Profitable commercial office space depends on healthy numbers of employees in order to keep companies initiating and renewing leases. As office vacancies increase due to the recession and downsized office staffs, many building owners find themselves heading toward foreclosure, struggling to service mortgages on office buildings that are declining in value. In 2009, commercial office vacancies nationwide jumped to a 15-year high of 17 percent from 14.5 percent a year earlier, according to commercial real estate research firm Reis Inc. Commercial rents plunged by nearly 9 percent in 2009, the largest drop since Reis began tracking commercial occupancy in the 1980s.
Commercial mortgage–backed securities (CMBS) became one of the top sources of real estate finance early in the 2000s, providing sizable liquidity to both investors and commercial lenders. Many financial institutions met the increased demand for CMBS during the real estate bubble of 2005 to 2007 by lowering their underwriting standards. When the bubble burst, rents and occupancies in commercial properties fell, and borrowers found themselves with insufficient revenue to make regular principal and interest payments to meet current debt service.
There is now more than $600 billion of commercial real estate loans in the CMBS structure. According to Deutsche Bank’s April 2009 report, The Future Refinancing Crisis in Commercial Real Estate, at least two-thirds of loans maturing between 2009 and 2018, totaling $410 billion, likely will not qualify for refinancing at maturity. To refinance all $600 billion in loans, borrowers would need to put up at least an additional $100 billion of equity.
While CMBS loans were not the only source of investment during the real estate bubble, these numbers paint a picture of the dire situation property owners are facing and help explain why commercial real estate will not see a recovery in the near future. Owners facing the numerous problems in the commercial real estate market have several options to consider before foreclosure or bankruptcy.
When Cash Flow Becomes a Problem
When a property begins to experience cash-flow problems, owners are often placed in the unenviable position of meeting monthly debt-service payments that can far exceed the amount of monthly cash flow generated by the property. Even those who can still meet monthly payments might find themselves in default of their loan if the property can no longer generate enough money to meet the prescribed debt coverage or loan-to-value ratios imposed by the loan documents.
In the world of commercial real estate, properties are measured by the amount of cash they produce. When cash flow drops, owners are forced to think creatively in order to maximize their investments.
One option is simply to sell the underperforming property and move on to the next deal. However, this may not be feasible for most owners of cash-strapped properties. Because the value of a commercial property is primarily derived using some measure of the holding’s annual cash flow, a property with reduced cash flow will garner a reduced price on the open market and often will be valued at less than the total debt on the property.
For the owner, the only option may be a short sale, but lenders are not always willing to take a huge hit if they think there are better roads to recovery. Short sales also do not necessarily protect a personal guarantor from liability. In some cases, requesting a short sale from a lender may actually increase the potential liability of the guarantor. This is the case when lenders include in their documents “badboy” carve-outs—stipulations that allow the lender to convert a limited guaranty to a full guaranty when one in a list of prohibited actions is taken.
Owners may also want to consider restructuring their leases in order to continue generating income. Reducing rents or granting deferrals to tenants who are having difficulty paying rent is an option if there is a possibility that the owner can maintain ownership by taking a slight hit now to keep the property successful in the future.
A tenant whose lease is due to expire soon is in a good position. A credit tenant may be sought out by other landlords dangling enticing offers, including “free” rent and generous improvement allowances to encourage that tenant to disrupt its operations and move across town. They may hide fees and costs and hope that the tenant—attracted by a teaser lease rate and an appealing package of tenant improvements— will bite.
Tenants are often willing to extend the term of the lease or make a small payment toward a past-due amount if the owner is willing to reduce the rent. An owner may be able to increase cash flow in the long term and lock in longer leases by thinking creatively and working with tenants who may also be struggling financially.
Another option for owners is to seek a capital infusion from additional investors—either in the form of equity or debt—though this approach is easier to consider than to execute. But if a property is generating cash flow—or has the potential to maintain or even increase cash flow—obtaining additional short- or long-term equity investment or financing may be possible.
Equity investors are looking for bargains, so an owner should be prepared to part with a sizable stake in the property. One of the most successful examples of an equity investment occurred several years ago when Bank of America—then, as now, a troubled institution—sold a 50 percent interest in its San Francisco headquarters to a major developer, which also obtained an option to sell its stake back to the bank when times improved. Several years later, the bank was able to buy out the developer, which pocketed a tidy profit while Bank of America preserved its complex, as well as its dignity.
Much-needed cash can also come in the form of debt from private, mezzanine, or hard money lenders. Success will depend on the cost of the additional capital, but refinancing is often the easiest way for a property owner to inject new cash into a troubled property.
Know the Property and the Marketplace
The single worst thing a troubled borrower can do is nothing. While it may be hard to believe that things will not be made better simply by waiting—because that has been true for years—today’s world is different, and waiting is likely to bring nothing but pain.
An owner with a troubled property should quickly prepare for and arrange a meeting with the lender (see “Meeting Your Lender,” on facing page). While no amount of preparation can save a leveraged property that is beyond rescue, most properties have intrinsic value at some level, and opportunities exist even in these difficult times to increase that value. Thoughtful preparation before meeting with the lender can be the critical difference between success and failure.
To prepare for a meeting with the lender, the owner should:
- Know the property and its financial situation.
- Know the tenants and understand the rent roll.
- Know when the leases expire and the likelihood of renewal.
- Understand the local market, and try to determine what rental rate will attract new tenants and retain existing tenants.
- Look at the marketplace through the eyes of the tenants who can make or break the property.
- Regard all the existing tenants as if they are prospective tenants and try to make the property as attractive as possible, financially and otherwise, to convince them to stay in the building.
- Plot the expected income of the building over time to determine the amount available to service debt in the future. Simple dynamic projections can determine whether the building can support the debt that is already against it and, if it can, at what rate.
- Factor in an extension of the existing loan at current market rates to see the effect it would have on the future performance of the building.
- Create a model spreadsheet that shows the effect of backloading the debt service to later time periods when higher cash flow is projected.
- Analyze lease expirations, potential opportunities to increase lease rates, rate increases that are built into existing leases, and opportunities for new tenancies. The analysis does not have to be perfect or exact, but the estimates should be based on verifiable facts and an understanding of what makes the building successful.
- Check with other prospective lenders to determine whether there is any interest in refinancing the building based on current performance or reasonable projections. If the building has significant vacancies or other problems, the owner will be hard pressed to find any interested lenders. If an alternative is
found, the owner should carefully consider whether changing lenders is a viable option.
Work with the Lender to Avoid Foreclosure
Owners should put themselves in the position of the lender. In the lender’s eyes, the building does not produce adequate cash flow to service the debt and aintain building operations at an acceptable level. The lender’s only realistic move is to foreclose and acquire the building.
If the owner has a nonrecourse loan, the lender usually has no choice but to foreclose. Most lenders do not want to foreclose because they realize they will face the same problems as the owner, only the lender, not being in the real estate business, does not know the building as well as the owner does.
The owner should consider the value he or she can add to the lender to help bridge the gap during these difficult times. Most studies indicate that the real estate industry is in for at least two or three years of difficulty. How can the lender protect its investment and, at the same time, allow the owner to protect its own investment?
The lender will demand additional fees, additional interest, attorneys’ fees, other professional fees, new appraisals, and perhaps other consultant fees. The owner should resist as many of these as possible; if cash is in short supply, the owner will not have the money to pay those fees upfront, maintain and operate the building, and service the debt. The best way for the owner to minimize these external fees is to come prepared and offer the lender a thoughtful alternative to foreclosure.
The owner should set up a meeting with the lender and come armed with all the knowledge that can be mustered about the building, its tenants, the local marketplace, the financial marketplace, and the lender’s situation. The best workouts start with an open dialogue between borrower and lender. There is no reason to hide facts about the operation of the building: chances are it would perform well if this were even an average marketplace, but in this difficult market, it, like hundreds of other buildings, has been hit hard.
The owner should present the facts as they are to the lender, providing the best estimate for the months and years going forward. Owners should resist the temptation to project revenue increases that take the shape of a hockey stick—a sharp increase after a flat period. The lender will know the owner did not spend the necessary time carefully projecting future revenues if the projections show an unwarranted steep increase in revenue.
The owner should make certain that any payment restructuring plan entered now will be realistic tomorrow—in short, that a deal made today will not result in default a year from now.
The owner’s goal is to convince the lender that his or her ownership adds value to the building. Otherwise, there are building managers looking for business, and the lender can simply foreclose and replace the owner with one of the many companies looking to operate the building.
The lender wants to avoid foreclosure as much as the owner does because it results in a loss for both parties—for the lender, the loss of any opportunity to recoup the money loaned. Interest income has gone by the wayside, and the expense of capitalizing and operating the building will fall squarely on the shoulders of a foreclosing lender. The lender will try to cut off the bleeding by selling the property as soon as possible. But in today’s market, a quick sale may not be possible, so the lender must come to understand that it may be operating the building, possibly at a loss, for many months or years to come.
A thoughtful presentation by the owner can offer the lender hope, just as the lender offers the building owner hope. While the owner needs to talk to the lender about forgiving or restructuring payments, it also is important that the owner explain what can be done to direct some cash flow to the lender in the early years to give the lender an opportunity to be made whole toward the end of the loan. The owner should make certain that any payment restructuring plan entered now will be realistic tomorrow—in short, that a deal made today will not result in default a year from now.
The owner should ask the lender to keep the interest rate low and try to determine the lender’s cost of funds to obtain a clue regarding an acceptable interest rate. Although it may not be possible if valuations have dropped dramatically, the owner should try to find a way to restructure the loan so it becomes or could become a performing loan.
The owner also should try to determine whether there is additional collateral that might be offered to the lender. In some cases, there may be other real estate that can be offered, although in the case of special purpose entities, it can be extremely difficult to find additional collateral that can be offered.
Lenders may ask for guaranties of the debt, but the owner should consider the ramifications of offering a personal guaranty. Is the owner really willing to risk other assets in order to save the investment in the property? If the owner cannot truly answer yes to that question, he or she should tell the lender no as soon as the issue is raised and be prepared to defend that response.
Plan for Bankruptcy and Foreclosure Before it is Necessary
If the borrower and the lender cannot reach agreement, the lender will start to enforce the loan, usually through foreclosure. The lender may first seek to have a court-appointed receiver take over operations of the building and collect rent if there is a significant amount of time before the foreclosure is complete. This period varies by jurisdiction from only a few days to several months.
A borrower who has been unable to negotiate a restructured loan with its lender is left with few options. The most obvious choice is for the borrower to file for Chapter 11 bankruptcy. At an early stage, it is advisable for a borrower—and the guarantors—to retain competent insolvency counsel, making sure that the lawyers practice actively in the local bankruptcy courts, know the judges and other practitioners, and have excellent reputations. The lawyers should understand the economics of real estate and of the particular project, and attend meetings with the lenders and other interested parties. The owner should be sure that he or she can work with the lawyers as a team and verify their commitment to playing it straight and being truthful with the lender.
The owner should start planning for bankruptcy early, even while remaining hopeful that there is a deal to be made. Nothing is worse than a last-minute, surprise bankruptcy with no exit strategy in place. These rarely succeed and usually waste thousands of dollars in legal fees and other costs.
The owner should take the time at an early stage to see what a bankruptcy would look like and learn the answers to these questions:
- Is this a single-asset real estate case, and will that have an effect?
- What options does bankruptcy provide?
- Is there an opportunity for a cram-down plan that will lower the secured debt to the value of the property, and what effect will that have? The owner should explore what type of protection payments to the lender will be needed, if any.
- Is there a possibility of selling the building under Bankruptcy Code Section 363, or does inadequate equity in the building prevent it?
- Can a plan of reorganization be confirmed, or is it impossible absent the consent of all parties?
The borrower should remember that other options exist if action is taken quickly and creative thinking is employed.
The owner and his or her lawyer should explore these questions at an early stage. It is pointless to spend money filing for bankruptcy that might otherwise be directed toward restructuring the loan or used for a fresh start, unless bankruptcy can truly provide the answer to a restructured loan.
If the commercial property is not performing well enough to cover the owner’s financial obligations, it is easy to panic and assume that bankruptcy and foreclosure are the only outcome. The borrower should remember that other options exist if action is taken quickly and creative thinking is employed. Everyone is trapped in the same bad commercial real estate market. Trying to work things out with the lender and the tenants is a more sustainable solution than bankruptcy or foreclosure. It is possible to hold on to the investment—if the owner recognizes problems when they crop up and plans ahead to deal with them.