When disaster strikes: property damage and defect issues for real estate borrowers and lenders

In-depth analysis

A number of prominent building fires in recent months have brought the prospect of buildings being damaged or destroyed back to the front of the minds of property owners, their lenders, and those who act for them, as well as bringing back memories of the fire safety defects crisis and much needed investigation which rightfully followed the Grenfell Tower tragedy.

What can (or must) borrowers and finance parties do when a building is significantly damaged, with the loss of income and/or delays to development completion this entails, or when a property is revealed to have significant defects? In this article, we discuss the issues, and how they are usually dealt with under Loan Market Association (LMA)-form Real Estate Finance loan agreements in England and Wales.

Information provisions

The borrower will not be able to escape informing the finance parties of the damage or defect. As well as the requirement to notify the facility agent promptly upon becoming aware of a "Default" as defined in the facility (which the damage or defect is likely to constitute and/or lead to – for which see further below), the LMA standard property reporting requirements for each interest period include details of any actual or required material repairs to each relevant property, catching this situation. Under a development loan agreement there are also monthly reporting requirements and a requirement to promptly notify the facility agent of any breach or alleged breach by any party of a document designated a "Development Document". Also, it is prudent for a borrower to inform its finance providers of serious issues with the property once they are aware of their extent, both from a relationship perspective and to allow more time to negotiate any waivers or amendments that might be required in order to address the consequences of the damage or defect.

Maintenance covenant

Subject to any envisaged development, maintenance or refurbishment works at the property, an LMA-form loan agreement will contain a covenant requiring the property to be in and maintained in good and substantial repair and condition and in such repair and condition as to enable it to be legally let. Material damage to or a material defect in a property will put the borrower in breach of this covenant, creating a "Default" (and given that any grace period will almost certainly be too short to effect relevant repairs, an inevitable "Event of Default").

Given this, the borrower should be proactive in raising the matter with the facility agent to obtain at least a 'soft' confirmation the finance parties will not seek to accelerate the loan whilst the scope of the issue is understood and a longer term solution is agreed between the parties and, where the loan is not already fully drawn (for example in the case of a development facility where the development remains ongoing), to discuss whether continued drawdowns will be permitted (this is more likely to be allowed for costs already incurred, or where expenses are being incurred to preserve the asset and there is no practical alternative source of funds).

The facility agent would generally be well advised to serve a reservation of rights letter on the borrower in order to preserve the finance parties' rights, whilst discussions with the borrower are ongoing. This letter prevents the borrower from arguing that by failing to take action (or by permitting further drawdowns, therefore advancing further funds) the finance parties have impliedly waived the breaches of the facility agreement resulting from the damage or defect, so cannot later take action against the borrower because of it.

Event of Default for major damage

The LMA-form Real Estate Finance loan agreement contains a standalone "Event of Default" for major damage to properties (the Major Damage Event of Default). The Major Damage Event of Default occurs if any part of a property is destroyed or damaged and the "Majority Lenders" (as defined in the facility and usually approximately 2/3rds of the lender group) believe, taking into account the amount and timing of any insurance proceeds, such destruction or damage will have a material adverse effect.

Whilst it is possible to envisage quite severe damage which is nevertheless so well insured against that the Major Damage Event of Default is not triggered, the standard LMA wording that the material adverse effect is only required to exist in the opinion of the Majority Lenders (with no requirement to act reasonably, although this is frequently a point negotiated on actual transactions), effectively forces the borrower into discussions with the finance parties (from a somewhat disadvantageous position) as soon as there is significant damage.

There is no equivalent of this immediate Major Damage Event of Default for newly discovered defects in a property, as a defect isn't damage or destruction as such, but the reality is that the maintenance covenant discussed above will have the same practical effect (albeit potentially with a short grace period from the defect coming to light).

Financial covenants

Any significant damage to, and many defects with, a property are likely to negatively affect the revenue from that property, as well as its value. Depending on how tightly drawn they are, and on whether any insurance proceeds for loss of rent count as income (in our experience this is a matter of negotiation on a deal-by-deal basis, with there being no settled market approach), this is likely to put compliance with any financial covenants in the facility agreement under pressure. This is as much the case for value-based covenants (eg 'loan to value') as for income based covenants (eg 'interest cover ratio').

Given that many covenants are calculated on the basis of past income (so called 'backward-looking' covenants), are only tested on certain dates or following certain events (such as a valuation), or allow for money to be injected from equity (either in prepayment or into a blocked bank account) to 'cure' a breach, it may be the case that there is a delay before any "Event of Default" arises via a financial covenant breach, but this is something both borrowers and finance parties must bear in mind when negotiating any package of waivers or forbearance.

Construction delays

If development or refurbishment works are ongoing at the time the damage occurs or the defect comes to light, the completion of these works may be delayed, in some cases significantly. Any loan facility where a property is envisaged to undergo significant works (whether or not the facility is being used to fund them) is likely to have provisions relating to when such works are required to be completed. Borrowers and finance parties in this situation will need to note that:

many of these timing requirements are linked to the opinion of another party (eg a project monitor or the facility agent) as to when completion will occur, so an "Event of Default" can be triggered well before the completion deadline itself

where the facility is funding the development or refurbishment, expected completion timing slipping beyond a certain point (which may be before the point an "Event of Default" occurs) is highly likely to trigger a drawstop and mean that the lenders are not required to make further funding tranches available

which in each case means that parties will need to consider acting swiftly to arrange a full or partial waiver and/or issue a reservation of rights letter to avoid negative outcomes.

Insurances

The LMA-form Real Estate Finance loan agreement requires the borrower to ensure insurances are in place which, amongst other things, cover damage to the property (and in many cases loss of rent and/or business interruption insurance also). Assuming this insurance is in place, damage (but most likely not an inherent defect) will lead to a payment being made.

The terms of that insurance may require that payment to be applied in repair or reinstatement of the property, in which case the facility agreement will also require that it be so applied, but otherwise the proceeds will either be absolutely required to be applied in prepayment of the loan(s) under the facility agreement (whether immediately or on the following interest payment date) or will be required to be applied in prepayment if they are not used within a certain time to repair or reinstate the property. To reinforce this, the loan agreement will provide that the security agent is named on the relevant insurance policies as composite insured or co-insured, and is the first loss payee in respect of claims over a certain value. This gives the security agent the right to claim directly for any losses the finance parties suffer and to take control of the proceeds of substantial insurance payouts.

Claims against contractors, report providers

Where there are defects with the property, and in some cases where damage has been caused by an identifiable third party, it may be possible for the borrower to make a claim against the person who caused the defect/damage or who failed to declare, discover or properly report on it. Lenders are generally concerned to see that the borrower takes such action where appropriate and that the proceeds of such claims are used in certain ways.
Standard LMA-form Real Estate Finance investment loan agreements don't contain specific provisions controlling the bringing of claims against third parties but do restrict entering into material agreements other than "Transaction Documents" without facility agent consent. This may make bringing proceedings without involving the finance parties impractical, and well advised finance parties would consider requiring oversight over any claim process as a condition of waiving the "Event(s) of Default" arising from the defect or damage. The LMA standard development loan agreement does contain a covenant obliging the borrower to exercise their rights (and ensure to the extent in its control that others comply with their obligations) under the "Transaction Documents" – the definition of which includes "Development Documents" – so there is more compulsion there.

If a claim is successful, the facility agreement will prescribe what is done with the proceeds. Where the claim is against a vendor of the property (or the shares in the borrower) or a provider of a due diligence report, the standard LMA-form Real Estate Finance loan agreement provides that such proceeds, after deducting the expenses incurred (otherwise than to obligor affiliates) in obtaining the proceeds and any relevant taxes (defined as "Recovery Proceeds"), are applied in prepayment of the loan(s) unless applied to satisfy (or reimburse an obligor that has discharged) a liability of an obligor (other than to another obligor) or to replace, reinstate or repair assets of the obligors as soon as possible but in any event within a certain period following receipt (proceeds so applied being "Excluded Recovery Proceeds"). The length of that period, typically 60 to 120 days, is a matter for commercial negotiation, but is unlikely to be sufficient to allow for substantial repairs to a property. Given this, an approach to the finance parties for an extension would probably be required.

Where the claim is in respect of damage or defects themselves, proceeds are likely to be considered "Compensation Prepayment Proceeds", and therefore required to be applied in prepayment of the loan(s). By default the LMA-form Real Estate Finance loan agreement doesn’t permit these proceeds to be applied in replacing, reinstating or repairing the property instead of prepaying the loan, but the LMA templates do include an optional provision for this (proceeds so applied being "Excluded Compensation Proceeds"), with time restrictions as for "Excluded Recovery Proceeds".

Reputational risk

Significant damage to a large building, especially where the mechanism is unavoidably public (like a fire), frequently results in public and press attention. The same is the case where a defect has a significant impact on individual occupants (for example flammable cladding causing a build-to-rent block to be unsafe to occupy or to require continuous fire watch). Where this occurs, borrowers may find that their primary concern is doing (and being seen to do) the right thing, rather than protecting their short-term financial interests. This will sometimes involve a borrower taking a decision not to strictly comply with the terms of the loan agreement without necessarily obtaining the finance parties' agreement beforehand.

In our experience, finance parties generally take a constructive approach in these situations. Whilst short-term financial performance is important to them, if the borrower is able to articulate a plan which provides comfort that the lenders will be repaid within an acceptable timescale and the value of the property will be restored and/or maintained, lenders usually don’t look to enforce the letter of the facility agreement and are willing to discuss amendments to the finance documents necessary to regularise the situation and provide for a way forward. For example, financial covenants could be switched off or relaxed for a period, or development completion deadlines and loan terms could be extended. Lenders typically seek to apply certain conditions to these amendments, whether to manage risk (for example by the debt being partially paid down by the sponsor from equity) or to increase control or oversight over the process (for instance by requiring reporting on the progress of the repair works or setting deadlines for certain steps to be taken to ensure the property is in a proper condition by the end of the term of the loan). Some lenders, particularly those with retail banking activities within the jurisdiction or which market themselves on the basis of ESG factors, may have similar concerns to borrowers about public perceptions, so may push for the borrower to act in a certain way to manage this.

Conclusion

The issues surrounding how to respond to a building you own or lend against being significantly damaged or being revealed to have substantial defects are complex and multi-factorial, going far beyond the boundaries of the terms of finance documents, or indeed legal considerations more generally, so of course cannot be fully dealt with in an article of this nature. However, the industry standard terms for property-based lending clearly have a substantial impact on how these matters can be, and are resolved.