MORTGAGE WORKOUTS FOR THE PUBLICLY HELD REAL ESTATE COMPANY NAVIGATING THE CAPITAL STACK

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1 MORTGAGE WORKOUTS FOR THE PUBLICLY HELD REAL ESTATE COMPANY NAVIGATING THE CAPITAL STACK Introduction and Thesis In the context of a maturing mortgage loan that the owner/borrower is not able or willing to fully repay, the owner/borrower is faced with a number of options, inclusive of: 1. Refinancing the loan with a third party lender; 2. Restructuring the loan with the existing lender; 3. Totally or partially replacing the debt with equity, often by contributing the property to a joint venture with a passive institutional investor; 4. Selling the property to a third party; or 5. Turning the asset over to the lender in satisfaction of the loan, and presumably as a means of eliminating any potential recourse deficiency or carve-out obligations. The thesis of this paper is that the owner/borrower s options and tactics in connection with a mortgage loan default or workout will be significantly impacted and complicated if the owner/borrower is a publicly held real estate company, whose overall capital structure is comprised of layers of equity and debt at the corporate level as well as mortgage financing at the property level. Those layers of corporate equity and debt, in conjunction with property financing, are commonly referred to as the capital stack of a publicly held real estate company. Within the various layers of the capital stack, various financial, ownership and operating covenants and ancillary financial commitments are typically made in favor of the various providers of capital, and violation of those covenants can have draconian and even catastrophic consequences for the consolidated enterprise. Given the disintermediation between lenders and borrowers in the world of CMBS financing, executing a mortgage loan restructuring, refinancing, or deed in lieu of foreclosure, or even a simple alteration in the management or operation of a mortgaged property, can entail a substantial and often frustrating process of aligning the requirements of the property lender (i.e. the special servicer) with the requirements embedded in the various layers of the capital stack. This paper will briefly assess some of the more important issues confronted in so doing. 1

2 While this paper focuses on publicly traded real estate investment trusts, it should be noted that many of the same issues will be operative for a borrower that is a non-listed (nontraded) REIT, or a publicly traded real estate operating company (REOC). 1 Basic Capital Structure of REITs UPREIT Structure. In a typical umbrella-partnership (aka UPREIT) form of real estate investment trust, ownership interests in all of the Consolidated Enterprise s 2 properties are ultimately held by a limited partnership (known as the Operating Partnership, or OP ). The general partner of the Operating Partnership (known as the REIT ) is typically organized as a corporation, in order to facilitate access to the public equity markets through the sale of shares in the general partner. The REIT makes an election under the Internal Revenue Code to be taxed as a real estate investment trust, which eliminates corporate level tax, but subjects the REIT to various distribution requirements and ownership restrictions. The Operating Partnership typically holds its interests in individual properties through a variety of subsidiary special purpose entities (known as SPEs ), which are typically organized as limited partnerships or limited liability companies. The Operating Partnership also typically conducts non-investment bad income business through SPEs that are typically taxable C-corporations, each known as a taxable REIT subsidiary, or TRS. 1 A publicly held real estate company typically takes one of three (3) basic forms: (i) an exchange-listed REIT (with or without an UPREIT structure as hereinafter described); (ii) a REOC (a corporate entity taxed as a C Corporation rather than a REIT, which, unlike a REIT is a corporate taxpayer that cannot deduct dividends paid to shareholders from its taxable corporate income); or (iii) a non-listed, and therefore non-traded, public corporation that has elected REIT status. Each of these varietals typically has in excess of 500 shareholders and is therefore typically a reporting company under the Securities Exchange Act of 1934, so as to be required to file quarterly and annual reports, and disclose material information on a current basis. 2 For purposes of this paper, the term Consolidated Enterprise is used to refer to the consolidated company, consisting of the Operating Partnership, the Operating Partnership s general partner (i.e., the REIT) and each of the property-owning SPE subsidiaries of the Operating Partnership. Where applicable, specific reference will be made to the separate REIT, Operating Partnership, and SPE entities, so as to distinguish the various constituent members of the Consolidated Enterprise. 2

3 Sources of Equity Capital Two Basic Sources. Equity capital is typically obtained from two basic sources: (1) property owners that contribute real property (including interests in partnerships or LLCs that own real property) to the Operating Partnership on a tax-deferred basis; and (2) public investors that contribute cash to the REIT. 3 3 The UPREIT structure is typically tax-driven, as it enables REIT founders and contributors to execute tax-deferred dispositions of low tax basis properties under Section 721 of the Internal Revenue Code. 3

4 Real Property Contributions to the Operating Partnership. Generally, property owners contribute real property assets to the Operating Partnership in exchange for a percentage of limited partnership interest in the Operating Partnership, denominated in Units. Units are valued based on the fair market value of the contributed property, net of any debt assumed by the Operating Partnership. The contribution of the asset generally is treated as a tax-deferred contribution to a partnership under Section 721 of the Internal Revenue Code, and accordingly no taxable gain or loss is recognized at the time of contribution. Generally, the contributor receives a substitute tax basis in its limited partnership Units equivalent to the contributor s adjusted tax basis in the contributed property, decreased by any debt assumed by the Operating Partnership and increased by the contributor s allocable share of the partnership s liabilities. The Operating Partnership will have a carryover basis in the contributed property equal to the contributor s adjusted tax basis immediately prior to the contribution. Limited partners of the Operating Partnership are typically entitled to elect to convert their Operating Partnership Units for shares of common stock in the REIT (or an equivalent amount of cash at the REIT s election) after the expiration of a specified holding period. Therefore, contributors of real property assets to an UPREIT commonly are real property owners seeking to diversify their holdings and increase their liquidity, while deferring the recognition of any taxable gain inherent in the real property. Satisfying this deferral objective, and fulfilling deferral commitments made to contributors, can be a significant issue in the context of mortgage workouts by the Operating Partnership, as the contributors will typically have negotiated the contractual right to be made whole with respect to any restructuring transaction that accelerates their recognition of taxable gain. Cash Contributions to the REIT. The Consolidated Enterprise accesses public equity markets by issuing capital stock of the REIT to investors. For each share of capital stock issued by the REIT, the Operating Partnership issues an economically equivalent limited partnership Unit to the REIT in exchange for cash contributed to it by the REIT. Therefore, as more shares in the REIT are issued, a greater proportion of the Operating Partnership is economically owned by the REIT rather than the limited partners of the Operating Partnership that contributed property in exchange for Units. Equity issued through the REIT can be structured as the markets require. Offerings can range from basic common stock to various tiers of preferred stock that may provide for a liquidation preference, conversion rights or a cumulative coupon rate. Although less common, several REITs have offered hybrid shares in the form of senior common stock, which combine some of the features of preferred and common stock. 4

5 Sources of Debt Three Sources. UPREITs typically incur long-term debt from three sources: (1) First, the Operating Partnership may sell rated unsecured bonds through public and private offerings which are fully recourse to the REIT and to the Operating Partnership. (2) Second, the Operating Partnership and the REIT, typically as co-obligors, may obtain a line of credit from an institutional lender or lending group, which may be unsecured or secured and is typically fully recourse both to the REIT and to the Operating Partnership. (3) Finally, the Operating Partnership may obtain property-specific mortgage or mezzanine debt secured by individual properties owned either directly by the Operating Partnership or indirectly through one or more subsidiary SPEs. Indirect Recourse. Mortgage and mezzanine debt is structurally senior to the bond and line of credit financing made to the Operating Partnership and REIT. However, recourse for the mortgage and mezzanine lenders is typically limited to lender access to the individual property securing the loan. Property-only recourse is typically subject to certain caveats, imposing contingent recourse on the Operating Partnership or a credit-worthy affiliate for (i) a familiar litany of property-centric bad acts of the borrower, and (ii) environmental liabilities. In the context of an OP (or SPE) borrower, recourse to the Operating Partnership and REIT may also be triggered by the violation of covenants regarding continued direct or indirect ownership by the Operating Partnership of its assets, and/or legacy pre-contribution covenants regarding the REIT/UPREIT founders ownership of, economic stake in or management of the Operating Partnership portfolio. 4 Defaults and Workouts Involving Property-Specific Debt Mortgages and deeds of trust for SPE mortgage debt identify a litany of monetary and non-monetary events that constitute defaults. Defaults under mezzanine security documents are 4 Mortgage and mezzanine loan requirements regarding founders levels of (i) economic ownership percentage in the Operating Partnership, typically either through a combination of share ownership in the REIT and Unit ownership in the Operating Partnership, and/or (ii) governance rights in the Operating Partnership, typically held through ownership of common shares owned in the REIT, are often respectively referred to as (i) stake and (ii) control test requirements. Covenants containing such provisions can become anachronistic when a formerly private real estate enterprise that was the borrower under such financing becomes a REIT/UPREIT or other form of Consolidated Enterprise in which the stake and control of the founders is intentionally and inherently diluted, for purposes of building the capital base of the Consolidated Company and presumably enhancing the security of the loan. Waivers of stake and/or control requirements are typically required at the time of the going-public event (typically either an IPO or a reverse merger into an existing publicly traded shell company), and may be required de novo in connection with certain types of restructurings, particularly where the Operating Partnership s (and therefore the founders ) interest in the mortgaged or pledged property in question is being diluted, and mortgage debt is being paid down or retired through the infusion of property-specific equity via a joint venture between a new capital provider and the Operating Partnership or SPE owner of the mortgaged property, or through a substantial needle-moving infusion of equity capital at the REIT or Operating Partnership level. 5

6 typically similarly triggered, although the mezzanine lender is generally entitled only to foreclose on the equity interests of the SPE, making the mezzanine loan structurally subordinate to the mortgage loan. In attempting to work through relief from mortgage or mezzanine loan defaults, various layers of the capital stack are implicated and must be addressed, as follows: Enterprise Debt (Line of Credit and Bonds). Concurrent maintenance of enterprise debt (bonds and line of credit) and property-specific debt (mortgage and mezzanine debt) can substantially complicate an SPE borrower loan workout. The credit agreement and the bond indentures may include cross-default provisions in which a default under any or some defined critical mass of mortgage or mezzanine loans could trigger defaults under the line of credit and bond indentures. Therefore, even though loan recovery by mortgage and mezzanine lenders is typically limited to the individual property held by the OP or borrower SPE, the consequence of a default by the OP or SPE borrower can be the acceleration of line of credit and/or bond obligations that are recourse to the OP, and possibly the REIT. 5 Going Concern. In addition, the Consolidated Enterprise s external auditors may be unable to give an annually required audit opinion without qualifying it by stating that the crossdefault has raised substantial doubt about the Consolidated Enterprise s ability to continue as a going concern. A qualified going concern opinion can precipitate a downward spiral for a REIT that can lead to catastrophic consequences for the Consolidated Enterprise, in terms of suppression of stock price, resulting in Consolidated Enterprise s non-compliance with certain financial covenants and consequent line of credit and/or bond obligations. In the worst-case scenario, cross-defaults can propel the Consolidated Enterprise into an irreversible tailspin. At a minimum, cross-default provisions serve to give both the mortgage lenders, the line of credit lenders and the bondholders greater power and influence than their loan documents would, on their face, suggest. Financial Covenants. A further source of complication is that the credit agreement for the line of credit and the bond indentures will typically contain financial covenants that impose debt and debt-service limits from a number of different perspectives, including the following: Leverage ratio covenants limiting the maximum amount of Consolidated Enterprise debt and secured SPE or OP debt (i.e. mortgage and mezzanine debt) as compared to the enterprise value of the Consolidated Enterprise; 6 5 Note that bond and line debt is often cross-defaulted inter-se, meaning that if either is primed by a mortgage default, the other will also be primed. 6 Enterprise value is typically determined periodically by applying an agreed or indexed capitalization rate to the company s net operating income (NOI) or earnings before interest, taxes, depreciation and amortization (EBITDA). NOI and EBITDA are both non-gaap financial measures, and are typically defined with specificity in the credit agreement or the bond indenture. 6

7 Coverage ratio covenants requiring a minimum amount of NOI or EBITDA as compared to the Operating Partnership s fixed charges (e.g. debt service, preferred stock coupon payments and ground lease payments); and A required minimum amount of equity in, and cash flow from, unencumbered properties, as compared to the total amount of, and interest paid with respect to, unsecured debt (i.e., bonds and the line of credit). In the event that an SPE borrower defaults on a mortgage or mezzanine loan and the Operating Partnership (or SPE borrower) desires to refinance the loan or otherwise restructure the debt, the Operating Partnership s flexibility may be limited by the financial covenants. For example, covenants may limit the Operating Partnership s ability to incur additional indebtedness or provide supplemental collateral to secure the defaulted loan, or the Operating Partnership s ability to provide more expansive guarantees of the defaulted mortgage loan. Further, even if the lead lenders under the line of credit or a substantial bond holder are willing to provide a waiver of a default resulting from a cross-defaulted mortgage loan or a covenant violation, the documents governing the line of credit or the bonds will often require a threshold percentage approval (sometimes unanimous) from the lending group or bondholders. Not only does this increase the administrative burden and time required to obtain a waiver, but it also empowers minority lenders or bondholders to frustrate or hijack the consent process by demanding a payoff amount or exacting other onerous conditions to consent. Enterprise Rating Agency Issues In CMBS workouts, whether the borrower be a private or publicly held company, the mortgage or mezzanine lender will have securitized the property-specific debt, and the securities that are the end-product of the securitization will have been assigned credit ratings by national rating agencies. In those situations, the servicing agreement will typically require, as a condition of the workout, that the rating agencies approve any proposed restructuring of the debt, which can lengthen the restructuring process. In the public company context, the problem runs deeper: If the rating agencies downgrade the mortgage-backed securities due to the restructuring, or if the negotiation with the servicer results in a transfer of the property to the servicer rather than a restructuring of the debt, the rating agencies may also downgrade the company s bonds or preferred stock. This broader downgrade could have a variety of contractual and other effects, including (i) increases in interest rates on the Consolidated Enterprise s unsecured debt, (ii) entitlement of preferred stockholders to appoint directors, (iii) triggering of a default under the line of credit or bond indentures, and (iv) suppression of the trading value of the REIT s common shares. In conjunction with each other, these side effects can have devastating consequences for the Consolidated Enterprise as a whole. As a result, what can appear on its face to be a supposedly contained and non-recourse mortgage default at the SPE borrower 7

8 level can have serious enterprise-wide recourse implications and drastically adverse consequences for the enterprise as a whole. Securities Laws Issues If the shares issued by the REIT and the bonds issued by Operating Partnership are each respectively held by more than 500 holders of record, or are traded on a national securities exchange, or if the REIT or the Operating Partnership has undertaken a public offering within the preceding year, then each of the REIT and the Operating Partnership will be a separate Reporting Company, and each will be required to comply with the periodic reporting requirements of the Securities Exchange Act of Reporting Companies are generally required to publicly file annual reports (Form 10-K) and quarterly reports (Form 10-Q). If information concerning a loan default or workout is material and is omitted from a required K or Q report, the company may be exposed to liability under Rule 10b-5 or Section 18 of the Securities Exchange Act of There is no bright-line rule as to what constitutes a material fact or event. However, in general, a fact is material for purposes of the federal securities laws if a reasonable person would consider that fact important when deciding whether to buy or sell shares of the company s stock, or if a reasonable investor would view the nondisclosed information as significantly altering the total mix of information available about the company. 8-K Filings. The Securities Exchange Act of 1934 also requires a Reporting Company to publicly file current reports (Form 8-K) when certain specified material events occur. For example, if a lender declares a material mortgage loan to be in default and accelerates the debt, the company must publicly disclose the default on Form 8-K within four business days of the occurrence of that event. The REIT may also have to issue a press release announcing the event if the REIT s shares are traded on a national securities exchange. Similarly, any default waivers granted by line of credit lenders or bond trustees typically must be publicly disclosed. REITs typically prefer to avoid disclosure of issues with their lenders, and as such they have a special incentive to negotiate with lenders before defaults and other Form 8-K triggering events occur. Material omissions and misstatements in a Form 8-K also expose the company to liability under the Securities Exchange Act of The consequences of such filings can be adverse to the borrower, both at the property level vis a vis tenants and employees, and at the enterprise level. As such, workouts for the public company typically entail efforts to preempt the need for such disclosure. Offering Prospectus. REITs must disclose any material loan defaults or workouts in any securities offering prospectuses. Documents used in a securities offering expose the issuer to increased standards of disclosure and increased liability under the Securities Act of 1933, as compared to reports filed under the Securities Exchange Act of If an investment bank is serving as underwriter for the offering, the underwriting agreement between the REIT and the 8

9 bank will typically require the REIT to indemnify the underwriter for any losses that it suffers resulting from material misstatements or omissions in the prospectus. Therefore, if a material default or workout is omitted from an underwritten offering prospectus, the REIT may be exposed to direct liability with respect to purchasers of shares, and indirect liability based on the REIT s contractual obligation to indemnify the underwriter for its losses. As a result, the pendency or imminence of an offering may put pressure on a REIT/OP and affect the manner in which it addresses an imminent material loan maturity or default. Material Agreement Filings. A public company is also required to publicly file any material agreements to which it is a party that were not executed in the ordinary course of business. This typically requires filing of the company s line of credit agreement and bond indentures. Mortgage loan agreements are usually not filed, although a material mortgage loan agreement would be required to be filed if it were outside the usual scope of the company s business. Similarly, a modification of a material loan agreement would need to be filed, calling public attention to the problem being solved. Publicly disclosed loan agreements and bond indentures can be scrutinized by analysts and interested investors, and can provide these constituencies with tools to question management s actions. For example, analysts may be able to calculate the amount of cushion that a company has under its loan covenants, and subject management to interrogation during quarterly earnings calls concerning the company s ability to address a publicly disclosed loan workout while remaining in compliance with debt covenants. This factor will also influence the timing and the substance of tactics deployed by a REIT/OP in the loan maturity or default context. Trading Blackout Insider Trading. If a material default or workout has occurred and has not yet been publicly disclosed, any officers or employees of the REIT with knowledge of the distressed loan situation must refrain from trading in the REIT s securities until the information has been disclosed and reflected in the REIT s trading price (the common view is that hours must elapse before disclosed information is fully assessed by the market and reflected in a company s share price). Trading on material non-public information will expose the officers and employees to insider trading claims under Rule 10b-5 under the Securities Exchange Act of Tax Indemnification Recognition of Built-In Gain. As discussed above, under Section 721 of the Internal Revenue Code, limited partners that contribute properties to the Operating Partnership in exchange for limited partnership Units generally will not recognize taxable gain or loss at the time of contribution. However, section 704(c) of the Internal Revenue Code requires that the built-in gain inherent in each contributed property be specially allocated to the property contributor if and when each property is disposed of in a taxable transaction. As of the 9

10 contribution date, the built-in gain is equal to the agreed fair market value of the property less the adjusted tax basis in the property. This built-in gain allocation will decrease over time as tax depreciation is specially allocated to the non-contributing partners. Because of this allocation, property contributors often negotiate for tax indemnification agreements with the Operating Partnership at the time of contribution. Typically, in these agreements, the Operating Partnership will agree to refrain from disposing of the contributed property for a specified period of time (typically anywhere from 3 to 15 years) unless the exit transaction is structured in a tax-deferred manner, e.g. as a like-kind exchange under Section 1031 of the Internal Revenue Code. Income Resulting from Negative Capital Account. In addition, if the Operating Partnership assumes the mortgage on a contributed property, then the contributor will be deemed to have received a distribution equal to the amount of the debt for federal tax purposes. Any amount by which this deemed distribution exceeds the contributor s adjusted tax basis in the property will result in a negative capital account. The contributor will be taxed on the amount of its negative capital account unless it is able to secure enough debt tax basis from the Operating Partnership to offset it. Generally, all of the Operating Partnership s recourse and nonrecourse debt will be allocated pro rata among its partners (including the REIT), and the partners collective tax basis will be increased by the total amount of the Operating Partnership s outstanding debt. Therefore, if the Operating Partnership had paid down all of its debt at the time of the contribution, including the mortgage debt on the contributed property, then there would be no debt to be allocated to the contributor and the contributor would have to recognize taxable gain. However, in many cases, the Operating Partnership will not pay off the mortgage debt on the contributed property and the debt will remain to be allocated among the partners. Recourse debt of the Operating Partnership (e.g., bonds and line of credit) is generally allocated to the general partner (i.e., the REIT) unless some other partner has specifically guaranteed it. Nonrecourse debt (e.g. mortgage and mezzanine debt) is allocated among the partners of the Operating Partnership pursuant to the specific three tier rules set forth in the Treasury regulations. These allocation rules are beyond the scope of this paper. However, these rules will usually result in a substantial portion of the nonrecourse debt encumbering a contributed property, at least initially, being allocated to the contributor. If the contributor would have a negative capital account by reason of its contribution, it will be important to the contributor that it maintain sufficient debt allocations to prevent gain recognition. Therefore, a contributor may also negotiate tax indemnification provisions under which the Operating Partnership agrees to maintain enough nonrecourse debt on the contributed property to ensure the contributor has sufficient debt allocations to avoid triggering its negative capital account. Additionally, the agreement may also obligate the Operating Partnership, for an agreed time period, to allow the contributor to enter into a bottom dollar guarantee of certain Operating Partnership debt. If the contributor guarantees debt of the Operating Partnership, then 10

11 it will be responsible, under certain circumstances, for the repayment of the guaranteed amount to the lender if the lender would otherwise recognize a loss on the loan, such as, for example, if property securing the loan was foreclosed and the value was not sufficient to repay a certain amount of the debt. Workout Can Trigger Tax Indemnity Obligations. After a property is contributed to the Operating Partnership, the REIT, as the general partner of the Operating Partnership, will likely be empowered to make decisions with respect to the contributed property, such as by selling it in a taxable transaction or paying off the mortgage debt, that could result in negative tax consequences to the contributor. For example, if an SPE s mortgage loan is paid off, each partner s basis in its Units will be decreased by the amount of the liability that had been allocated to the partner. If the decrease in basis results in the partner having a negative capital account, the partner will recognize taxable income. Further, in the event a lender acquires a contributed property through foreclosure or a deed in lieu of foreclosure and in full satisfaction of the mortgage, the Operating Partnership will recognize gain to the extent the value of the mortgage exceeds the Operating Partnership s adjusted tax basis in the property. Any portion of this gain that is built-in gain will be required to be allocated to the contributor under Section 704(c) of the Code, along with the partner s allocable share of any other gain that is recognized upon the disposition of the property. Depending on the terms of any given tax indemnification agreement, a restructuring of mortgage debt or the disposition of a property to a lender in lieu of foreclosure may require the Operating Partnership to indemnify the contributor for the resulting tax liability, and therefore find itself in the position of taking on a recourse liability (the indemnity) as part of the cost of addressing a non-recourse liability (the mortgage) or salvaging or repatriating equity in the subject property. In addition, contributors may negotiate tax gross-ups, which will require the Operating Partnership to further indemnify the contributor for the taxes (and the taxes on the gross up payment) that arise as a result of the original indemnification payment. Not only may loan workouts affect the tax basis of each partner of the Operating Partnership, but any indemnification payments will negatively impact the company s earnings and cash flow, potentially to a material extent, thereby potentially creating a downward spiral due to defaulted loan covenants under the line of credit and/or corporate bonds. Moreover, although a Form 8-K will generally not be triggered by the incurrence of an indemnification obligation, if the obligation is material, the company may be required by exchange rules to publicly disclose the event. Even if immediate public disclosure is not required, the obligation will become public knowledge with the filing of the company s next quarterly report on Form 10-Q. As a result of all of the above, the tax-driven UPREIT structure adopted by a REIT will create another potential obstacle to be navigated in the engineering and execution of various forms of loan workouts, inclusive of sale of the mortgaged property to a third party, conveyance 11

12 of the property in lieu of foreclosure to the lender, or deleveraging of a property, in whole or in part. Conclusion The publicly held real estate enterprise is, as a mortgage borrower, fundamentally different from most privately held real estate enterprise borrowers because of the presence of (i) layers of enterprise debt in addition to property-specific debt containing recourse, cross-default and financial covenant provisions that are cross-defaulted with other enterprise debt; (ii) layers of equity capital at the corporate GP level that impose regulatory requirements that include antifraud, trading and disclosure obligations; and (iii) tax mitigation structures, and tax indemnification provisions, that can substantially limit, or impose substantial costs on, the restructuring of straightforward property level debt. As a result, even the most apparently innocuous or theoretically contained default under a non-recourse mortgage can have a materially adverse enterprise impact, and this paper has been an attempt to point out some of the more significant touchstones that need to be evaluated and managed by borrower s counsel in the engineering and execution of a mortgage loan workout or restructuring. 12

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