Real Estate Workouts: Building a New Paradigm Written by: Ronald Greenspan1 FTI Consulting; Los Angeles firstname.lastname@example.org
he current real estate restructuring environment is unlike any we have seen since the early 1970s and perhaps, for even the most seasoned bankruptcy industry veterans, unlike anything they have witnessed during their careers. The three previous real estate downturns, those of 1974-75, 1980-82 and 1990-91, resulted primarily from distinct periods of overbuilding— with excess supply eventually outstripping waning demand. The year 1971 began an era of consistent one million-plus new single-family home starts, a mark that was missed only during these three downturns. Coinciding with these real estate slumps were cyclical peaks in long-term interest rates and periods of contraction for the overall U.S. economy.2 In contrast, 2008 witnessed a virtual collapse in residential demand despite near-record low mortgage rates, with starts and sales of new homes falling to their lowest levels since the end of World War II. Just 620,000 new homes were started in 2008, down more than 50 percent from 2006. In 2009, with interest rates dipping even lower, results have been worse and single-family housing starts will not reach 500,000 units. Commercial real estate markets, where uniform statistics are not as readily available, also experienced severe challenges during the three earlier periods, and they too have suffered badly since 2008. Generally, the current slump in commercial property markets, unlike other downturns in U.S. commercial real estate, was not preceded by a protracted period of overbuilding. All four of these real estate corrections have been marked by a scarcity of reasonably priced financing and other workable credit terms. To an extent not evident with other asset classes, market demand and price support for real estate hinges on the availability of reasonably priced capital. Equity returns on real estate investments depend critically on the leverage employed in structuring a deal. Interest rates had peaked at or near the outset of the three prior real estate downturns—including 1 The opinions in this article are those of the author and not of FTI Consulting. 2 The National Bureau of Economic Research (NBER) actually counts four rather than three recessions during this period—with the timeframe of 1980-82 consisting of two distinct recessions.
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About the Author Ron Greenspan is a senior managing director and the West region leader in FTI’s Corporate Finance Practice and is based in Los Angeles. the infamous recession of 1981-82, when the prime rate hit 21.5 percent and long-term mortgage rates exceeded 15 percent per annum. The current market is drastically different: Interest rates are at cyclical lows, but credit for real estate projects is extremely difficult to obtain on favorable terms, as underwriting standards have tightened considerably.
What to Do in Today’s Market
The resolution of prior real estate corrections was straightforward: A moderation of high interest rates coupled with gradual economic recovery from recession eventually revived real property markets. The current correction cannot possibly be resolved similarly; interest rates will inevitably rise from current low levels, and few experts, if any,
such a depressed market, neither party wants a hasty retreat or a temporary remedy that will need to be revisited or renegotiated when the market is still in the doldrums, perhaps more so. Retail vs. Wholesale Solutions
While exits in today’s market are mostly painful ones, the degree of pain can be better managed through a well-executed workout and asset-disposition program. The worst outcome for both the lender and borrower is usually the cessation of construction and the “wholesale” disposition of partiallybuilt inventory rather than the “retail” sale of finished product to natural buyers. This is seen frequently in negotiated restructuring agreements that, despite covenant defaults or loan maturity, provide for continued funding of construction loans sufficient to permit a developer to complete the construction and either sell finished homes to residential buyers or to lease-up and dispose of commercial developments. There might be a moribund market for finished real estate product intended to be sold to “retail” buyers, but the market for partiallybuilt projects is substantially worse.
Turnaround Topics are predicting a robust U.S. economic recovery. Confronted with this atypical recovery scenario, sophisticated creditors and their troubled real estate borrowers have discarded the old playbooks that had served them well and have adapted their workout and restructuring strategies to today’s new realities in the following four key aspects. New “Partnerships”
While not partners in any legal sense, borrowers and creditors today are often financial partners in a very practical sense. Very limited financing and depressed property values mean that there are few attractive exit strategies for either party, which augers for considering a longerterm workout horizon. This creates a mutually dependent financial arrangement that requires the lender to re-underwrite using predominantly noneconomic parameters. Is the borrower financially stable enough to ride out this slump? Is the borrower’s senior management team capable and trustworthy enough for a lender to remain invested with them (or their project) for an extended period? In
More Players/More Problems
Previous major real estate corrections, the last of which took place nearly two decades ago, occurred during the “prediffuse” period of real estate finance. Twenty years ago, real estate developer financing was characterized by project financing—a loan tied to and secured by a specific project—that was converted into permanent financing upon completion of the project. Such loans were usually retained and serviced by the originator or participated to a relatively small group of regulated financial institutions. This model has since become the exception rather than the norm for large properties and major developers/owners. Today’s real estate finance market is characterized by a complexity arising from multiple creditor participants and structural priorities: commercial mortgage-backed security (CMBS) loans that require a distressed project’s owner to deal with a servicer, often having no direct economic interest in the credit and typically seeking to apply a servicing standard crafted for continued on page 85
Turnaround Topics: Building a New Paradigm in Real Estate Workouts from page 26
different circumstances; complex senior/ mezzanine structures with inherent conflicts between the multiple classes of lenders, and untested documents and contractual relationships; and real estate portfolios that have reached a previously unheard of size, with billions of dollars of assorted debt structures, including individual property mortgages, portfolio senior and junior secured debt, unsecured senior or junior bonds, secured and unsecured bank terms, and revolving credit structures. Many of these structures are now being tested for the first time in a major real estate downturn. In the historically tradition-bound mortgagefinancing business, this is an entirely new experience, and creditors and debtors are both learning as they go. This added complexity and lack of established precedent confers an advantage to creative, persistent and capable counterparties who are producing the best results in an extremely difficult business environment. It is also becoming clear that some of the financial structures that looked so appealing in an up market are severely dysfunctional in a major down market and are unlikely to return with any vigor, even after financial markets regain their equilibrium. Unprecedented Single Credit Exposure
It seems counterintuitive in an age of securitization and widespread loan syndication that financial institutions
would be exposed to very large single credits or highly-correlated credits. However, bank mergers and the widespread (but misplaced) belief that real estate security always provided a fundamental level of credit support have led to unprecedented institutional exposure to the current real estate decline. Even the largest U.S. banks, those with assets exceeding $10 billion, had commercial real estate loans averaging in excess of 100 percent of their regulatory capital, with smaller banks averaging up to 350 percent of regulatory capital. The broad-based collapse of commercial values across entire regions and property types means that diversification no longer provides a portfolio with immunity to loss of value. Furthermore, anecdotal evidence shows that there are a surprising number of single-institution exposures to a single real estate project or owner with profound potential consequences to such institution, sometimes exceeding the billion-dollar mark. Moreover, complex subordinated structures, such as securitizations and mezzanine structures impose asymmetric exposure to loss in the event of value declines that we have witnessed in the past two years. The unprecedented magnitude of these risks and exposures to loss magnify the importance of these restructurings and increase the downside from any misstep.
Broad U.S. economic recovery may have just begun, but not for real estate. Some residential real estate markets have begun to stabilize at best, while commercial property markets have yet to give a clear signal of a bottom by most indicators. Many experts believe that the worst lies ahead for regional financial institutions with respect to commercial real estate losses and loan workouts. Recessions are typically followed by early bursts of above-average economic growth followed by steady-state expansion, with commercial real estate cycles typically lagging the overall economy by about one year. Most economists believe that this recovery will be uncharacteristically weak throughout 2010, and a few are concerned about a â€œdouble dipâ€? recession, as happened in the early 1980s, if labor markets do not show visible improvement next year. Perceptive restructuring professionals understand the distinction between an economy no longer in freefall and an actual recovery. The depth of this recession coupled with possibly enduring changes in credit market conditions, regulatory structures and consumer behavior may very well mean preparing for an economic recovery, and real estate workouts, that do not conform to any prior script. n
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