Unprecedented Challenges in Commercial Real Estate Restructuring

Negative Equity and Its Impact on Multi-Lender Debt Restructurings

In March 2010, Elizabeth Warren, chairperson of the Troubled Asset Relief Program Congressional Oversight Panel, famously commented that about half of all commercial real estate mortgages will be “underwater” by the end of 2010. Given the recent volume of restructuring engagements in the CRE sector, this statement certainly appears to be holding true.

The phenomenon of negative equity alone makes restructuring difficult; strategic sales and divestitures are more or less off the table unless a lender is willing to take a significant “haircut.” Vulture investors are abundant ' unfortunately, strategic buyers with access to capital and a willingness to pay a premium for synergies are not. Today's multi-lender environment only complicates this issue further as a lender's willingness and ability to engage in a restructuring can be tied to internal policies and whether the lending institution has already written down the loan in question.

With several lenders often present at the bargaining table, competing viewpoints can make reaching a consensus difficult. One lender who has already taken a significant write-down on the loan may be willing to explore a debt restructuring. Another lender who has reserved nothing may be loathe to reserve any portion of the loan whatsoever, particularly if its portfolio is full of troubled credits and bank regulators are closely monitoring their capitalization. A third lender may be faced with an internal mandate that compels it to aggressively pursue any and all guarantors.

A restructuring professional's role in the above scenario is key to a successful outcome. Brokering a consensual agreement with so many competing interests can be a tall order, and a creative and imaginative solution needs to be crafted on a case-by-case basis.

Some deals have been brokered by restructuring notes in such a way as to divide them into performing and non-performing tranches. Shortfalls can be converted into equity positions, allowing a financial institution access to any upside resulting from a general recovery in the CRE industry. This strategy is useful in that it allows those lenders who want to exit the relationship the ability to sell their performing note, while those lenders with more of an appetite for a hold strategy can restructure their note, take a leadership role in the overall restructuring effort, and wait for the longer term benefit to accrue.

Sub-Optimal Debt Structures and Other Liquidity Pitfalls

The growth of the CRE industry brought on the genesis of many unconventional and creative financing arrangements that are resulting in unintended consequences. It is more important now that the restructuring professional involved in a CRE restructuring must therefore have an understanding of the kinds and types of debt instruments that finance the underlying assets.

Many CRE loans, particularly those used to finance Real Estate Investment Trusts (REIT) acquisitions, were not designed for the long term. Many of these loans included tantalizingly low interest rates, interest-only provisions with balloon payments on the back end, and few cash controls ' so long as the CRE asset was sold by a certain date. At origination, these terms didn't give anyone concern ' at the time, financing was abundant and loans that became cost prohibitive could more often than not be replaced.

Unfortunately, many REIT managers never contemplated the current scenario where the criteria for obtaining financing have become more rigorous and the underlying assets have reduced in value. Loans that were designed to be short-term instruments are now maturing and encountering unforeseen and unintended consequences. Springing lockbox provisions may be enacted, giving the lender the ability to sweep all operating cash. For the borrower, this can make an illiquid situation even worse, and for the lender, this is a way that the repayment obligations are repaid. Some loans contain letters of credit provisions that require an owner to secure a new lease commitment within a certain number of years of an existing lease's expiration. If they fail to re-lease the space by a certain date, a sizable letter of credit is often required to protect the lender against default.

An adviser must identify these issues as soon as possible so that they are adequately equipped to provide advice on the widest possible range of options. Often this starts with the negotiation of a standstill agreement with the lenders which can provide the stability to enter into more detailed negotiations aimed at providing a long term solution. The situation is often made more complex as the debt instruments are traded through the negotiations so that new players are introduced into the mix whose motives as investors may be different from the original holders of the debt.

Commingling of Cash and Assets

One trend that has been present in nearly all of the CRE restructurings with which we have been involved is commingling of cash and assets. Many CRE companies, particularly REITs, possess extremely complicated legal structures and often a considerable number of legal entities that in some cases can outnumber the number of properties by at least five to one. Unfortunately, their cash management systems may not be nearly as sophisticated.

Restructuring advisers must be diligent in tracing which legal entities secure which loans ' a basic concept, but a very important one when dealing with dozens of entities, countless bank accounts, multiple loan facilities, and sometimes several lenders.

In a distressed situation, many CRE developers and operators, however unintentionally, often commingle funds from multiple properties and projects. Companies with dozens of CRE assets may accumulate funds in a few bank accounts, or even a single bank account, in order to pool funds and minimize liquidity issues at individual assets. This can result in a misalignment between the cash-generated and the underlying income-producing assets. It may be extremely difficult to trace the cash attributable to each individual asset. Complicating this scenario is that the structures in place may have been derived from tax-driven strategies, the goals of which differ substantially from that which result in a distressed situation.

In the above scenario, receipts from profitable properties or projects can be used to fund the losses for others ' assets which may be collateralized under completely different loans with different lenders. In this way it is possible for a lender's cash collateral to slowly bleed away, largely unnoticed. It is therefore critical to ensure that strong cash controls are in place. This process involves setting up segregated cash accounts which are tied to each individual asset. In many cases, a lockbox arrangement works well for depositing cash receipts and giving a lender ultimate control over how and when those funds are dispersed. This is often supported by a cash control agreement to further protect the lender's position.

Once the cash has been segregated, it is important that fund flow analysis are prepared regularly so that all sources and uses of lender proceeds can be identified, and, more importantly to ensure that the borrower hasn't started to slip into bad habits and funds have started to become comingled again.

Things Aren't Always What They Seem

Recent case experience has brought to light several instances of operating strategies that were either misaligned with market practices or resulted in confusing or misleading operating statistics.

When taking a hard look at operations, it is important to calibrate a CRE entity's performance to the overall market. For example, an owner/operator may choose to establish a higher management fee in order to fund internal overhead costs. While on its face this practice may seem sensible, it is essential to benchmark both the management fee and service against those provided by external service providers. The outsourcing of the property management function to a third party specializing in these services could provide significant savings. For properties that may be considerably “under water,” this step could be the first in a long haul to improving the value of the asset and immediately start improving the cash position.

It is important to understand the motives and objectives of the parties involved in a restructuring. This divergence of interests can sometimes come to the forefront in a cram-down situation where it is vital to understand the way in which operating results and forecasts have been prepared to ensure that they hold up under scrutiny. For example, the reported net operating income, while used to gauge the profitability of an asset, also impacts key negotiation items such as valuations and break even calculations, which can drive the overall course and outcome of a debt restructuring. An adviser should always exercise proper due diligence when analyzing a CRE entity's operating performance for this reason.

Beware the Hidden Liabilities

Also in the category of “things aren't always what they seem” are the hidden liabilities that seem to plague many CRE entities undergoing a restructuring effort.

When a CRE entity faces financial distress, usually cash disbursements have been delayed and accounts payable stretched as far as possible. Delinquent real estate taxes, unfunded security deposits, and deferred maintenance are all hallmarks of a CRE entity in distress; unfortunately, each of these liabilities remains with the asset in question, and often the lender bears the cost. While deferred maintenance may not be a one-to-one chargeback, it usually depreciates the value of an asset such that, upon a sale, the lender's recovery is proportionally decreased.

An adviser should ask targeted questions of management in order to quickly identify any hidden liabilities such as the above.

Developers Expanding Beyond Their Core
Competencies

Sticking to core competencies sounds like Business 101, but in the case of the CRE industry, this key business tenant is especially important.

Not all CRE assets are created equal. Included in this category are strip malls, high rises, multi-family properties, and manufacturing facilities, among many others. During the real estate boom, many owners/developers were lured to different assets outside of their comfort zone with the promise of large returns and sizable dividends. Unfortunately, for those developers who also managed these assets, they quickly discovered that while they might be excellent property managers of 12-unit multi-family units, a sprawling industrial park is another story altogether. Similarly, an experienced owner/manager of Class A multi-family units might find that Class C multi-family units require very different operating strategies.

Outsourcing still remains a very useful tool in any restructuring. Those functions that are inefficient in-house are better left to outside, experienced contractors. Improved operations aside, this tactic usually has the added bonus of reducing costs and/or changing a highly variable cost to something more predictable and manageable.

Not only did many developers expand into different assets and asset classes, but many expanded beyond their geographical reach. Some owner/property managers are simply not structured to effectively manage assets in remote locations, where their onsite presence is either impractical or cost prohibitive.

A restructuring adviser should always approach a CRE restructuring with a sober outlook of fixing what can be fixed, and disposing of problems that cannot. Underperforming CRE assets that do not fit with a client's portfolio, are outside the client's core competency, and/or subject to chronic mismanagement, are assets that should be strongly considered for sale. Even if recoveries are small, eliminating distractions caused by these kinds of assets can create many intangible benefits for an overall restructuring effort.

Act Now, Not Later

In the current climate, many CRE entities are tempted to bury their heads in the sand and wait for credit markets to improve before implementing restructuring strategies. They may argue that since credit is tight and asset values are so depressed, it's better to initiate a restructuring when the overall business environment is more favorable. But by then it may be too late.

The current liquidity crisis will inevitably end, but when it does there will be extraordinary competition among companies seeking to refinance and/or restructure. Too many entities will be competing for a finite amount of capital, and at that point it will be survival of the fittest. Companies, and particularly CRE entities, must be forward-thinking in their approach to restructuring. Armed with some of the key strategies above, restructuring professionals everywhere should be leading the charge and helping to implement strategic changes that will drive their clients' future growth.

Paul Melville ([email protected]) is a principal in the Corporate Advisory & Restructuring Services group of Grant Thornton LLP. He has addressed complex issues relating to real estate valuation, the evaluation and renegotiation of complicated financing structures, and monitoring ongoing performance of multi-tenant commercial properties. Melissa Dmitri ([email protected]) is a manager in the Corporate Advisory & Restructuring Services Group. She concentrates her practice in the restructuring, workout and bankruptcies of large commercial and other properties, and is currently providing advisory services in the Chapter 11 bankruptcy of a Real Estate Investment Trust with foreign ownership and domestically held properties.

It is not often that restructuring professionals agree on anything, but if you ask which sector of the economy is providing them with the most opportunities, they will pretty much agree on the answer as commercial real estate (“CRE”). Many scholarly articles point to frightening statistics such as the $1.4 trillion in CRE loans that are scheduled to come due in the next three years. Or perhaps they mention the fact that office-sector vacancy rates were forecast to rise from 16.3% in the fourth quarter of 2009 to nearly 18% in 2010, only to remain high in 2011. Then, of course, there's the well-publicized liquidity crisis.

The unprecedented challenges currently facing the CRE industry make many of the traditional restructuring strategies, including cash preservation, traditional debt restructuring and delevering, and divestitures, too generic to be actionable, or, simply impractical.

In this article, we identify some practical “watch out for's” when attempting to restructure a CRE entity against the backdrop of today's unprecedented market conditions.

Negative Equity and Its Impact on Multi-Lender Debt Restructurings

In March 2010, Elizabeth Warren, chairperson of the Troubled Asset Relief Program Congressional Oversight Panel, famously commented that about half of all commercial real estate mortgages will be “underwater” by the end of 2010. Given the recent volume of restructuring engagements in the CRE sector, this statement certainly appears to be holding true.

The phenomenon of negative equity alone makes restructuring difficult; strategic sales and divestitures are more or less off the table unless a lender is willing to take a significant “haircut.” Vulture investors are abundant ' unfortunately, strategic buyers with access to capital and a willingness to pay a premium for synergies are not. Today's multi-lender environment only complicates this issue further as a lender's willingness and ability to engage in a restructuring can be tied to internal policies and whether the lending institution has already written down the loan in question.

With several lenders often present at the bargaining table, competing viewpoints can make reaching a consensus difficult. One lender who has already taken a significant write-down on the loan may be willing to explore a debt restructuring. Another lender who has reserved nothing may be loathe to reserve any portion of the loan whatsoever, particularly if its portfolio is full of troubled credits and bank regulators are closely monitoring their capitalization. A third lender may be faced with an internal mandate that compels it to aggressively pursue any and all guarantors.

A restructuring professional's role in the above scenario is key to a successful outcome. Brokering a consensual agreement with so many competing interests can be a tall order, and a creative and imaginative solution needs to be crafted on a case-by-case basis.

Some deals have been brokered by restructuring notes in such a way as to divide them into performing and non-performing tranches. Shortfalls can be converted into equity positions, allowing a financial institution access to any upside resulting from a general recovery in the CRE industry. This strategy is useful in that it allows those lenders who want to exit the relationship the ability to sell their performing note, while those lenders with more of an appetite for a hold strategy can restructure their note, take a leadership role in the overall restructuring effort, and wait for the longer term benefit to accrue.

Sub-Optimal Debt Structures and Other Liquidity Pitfalls

The growth of the CRE industry brought on the genesis of many unconventional and creative financing arrangements that are resulting in unintended consequences. It is more important now that the restructuring professional involved in a CRE restructuring must therefore have an understanding of the kinds and types of debt instruments that finance the underlying assets.

Many CRE loans, particularly those used to finance Real Estate Investment Trusts (REIT) acquisitions, were not designed for the long term. Many of these loans included tantalizingly low interest rates, interest-only provisions with balloon payments on the back end, and few cash controls ' so long as the CRE asset was sold by a certain date. At origination, these terms didn't give anyone concern ' at the time, financing was abundant and loans that became cost prohibitive could more often than not be replaced.

Unfortunately, many REIT managers never contemplated the current scenario where the criteria for obtaining financing have become more rigorous and the underlying assets have reduced in value. Loans that were designed to be short-term instruments are now maturing and encountering unforeseen and unintended consequences. Springing lockbox provisions may be enacted, giving the lender the ability to sweep all operating cash. For the borrower, this can make an illiquid situation even worse, and for the lender, this is a way that the repayment obligations are repaid. Some loans contain letters of credit provisions that require an owner to secure a new lease commitment within a certain number of years of an existing lease's expiration. If they fail to re-lease the space by a certain date, a sizable letter of credit is often required to protect the lender against default.

An adviser must identify these issues as soon as possible so that they are adequately equipped to provide advice on the widest possible range of options. Often this starts with the negotiation of a standstill agreement with the lenders which can provide the stability to enter into more detailed negotiations aimed at providing a long term solution. The situation is often made more complex as the debt instruments are traded through the negotiations so that new players are introduced into the mix whose motives as investors may be different from the original holders of the debt.

Commingling of Cash and Assets

One trend that has been present in nearly all of the CRE restructurings with which we have been involved is commingling of cash and assets. Many CRE companies, particularly REITs, possess extremely complicated legal structures and often a considerable number of legal entities that in some cases can outnumber the number of properties by at least five to one. Unfortunately, their cash management systems may not be nearly as sophisticated.

Restructuring advisers must be diligent in tracing which legal entities secure which loans ' a basic concept, but a very important one when dealing with dozens of entities, countless bank accounts, multiple loan facilities, and sometimes several lenders.

In a distressed situation, many CRE developers and operators, however unintentionally, often commingle funds from multiple properties and projects. Companies with dozens of CRE assets may accumulate funds in a few bank accounts, or even a single bank account, in order to pool funds and minimize liquidity issues at individual assets. This can result in a misalignment between the cash-generated and the underlying income-producing assets. It may be extremely difficult to trace the cash attributable to each individual asset. Complicating this scenario is that the structures in place may have been derived from tax-driven strategies, the goals of which differ substantially from that which result in a distressed situation.

In the above scenario, receipts from profitable properties or projects can be used to fund the losses for others ' assets which may be collateralized under completely different loans with different lenders. In this way it is possible for a lender's cash collateral to slowly bleed away, largely unnoticed. It is therefore critical to ensure that strong cash controls are in place. This process involves setting up segregated cash accounts which are tied to each individual asset. In many cases, a lockbox arrangement works well for depositing cash receipts and giving a lender ultimate control over how and when those funds are dispersed. This is often supported by a cash control agreement to further protect the lender's position.

Once the cash has been segregated, it is important that fund flow analysis are prepared regularly so that all sources and uses of lender proceeds can be identified, and, more importantly to ensure that the borrower hasn't started to slip into bad habits and funds have started to become comingled again.

Things Aren't Always What They Seem

Recent case experience has brought to light several instances of operating strategies that were either misaligned with market practices or resulted in confusing or misleading operating statistics.

When taking a hard look at operations, it is important to calibrate a CRE entity's performance to the overall market. For example, an owner/operator may choose to establish a higher management fee in order to fund internal overhead costs. While on its face this practice may seem sensible, it is essential to benchmark both the management fee and service against those provided by external service providers. The outsourcing of the property management function to a third party specializing in these services could provide significant savings. For properties that may be considerably “under water,” this step could be the first in a long haul to improving the value of the asset and immediately start improving the cash position.

It is important to understand the motives and objectives of the parties involved in a restructuring. This divergence of interests can sometimes come to the forefront in a cram-down situation where it is vital to understand the way in which operating results and forecasts have been prepared to ensure that they hold up under scrutiny. For example, the reported net operating income, while used to gauge the profitability of an asset, also impacts key negotiation items such as valuations and break even calculations, which can drive the overall course and outcome of a debt restructuring. An adviser should always exercise proper due diligence when analyzing a CRE entity's operating performance for this reason.

Beware the Hidden Liabilities

Also in the category of “things aren't always what they seem” are the hidden liabilities that seem to plague many CRE entities undergoing a restructuring effort.

When a CRE entity faces financial distress, usually cash disbursements have been delayed and accounts payable stretched as far as possible. Delinquent real estate taxes, unfunded security deposits, and deferred maintenance are all hallmarks of a CRE entity in distress; unfortunately, each of these liabilities remains with the asset in question, and often the lender bears the cost. While deferred maintenance may not be a one-to-one chargeback, it usually depreciates the value of an asset such that, upon a sale, the lender's recovery is proportionally decreased.

An adviser should ask targeted questions of management in order to quickly identify any hidden liabilities such as the above.

Developers Expanding Beyond Their Core
Competencies

Sticking to core competencies sounds like Business 101, but in the case of the CRE industry, this key business tenant is especially important.

Not all CRE assets are created equal. Included in this category are strip malls, high rises, multi-family properties, and manufacturing facilities, among many others. During the real estate boom, many owners/developers were lured to different assets outside of their comfort zone with the promise of large returns and sizable dividends. Unfortunately, for those developers who also managed these assets, they quickly discovered that while they might be excellent property managers of 12-unit multi-family units, a sprawling industrial park is another story altogether. Similarly, an experienced owner/manager of Class A multi-family units might find that Class C multi-family units require very different operating strategies.

Outsourcing still remains a very useful tool in any restructuring. Those functions that are inefficient in-house are better left to outside, experienced contractors. Improved operations aside, this tactic usually has the added bonus of reducing costs and/or changing a highly variable cost to something more predictable and manageable.

Not only did many developers expand into different assets and asset classes, but many expanded beyond their geographical reach. Some owner/property managers are simply not structured to effectively manage assets in remote locations, where their onsite presence is either impractical or cost prohibitive.

A restructuring adviser should always approach a CRE restructuring with a sober outlook of fixing what can be fixed, and disposing of problems that cannot. Underperforming CRE assets that do not fit with a client's portfolio, are outside the client's core competency, and/or subject to chronic mismanagement, are assets that should be strongly considered for sale. Even if recoveries are small, eliminating distractions caused by these kinds of assets can create many intangible benefits for an overall restructuring effort.

Act Now, Not Later

In the current climate, many CRE entities are tempted to bury their heads in the sand and wait for credit markets to improve before implementing restructuring strategies. They may argue that since credit is tight and asset values are so depressed, it's better to initiate a restructuring when the overall business environment is more favorable. But by then it may be too late.

The current liquidity crisis will inevitably end, but when it does there will be extraordinary competition among companies seeking to refinance and/or restructure. Too many entities will be competing for a finite amount of capital, and at that point it will be survival of the fittest. Companies, and particularly CRE entities, must be forward-thinking in their approach to restructuring. Armed with some of the key strategies above, restructuring professionals everywhere should be leading the charge and helping to implement strategic changes that will drive their clients' future growth.

Paul Melville ([email protected]) is a principal in the Corporate Advisory & Restructuring Services group of Grant Thornton LLP. He has addressed complex issues relating to real estate valuation, the evaluation and renegotiation of complicated financing structures, and monitoring ongoing performance of multi-tenant commercial properties. Melissa Dmitri ([email protected]) is a manager in the Corporate Advisory & Restructuring Services Group. She concentrates her practice in the restructuring, workout and bankruptcies of large commercial and other properties, and is currently providing advisory services in the Chapter 11 bankruptcy of a Real Estate Investment Trust with foreign ownership and domestically held properties.