become operative (or “spring” into effect) upon the occurrence of one or more enumerated “bad acts.” Second, the otherwise non-recourse loan obligation of the borrower will convert into a recourse loan obligation, thereby making the borrower and the sponsor guarantor fully liable for all obligations.
Although this approach has so far been robustly rejected in the EU market, perhaps the next two or three years will see these requests/requirements become more prevalent.
For transactions that have already completed and/or been funded, LMA standard terms for real estate financings provide that a borrower pays for a valuation on an annual basis. In our experience, these provisions are not generally heavily negotiated, and indeed bank policies tend to require an annual paid valuation. Borrowers often rely on their lender relationship to call for an annual desktop rather than full Red Book valuation, without making this explicit in their loan contract.
From a relationship lender’s perspective, an adverse valuation may not necessarily be a welcome outcome in a deal that is performing on an income/debt service basis. Anecdotally, we have already seen the greater uncertainty in valuations trigger re-negotiations as to pricing, not welcome news for a borrower financing an otherwise performing deal.
Many loan agreements allow the facility agent (on behalf of the lenders) to obtain an updated valuation if it considers that a default as a result of breach of the LTV covenant is likely to be evidenced as a result.
In CMBS transactions, a servicer (acting on behalf of the facility agent) tends to take a cautious approach to triggering an updated valuation in these circumstances, and will only do so if it is of the view that such action would be in accordance with its servicing standard. If the loan agreement does not provide for annual valuations, a servicer might be reluctant to call for a valuation unless the loan maturity is approaching.
CMBS transactions tend to have an appraisal reduction mechanism. This broadly allows for an examination of the total exposure of the loan versus the latest market value of the property and the amount of liquidity facility available to support payment of interest on the notes. Any evidence of reduction in the market value of the property could therefore lead to an appraisal reduction and a reduction in the liquidity facility commitment available – an undesirable outcome.
We would suggest that servicers, lenders and borrowers carefully review the valuation provisions in their loan and servicing agreements, both as to their rights and to their obligations, and consider carefully whether a new valuation in the current climate would be a benefit or is to be actively avoided. Interestingly, the market has historically tended to view a default called on MAE alone as an aggressive strategy. It strikes us that calling an LTV default on the basis of a fresh valuation in the coming months may well be regarded in a similar light.