PROBLEM PROPERTIES WHAT TO DO ABOUT THEM?

The resolution of a troubled real estate asset (“workout”) has been described as the “art of the practical.” It doesn’t matter if the people involved are all the “smartest people in the room,” a workout will not be successful if the underlying problem(s) of the real estate asset are not solved. Generally, there are no closing dinners or deal mementos from a workout; because for a workout to be successful, everyone with a stake in the deal has to make concessions and no one should walk away really happy.

A problem with a real estate asset is similar to any other problem. The surest way to exacerbate the problem is to ignore it—it won’t go away. A partial list of the indicators that a project is in trouble are as follows:

• Changes in market conditions;
• Significant changes in personnel;
• Significant changes in costs;
• Significant variations in revenue from budgets or pro-formas;
• Stop notices or mechanics liens; and
• Defaults or terminations of major contracts such as management or construction contracts.

 
If a problem arises, then what must the participations do? First, the participants must analyze the resources available to solve the problem. This includes analyzing the role of each participant in the project and the respective role of each in contributing to the solution. Second, the participants must propose a comprehensive solution. This is contrary to the current sentiment of many to delay a workout by temporarily extending loans and hope that down the road the market will have somehow solved the problem. For a solution to the problem to be credible, it must be comprehensive and realistic.
 
One of the first steps in obtaining resolution of the problem(s) is to understand who are the parties involved. If reviewed objectively, the elements of a workout plan are usually obvious. The difficulty is that the parties do not always analyze the facts in the same way. Therefore, the parties come to the table with different perceptions of what is needed for the workout. The phases of problem recognition and resolution have to be resolved to reach a workable solution. Who the lender is, what are its motivations, and what are the constraints that it is subject to may guide the process. Is the lender a federally regulated entity or is it a trustee for the benefit of bondholders of a securitized loan with a servicer and a special servicer? Is the lender focused on the time involved to reach a solution to the problem with the amount of loss playing a secondary role or vice versa? On the other hand, is the owner experienced in the product type and what is its ability to provide additional capital or collateral?
 
A lender may want to start the workout process with a “workout” agreement. Workout agreements vary widely in form and substance; however, there are some common themes to these agreement. First, it should be comprehensive. Second, it should involve concessions from all parties. Third, title insurance requirements, if any, should be set forth. Fourth, any releases to be granted from one party to another should be included. Lastly, the workout agreement and discussions surrounding it should be confidential. More specific considerations to be set forth in a workout agreement may include: a confirmation of all underlying documents; appraisals; a review and affirmation (or revision) of existing representations and warranties; a requirement, if any, for legal opinions; management and cash flow agreements (one problem with a cash management or a “lock box” arrangement by the lender is that it delays the time period in which the borrower learns of a payment issue); field exams or monitoring arrangements; additional collateral; guaranties (in today’s over-leveraged environment, the value of guaranties and additional collateral have been significantly reduced); subordination agreements for other lenders specifically including affiliates; and risk based pricing by the lender.
 
 
One negotiating tactic by the borrower is “lender liability.” The timing of this claim may arise early.  More often than not, the claim lacks merit. If the claim lacks merit, the lender should, and the borrower should expect, a prompt and aggressive response.
 
If a workout is not successful, then the lender has to decide if it wants to own the property and if so, how it wants to acquire it. Several alternatives available to the lender to realize on the collateral are foreclosure, current deed-in-lieu of foreclosure, or a future deed-in-lieu of foreclosure.
 
 
While there are various alternative methods available to a lender by which it may gain ownership of a property, the changes in ownership must be absolute. If the borrower retains a continuing interest in the property, whether continuing management, a right to repurchase or otherwise, then the lender could be exposed to a challenge that the deed-in-lieu transaction is just a hidden financing transaction and that no real change of ownership has occurred. While there is no specific guideline that sets forth when absolute ownership has taken place, the courts that have reviewed this issue have required that the risks, such as fluctuations in value and physical loss, and indicia of ownership, such as authority over management, reside in the new owner. If the borrower continues as a manager pursuant to a typical management agreement, then this should not void the deed-in-lieu transaction; however, if the borrower is granted a continuing right to profits from the property and is required to absorb losses then this could create a problem for the lender.
 
A delayed deed-in-lieu is an arrangement whereby the borrower agrees to deliver in the future a deed-in-lieu if certain achievement levels are not met. The deed-in-lieu constitutes a waiver or conveyance of the borrower’s equity of redemption. This arrangement is also subject to the challenge that the arrangement is just a financing transaction; however, if the lender provides new consideration, such as not foreclosing and the time period involved is not more than a few months, then the arrangement should withstand such a challenge.
 
A restructure will generally give back to the lender items it considers important that it originally gave up to get the deal. If the parties anticipate a successful turnaround, then they should expect the lender to improve its legal position by restricting the options of the borrower in the event the problems with the asset are not solved. Lastly, the parties should expect the lender to reward compliance and punish non-compliance.
 
In conclusion, the key to a successful workout is practical, careful analysis and diminished expectation by both parties.