Forbearance Agreement. Sounds dark and ominous, right? Understandable, but before you go into panic mode, you should first understand what exactly a forbearance agreement is and why commercial lenders, like Ignite Funding, keep this mortgage tool on their tool-belt. Below we go into a Q & A with our resident underwriter, Pat Vassar, to help clear the air on what is commonly misconstrued as an unfavorable situation.
What is a forbearance agreement?
A forbearance agreement is a way to make a modification to an original loan agreement. It is specifically used to modify and extend the original maturity date of the loan. In other words, it is simply a tool that can be used to extend the term of the loan without refinancing.
When would Ignite Funding negotiate a forbearance?
You have to remember that these Trust Deed investment loans are very short term (i.e. 6 to 18 months) relative to the amount of time it actually takes for the average real estate project to be completed. For example, a developer that is working on the horizontal development for over 200 residential lots is probably not going to complete this project in 18 months or less. They are going to have to continually refinance the loan or make a loan modification (forbearance agreement) to the original loan term to accommodate the actual time-frame to complete the project. Due to the short-term nature of Trust Deed investments, utilizing a forbearance in these situations is in no way indicative of the borrowers financial standing. It doesn’t mean their sales are bad or that they are building the wrong product.
99% of the time Ignite Funding will refinance the loan; however, there are situations where negotiating a forbearance agreement is more practical and more cost effective than attempting to refinance. An example of when it’s more practical is when the development work for a project is in mid-process. There are most likely mechanic’s liens outstanding for subcontractors who are also still working on the project alongside the borrower. The Title company will not insure the refinanced loan because the mechanics liens create a situation that the Title company calls “broken priorities.” This means that if we were to refinance the loan it would put our investors in a subordinate position (second lien as opposed to first lien position) to those mechanic’s liens. If Ignite Funding cannot put our investors into a clear first lien position, then we will negotiate a loan modification, or forbearance agreement, on the original loan to keep the investor’s first lien position intact. If the majority of the investors (51% of the loan balance) that were already invested on the loan approve the forbearance, they will continue to collect interest until the borrower pays-off the loan, either by selling the property or finding a different lender to refinance with.
Another example is if the borrower has completed the project, but they need another couple of months to close the sale of the property. It’s more cost effective for them and for us to negotiate a forbearance extension than to go through the whole refinance process.
When would Ignite Funding not negotiate a forbearance?
We would not negotiate to extend a loan, either via a forbearance agreement or a refinance, if it puts investor capital in harm’s way. For example, if the borrower is actually struggling financially or the product, they are working on is now in a declining market from when they initially started. Our number one priority is to protect investor capital. Another example of when we would not negotiate a time extension is if the borrower is changing the type of product they were originally building or developing. That particular situation would require us to go through the underwriting process again to draft up a new loan for what would essentially be a new project.
Why does Ignite Funding have to ballot investors in order to approve a forbearance agreement?
The investors are the beneficiaries of the loan, whereas Ignite Funding is simply the servicer of the loan. As the beneficiaries of the loan, 51% majority of investors must approve any changes/modifications to any terms of the original loan, whether it’s the duration of the loan, adjusting the amount of interest being paid, the accepted pay-down amounts, etc. That is why we send out a ballot to investors to either approve or deny the forbearance proposal, it is ultimately the majority’s decision.
What happens when the investor majority approves a forbearance?
It keeps investors in a first lien position by modifying the maturity date of the original loan, and they get a few extra months of accrued interest without having to put in the work of investing those funds onto a new loan. A forbearance nurtures a good borrower relation by being flexible and helping them lower their overall costs, which means investors will to continue to have access to great real estate projects with exceptional borrowers for the long-term. However, a forbearance does mean that an investor’s funds are still tied up on that loan, which our current investors should already be familiar with given the illiquidity of Trust Deed investing.
What would happen if the investor majority voted to foreclose instead of approving the forbearance?
If the 51% majority of investors rejected the time extension request through a forbearance, Ignite Funding would initiate the foreclosure process. The borrower has 90 to 120-day window, depending on the jurisdiction of the project, to pay back the loan by selling the property or finding another lender to refinance with. If the borrower is unable to sell the property or refinance the loan with a different lender in time, the borrower can go to court and file a lift-stay to pay back the principle only in order to take back the property. Essentially, foreclosing on the property means that investors would not get their principle back any quicker, nor would they receive interest payments during this time. It rarely makes sense to foreclose on a property that is in good standing with a borrower.
Historically, how many forbearances has Ignite Funding negotiated on behalf of investors?
Less than 1-2% of the 1,078 loans (as of 3.1.2020) we have funded have had a forbearance proposal presented to the investors. As you can see, it is a rare occasion when we negotiate a forbearance for a loan, but they are an extremely useful tool when the occasion calls for it.
Important takeaways from this conversation with Pat Vassar, our Director of Underwriting:
- Forbearance proposals are a mortgage tool to modify the original maturity date of a loan for the benefit of both investors and borrowers
- They are not inherently bad and are not a time to panic.
- When you invest in Trust Deeds you should always take into consideration the illiquidity of these investments.