ALI-ABA VIDEO SEMINAR. Handling Commercial Real Estate Defaults: Workouts. April 28, 2009 Live Video Seminar/Webcast

Transcription

1 ALI-ABA VIDEO SEMINAR Handling Commercial Real Estate Defaults: Workouts April 28, 2009 Live Video Seminar/Webcast Handling Commercial Real Estate Defaults: Workouts By Lynn R. Axelroth Ballard Spahr Andrews & Ingersoll, LLP 1735 Market Street, 51 st Floor Philadelphia, Pennsylvania DMEAST # v2

2 Handling Commercial Real Estate Defaults: Workouts 1 ALI-ABA Teleconference April 28, 2009 I. BACKGROUND. In many metropolitan areas, the earlier condominium boom has given way to a growing backlog of unsold units. 2 The developer, the unit owners and the condominium association are finding that they are long-term bedfellows, and that their interests are not necessarily aligned on such issues as construction defects and rental of unsold units. The developer s lenders are getting nervous as buyers abandon their purchase agreements and the interest reserve steadily diminishes. The contractor and design professionals are seeking payment for changes, delays and additional work. This paper will explore the differing interests, legal positions and leverage of the parties, and how these play out in the areas of condominium workouts, foreclosures, bankruptcies and bulk sales. II. THE WORKOUT SCENARIO. A. Lender Considerations. Lenders facing a loan default situation in connection with a loan to finance condominium construction or conversion projects will conduct the following analysis. 1. Preliminary financial analysis when the loan goes into default or on watch. a. Determine project value as completed in light of the current market conditions. Focus on the type of business at issue, its position vis-à-vis the economy and potential cyclicality. Are problems market-based, specific to the project or some combination of both? If the causes are mixed, try to apportion relative risks and likelihood of remediation as to each component. 1 2 Originally written by Lynn R. Axelroth, Philadelphia, Pennsylvania, Robert S. Freedman, Tampa, Florida, Michael J. Gelfand, West Palm Beach, Florida, Robert J. Ivanhoe, New York, New York, and Margaret A. Rolando, Miami, Florida. Howard J. Berman, New York, New York wrote Appendix C-1 concerning the lender s perspective on bankruptcy. The entire paper was then updated and edited for a program by Timothy P. Martin, Bethesda, Maryland and Lynn R. Axelroth, both of Ballard Spahr Andrews & Ingersoll, LLP, Their bios and contact information follow. Tim: , martint@ballardspahr.com; and Lynn: , axelroth@ballardspahr.com. The paper was again updated and edited by Lynn R. Axelroth for an ALI-ABA webcast in January on this topic, and again for this program by Lynn Axelroth, with contributions from other members of her firm, including Vince Marriott with respect to Appendices C-2 and D. Vince s contact information and bio follows: ( , marriott@ballardspahr.com, Here are just a few of the examples reported by The New York Times of January, 2009 year-over-year decreases in home prices based upon the Standard & Poor s/case-shiller 20-city house index from January 2008: Atlanta %, Chicago %, Detroit %, Los Angeles %, Las Vegas %, Miami %, Minneapolis %, Phoenix %, San Diego %, San Francisco %, Seattle %, Tampa % and Washington, D.C %. Boston and New York were relatively healthy markets with their declines a mere 7.3% and 9.6%, respectively. Obviously, still a staggering hit but less egregious than some of the other regions in the country. DMEAST # v2

3 b. Carefully reassess the project budget and amounts necessary to complete, paying particular attention to soft-cost adjustments required to account for the true time required to absorb the unsold units. c. Carefully assess realistic sales prices, and determine if sale of units is the best exit strategy for the project; determine whether there are liquidity issues and the timing and impact of these problems; review alternative exit strategies. Can, will or has the market value fallen below the cost of completion? d. Evaluate the performance, financial strength and commitment of the developer/sponsor to determine whether it is doing a good job under the current circumstances and whether it is best to continue with or change the developer/sponsor for the project. That is, are problems more than market-based and do they also include operational/ management deficiencies and/or issues of judgment? e. Review guarantees executed by the developer/sponsor to assess leverage to negotiate various settlement options or exit strategies. Confirm that any yield maintenance/pre-payment provisions are enforceable if the property is transferred, refinanced or there is a borrower default resulting in a loan acceleration. Assess the value of the loan being prepaid in bankruptcy or otherwise. f. Assess the various parties to the lender group, their profiles and capabilities and where each tranche is in relation to project value as of the time of analysis and as completed. Multiple tranches and risk allocation are common particularly in mezzanine financing and can complicate settlement opportunities. g. Evaluate current state of project and the loan. Review title updates, determine lien priority, review current construction inspection reports, update appraisal, litigation searches on borrower and guarantors and UCC searches. Identify existing defaults and analyze likely future near and long term defaults. Given the current state of the market it is becoming more and more difficult to determine market value and obtain realistic comparable sales or other valuation support and therefore, lenders may find themselves testing the market by requiring the developer to attempt to find a buyer or refinance existing indebtedness. situation. 2. Ascertain the philosophy and objectives of each lender in a distress a. Does the lender have the capability, experience and fortitude to go through a workout, restructuring or foreclosure of the loan? b. In a multitranche or syndicated loan, what is the likely behavior of others in the lending group? Will they be very aggressive or cooperative with the other lenders? Review the intercreditor or participation agreements to clearly understand intercreditor rights and responsibilities. c. If the loan is in a securitization, assess the role, responsibilities and temperament of the servicer and special servicer. If a syndication, assess the role, responsibilities and temperament of the lead lender/agent. DMEAST # v2-2-

4 3. Evaluate Options. a. Depending on the result of the analyses and factors described above, evaluate the options available and develop an action plan. b. If a subordinate mezzanine lender is holding a loan that is out of the money, determine whether it is best to write down the position to market value and hold on to see whether any value can be salvaged, or to sell at a significant discount to a party more suited to deal with distressed real estate. c. If a subordinate mezzanine lender s position is not completely out of the money and they are the junior position in the debt stack, determine whether it is best to (i) sell the loan at perhaps a small or no discount to par to a better suited party, or (ii) be prepared to take an activist role with the project, the borrower and the other parties in the lending group. d. An activist strategy will often involve negotiating a standstill or forbearance agreement between the junior-most lender and the senior lenders/servicer and other agreements with the borrower/guarantors. Each lender s leverage with the guarantors is based upon their financial exposure, relative capabilities and likelihood of completing the project successfully. These are critical factors in determining both strategy and objectives with the borrower/guarantors. e. If the loan is to be sold off as an exit strategy, determine how best to market the loan and what the realistic value and upside must be for a distressed loan buyer. f. Analyze the debt structure. If the loan is out of the money, a mezzanine or other junior lender will want to analyze the risk/reward of buying a more senior position to protect their respective investments, as well as how much more needs to be invested and what the return is likely to be on any new money invested, all with as much understanding as possible as to the likely outcome with respect to the parties original investment. g. What are the lenders capabilities to take on an activist role in a workout for a development project? Do they have the right people to oversee the project or is outsourcing needed? h. Should a new party be brought in to take over the responsibilities of the developer, and how will such a change affect the liabilities of the obligors under the guarantees, assuming they are financially viable. i. Consider making changes in various key positions in the development of the project if parties are not performing, and assess what costs, if any, may be involved in making changes, such as replacing the construction manager, selling agent, marketing agents, etc. Is there any reason to maintain a continuing relationship, rather than changing parties? j. Depending upon the factors, decide who should have a seat at the negotiating table, including parties such as other secured creditors, lienholders and vendors. 4. Succeeding to Developer Liabilities. In the event of a foreclosure or deed in lieu the foreclosing lender will need to evaluate which developer s liabilities it will inherit if it DMEAST # v2-3-

5 takes over the project. Assuming there s still the liquidity in the market, the senior lender would likely not actually foreclose and complete the project; thus, successor liability for the lender is more of a theoretical issue. However, any lender contemplating a takeover of the project (or of the ownership interests in the borrower) will want to analyze which developer liabilities it can avoid and to quantify the cost of those it cannot. If the exit strategy includes a bulk sale of units to one or more groups, then the scope of the successor developer s liabilities will affect what the buyer will pay. a. If there are lender liabilities with respect to the project, are they primary or secondary? These may include the following: (i) Construction warranties. Verify whether the developer has any contractual, common law or statutory construction warranties. Has the developer disclaimed them to the extent possible? If the developer has given construction warranties, is it receiving ones of comparable scope and duration from the contractors and subcontractors? Do the general contractor s and subcontractors performance bonds cover their respective warranties? Is the lender an obligee under the bonds? (ii) If unit buyers interests are not extinguished in a foreclosure action, what is the liability for repayment of deposits if buyers rescind their purchase agreements but the full amount of the deposits is not in escrow? (iii) What amounts are owed to the general contractor, subcontractors and design professionals for completion of the project, including common areas? Evaluate and quantify outstanding claims for delays and cost overruns and any other exposure there may be to the design and construction parties. (iv) Evaluate the developer s responsibility for paying assessments. Is the developer obligated to pay assessments on its owned units? Has the developer guaranteed the assessments? Is the developer obligated to subsidize the shortfall between the association s operating costs and the amount of the assessments charged or collected? (v) Is the developer-controlled association maintaining official records? Many of the uniform acts governing condominiums and statutes relating to various forms of association require documents to be kept and made available to interested parties. (a) Will the lender be able to obtain from the developer the necessary documentation that has to be provided to the association at turnover? See the checklist at end of this paper for typical documents and items to be delivered by the developer to condominium association. (b) Is the developer required to deliver to the condominium association, as built plans or record drawings? Is the developer assuring that the contractor and subcontractors are documenting the changes? Will these be available to the lender and at what cost? (vi) Compliance with regulatory reporting requirements. b. If a lender takes over the project, determine whether or not it can avoid becoming a successor developer. For example, if the lender sells the inventory of units in DMEAST # v2-4-