From Forbearance to Restructure: A Roadmap
September 22, 2020
By Joseph Rubin
Six Months in Crisis
Over the last six months, owners of commercial real estate have been hit with their worst case scenario: a sudden economic collapse brought on by a health crisis that has in many cases significantly curtailed their tenants’ ability to pay rent and their own ability to re-lease space. While certain sectors have been impacted more adversely than others, virtually all owners have lost revenue while the cost of property maintenance and taxes have remained high. The math is easy; even in a low interest rate environment, half a year of margin squeeze has made it increasingly difficult for owners to meet their debt obligations. And with each passing month reserves are further depleted and liquidity declines.
Many owners have taken advantage of an accommodative bank regulatory environment to request loan modifications including covenant waivers, temporary payment forbearance, reduced interest and/or principal payments, or maturity extensions. As we enter the fourth quarter of 2020, it is unclear whether banks will continue to modify and forbear on loans, particularly when the property cash flow is unlikely to recover in the near term and loan repayment is increasingly uncertain. Accordingly, this is the time for owners to reassess the probable performance scenarios of their properties and prepare for continued lender negotiations, and potentially third-party recapitalizations.
Property owners may require a new equity capital partner to be able to survive the crisis and hold on to their assets. Such capital is typically expensive, with the owner giving up an outsized portion of the equity to the rescue capital provider. However, the freshly capitalized ownership entity may then renegotiate the terms of the loan from a stronger position, including paying down a portion of the debt. This process of obtaining fresh equity and restructuring the loan is often termed “recapitalizing” a property.
Despite the fact that many owners have already been in discussions with their lenders and may even have completed a first modification, some now need to prepare for a more comprehensive equity and debt restructuring. This article describes the critical steps toward finding new capital and negotiating with lenders, enabling a long-term solution to the current crisis.
Gathering and analyzing the data
The first step in any recapitalization and restructuring program is collecting and organizing all the pertinent facts relating to property operations and then understanding the property’s current and near- term cash flow potential. Many borrowers have already gathered this information, but lenders are wanting more and more detail. This process starts with a rent roll review, including an analysis of tenant-by-tenant financial condition, rent payment history, and a summary of any recent lease modification negotiations. Owners should develop various scenarios driven by the assumed rent, occupancy, and estimated time required for each tenant to recover the liquidity required to pay contractual rent, as well as prospects for leasing vacant space and required concessions. For hospitality, retail, and entertainment properties, projecting recovery will be far more complex and the lender should be provided with a set of detailed assumptions supporting the owner’s estimates.
In projecting operating expenses, owners should consider the sustainability of any temporarily reduced expenses and the higher costs of marketing space. Additionally, certain expenses to protect the property and its tenants during the pandemic may have increased. All considerations and assumptions should be described in the expense budget. Moreover, the anticipated timing of capital expenditures that may have been delayed during the liquidity crunch should be described. As lenders resume physical inspections they will likely focus on deferred maintenance and leasing infrastructure.
The owner then models the cash flow of the property, on a monthly basis for 12-to-24 months and annually beyond, ideally using alternative rent and occupancy scenarios. Based on this rigorous analysis, a range of probable cash flows available for debt service is derived. In the case of a non-recourse mortgage, the lender can look only to the property’s cash flow and not the borrower’s assets. However, in certain circumstances the borrowing entity may elect to dip into its own resources to fund debt service and avoid a monetary default. As such, along with the property cash flow analysis, the owner should assess the liquidity of the borrowing entity and the sponsoring entities behind it to determine whether some of that cash could be lent to the borrowing entity on a short-term basis to cover shortfalls.
Reading ownership and debt agreements
Owners should refresh their understanding of existing loan agreements to recall covenant requirements, guaranty and recourse provisions, grace periods, the definition of default and lender remedies, and other pertinent provisions. The loan agreements include the note, mortgage, security agreements, guaranty agreements, escrow and reserve agreements, and assignments for the first mortgage and any mezzanine or sidecar financing. If the loan has been sold and securitized, owners should also become familiar with the rights and procedures of a borrower requesting negotiation with the special servicer. The owner might require legal advice in understanding a securitization trust’s pooling and servicing agreement.
Particularly if there are multiple equity participants, before going to market for a potential recapitalization, a review of the partnership/LLC and operating agreements relating to all ownership entities should be conducted to recall the rights of all parties including dilution provisions, voting rights, and rights of first refusal, as well as any accommodation made to IRC Sec. 1031 exchange investors.
Soliciting new capital
Once the owner has completed the financial analysis and become aware of any issues or considerations in the entity and loan agreements, an offering memorandum may be drafted for potential equity capital providers. This offering typically includes a description of the physical attributes of the property and recent supply/demand in its sub-market. Given the current situation, the offering should include a description on the pandemic’s impact on the property and its tenants, and what the owner has done in response. The tenant and cash flow analysis should be included, along with the assumptions used in the cash flow projections. The offering should also contain at least a diagram of the current ownership structure. The offering also should include the solicitation of capital and the preferred terms of the owner, as well as a description of the bidding process.
Often with a financial advisor, the property owner then goes into the market to solicit new capital for the property. The type of capital source to solicit depends on the size of the ask, the property type, and the property’s level of distress. Asset managers, insurance companies, real estate companies and other core plus investors might provide capital for properties that were stable before the pandemic and only need a liquidity bridge. More opportunistic private equity funds would be sought for properties with more complex situations or significant distress. The owner will then negotiate the terms with prospective bidders and select a new partner.
Part of the negotiation of the capital insertion will include which ownership entities the new investor will capitalize (a property may have multiple entities for ownership, borrowing, and operations as well as entity structures meeting specific requirements of existing partners) and the percentage levels and associated controls in each. New entities will likely be created above the existing borrowing entity. This restructuring will impact the tax positions of all owners and therefore should be designed with taxes in mind.
Restructuring the debt
Once the new equity is in place, or through simultaneous negotiations, the equity group can approach the lender(s) with loan modification options. Any loan restructure should be designed to be successful; that is, the new debt service level should be achievable given the most probable cash flow scenario modeled, with some cushion. How these deals are negotiated of course depends on the endless minutiae of the circumstances at hand. In assessing alternatives, in addition to modeling the resulting cash flow and returns, the owners should consider the accounting and tax impact of the proposed terms. A larger discount to the loan balance may appear advantageous on a gross cash flow basis but be less desirable net of taxes.
Immediate Next Steps
Every property owner should begin the detailed review and analysis of tenant and lease data and start developing prospective cash flow scenarios, not only to understand the current state (which may be a moving target) but to begin developing alternative strategies with respect to tenant retention, go forward liquidity, and the potential need for loan modifications or equity recapitalization. The review of legal documents will increase the owner’s understanding of its rights and obligations to existing equity partners and lenders. These immediate actions will position real estate owners to better deal with the continuing liquidity crunch caused by the economic fallout of the pandemic.