It's All About the Guaranty

Insolvency professionals, both lawyers and financial advisers, are often facing an all-too-common issue when advising on real-estate-related situations in today's market. The issue they face is that the property has more debt than it can support and/or more than it is worth and the entity they represent, the debtor, may be only one of the guarantors in the failed real estate venture. Every legal and financial adviser dealing with distressed real estate needs to put up a sign reminding themselves (and their clients) that “It's all about the guaranty.” In almost all distressed real estate situations today, the banks are looking to the guaranty as a source of funds for repayment.

Since real estate asset values can be established, this means the guaranty is the main factor that will impact the ultimate economic resolution and therefore the one the banks will focus on the most. This situation often creates numerous issues for the legal and financial advisers ' first and foremost that “the client,” the debtor is often only one of the decision makers in resolving the issues. In fact, the other guarantors may have different guaranty obligations than the debtor and therefore have retained their own legal advisers to protect their interests. Depending on the relative strength of the guarantors, the debtor you represent may or may not be the “real power.” This entire situation (very commonly) is further complicated when the debtor, often a LLC or other single purpose entity, has both corporate and personal guaranties ' often with many of the same key principals with a financial interest in both.

Whether your real estate client is a large single-asset entity or a holding company with multiple real estate types, you are likely to find that there is no restructuring plan, no matter how creative, that will change the asset value materially in the short-term (two-three years). If the fair market value of the property is less than the debt, then the lender is effectively the equity holder. But if there is no equity value then there are two vastly different scenarios to deal with, properties with recourse debt and those with non-recourse debt.

The focus of this article is on those situations that are cash-flow-negative ' where any additional cash infusion by the existing owners is effectively a “call option.”

Non-Recourse Debt

In the case of non-recourse debt, the solution is often pretty cut and dried ' hand the keys over. Unless there is an expectation of significant equity value in the near to intermediate term, it is better to give the keys to the banks and focus on properties with equity value. Notwithstanding the lender's many persuasive arguments why the principals should invest more equity, the lender had the opportunity to require security above the asset level and chose to underwrite the credit non-recourse. Since lenders are rarely willing to write-down debt to market value while leaving the principals in the deal, there are few alternatives for an underwater non-recourse deal. The principals need to focus their capital and attention on properties that are not underwater or on new investment opportunities.

Projects with recourse debt are often much more complicated than they might seem on the surface. Recourse can come in many forms; holding company guaranties (“Holdco”), personal guaranties and pledged assets among the most common. Lenders who happily put those impressive looking financial statements in their files in 2006 or 2007 and paid little attention when the 2008 year-end statement came in may be in for a rude awakening when the loan matures in 2010 or 2011. A Holdco with substantial net worth in 2006 or 2007 most likely provides little or no additional security to the loan, today or in the future.

Holding Companies

Let us look at what frequently happened. Loan X was made in 2005 for Holdco (and its principals), whose balance sheet showed little in the way of liquid assets but a number of projects in various stages, all which with comfortable LTV's and significant “equity” value. Several stabilized cash flowing deals showed carrying values well above their debt. The development, pre-development and existing stabilized projects all had impressive projections.