Struggling Properties Can Exercise Workout Options to Improve Financial Health
This year is shaping up to be the most active period for real estate workouts since the early 1990s, primarily due to the declining value and performance of commercial properties during the economic slowdown. Tightening capital markets have compounded the problem by severely narrowing commercial properties' recapitalization alternatives.
As a result, owners -- or their lenders -- are exploring alternative providers of capital to help struggling properties engage in workout scenarios to fortify their financial health and improve their performance. The distress can be a result of numerous factors: loss of tenancy due to market conditions or individual tenants' financial problems; increased expenses such as real estate taxes and insurance; environmental issues; or the need for capital improvements. Most lenders would prefer to have their borrowers work out such problems rather than resort to foreclosure, or worse, force their borrowers into bankruptcy.
A workout incorporates a feasible plan of reorganization, financial projections, and most importantly, some level of new capital to fund the plan and possibly pay down or bring current the existing debt. More often than not, workouts are funded by private lenders that have flexible capital readily available at a reasonable discount to face value.
A successful workout depends on two equally critical elements: the property must be capable of being turned around, stabilized, and profitably sold or refinanced; and the borrower must have the right background, reputation, commitment, and experience to obtain the financing and see the project through to completion.
Several factors must be present for a project to be worked out.
The debt must reflect a sensible and realistic loan-to-value ratio based on current economic conditions. Undertaking a workout that is overleveraged as compared to market value is a waste of time and money.
The turnaround plan must be based on conservative real estate fundamentals. Leasing, sale, expense, and cost targets must be obtainable.
The project's plan must reflect current economic conditions. For example, an owner shouldn't expect to turn his warehouse into a telcom hotel in today's economic climate.
The exit strategy, or repayment plan, has to be based on controllable results. Relying on a refinancing in three years based on regular rental increases, stable occupancies, and today's low interest rates would be a mistake.
Even with the best projects, workouts only are possible with the right borrower. Borrowers should have experience in the particular property type; commitment to the project, shown by an infusion of fresh equity; and a good reputation. Workout lenders will investigate a borrower's background to see how he has handled himself in similar situations. They will want to know if former lenders view the borrower favorably.
Financing a Workout
Workout situations typically are too complicated, time-sensitive, and risky for borrowers to combine conventional sources of first debt, mezzanine debt, and equity. As such, the most successful workout lenders operate as one-stop shops -- single sources that can provide most of the required capital to close a transaction. Most capital sources cannot provide 100 percent of the funding, but successful workout lenders can provide enough to mitigate significantly the borrower's need to search for third-party mezzanine debt and/or equity.
One-stop financing generally is structured in one of the following ways. A single funding source can be used, with two or three autonomous divisions making separate transactions for the senior, mezzanine, and equity pieces. In this scenario, each division acts independently with its own set of returns and controls. The second alternative is to have one single transaction for the full financing, incorporating a blended rate and fee schedule. Because there is a single loan -- not two or three adding up to the same aggregate amount -- the fees and interest rates are blended from the two or three sets of fees and interest rates that would have been charged individually for separate tiers of financing. This method sometimes is advertised as high-leverage debt.
Single-stop financing offers borrowers several benefits. First, it requires only one round of due diligence, saving valuable time and money. Second, fewer attorneys are involved, thereby speeding up the transaction. Third, the need for inter-creditor negotiations and documentation is eliminated, often making this the preferred structure for borrowers. Last, less equity must be raised and less, if any, ownership is relinquished.
One-stop lenders are ideal for workout situations because these deals usually are underwritten and priced to have limited development risk, but still offer enough upside to satisfy the mezzanine and equity returns built into the blended pricing.
Locating a Workout Lender
While workouts have become more prevalent, fewer capital sources are available to finance them. To locate a workout lender, borrowers should identify institutions that have aggressive mezzanine and equity programs since some level of mezzanine/equity typically is required in these scenarios. These firms include opportunity funds, Wall Street subsidiaries, institutional lenders, hedge funds, and private lenders. Each type of lender has its own preferences regarding product type, risk tolerance, and structure.
Successful workout lenders must possess an ample, flexible capital base, a strong due diligence team, and the ability to recognize hidden value and creatively tailor their financing structures to each scenario. These lenders typically see problem situations as opportunities that will be rewarded with higher-than-average returns.
Typically, a lender possessing the aforementioned attributes is not a public institution but a flexible, unregulated, privately held capital source in which the principals have extensive experience in real estate development and operation. This type of background, combined with a significant and largely discretionary equity capital base, helps borrowers turn workouts into opportunities.