Real estate assets across the United States have suffered the adverse effects of the COVID-19 pandemic and the resulting shutdowns of businesses. This unfortunate circumstance will present opportunities to purchase the debt encumbering these properties, whether as a way of generating yield, or as part of a “loan to own” strategy. Whatever the business case, purchasing distressed real estate secured debt presents considerations and hurdles which may not be completely familiar to buyers whose experience lies in purchasing direct interests in real estate.
As the fallout from COVID-19 continues to manifest, some sectors of the real estate industry have been hit harder than others. Retail properties, many of whose tenants were suffering pre-pandemic from the continued expansion of online shopping, have been hit hard. Hotel properties have been hit as hard or harder, as many were forced to shut down or severely ramp down operations, either due to legal restrictions or pragmatically given a lack of guests and a need to preserve cash. Office properties, especially suburban offices, seem to be faring relatively well thus far, as have multifamily properties (although whether that will continue when CARES Act stimuli and state and local eviction moratoria expire is a big question). Industrial properties may be doing better than any other sector, due at least in part to increased demand for on-line shopping.
Thus far, lenders generally have been working to provide relief to borrowers, especially those whose properties were doing fine pre-COVID-19, including temporary (e.g., three to six month) interest deferrals, extensions of forthcoming maturities and temporary waivers of covenant compliance requirements. More extensive, longer term loan modifications seem not yet to be occurring on a broad basis, although anecdotally those we have seen typically require some form of collateral enhancement for the lender, such as principal paydowns, enhanced guaranties, cash collateral reserves and letters of credit, and cash sweeps, among others. For borrowers with properties which are able to take advantage of these lifelines offered by lenders, such modifications provide an ability to continue to ride out the pandemic storm in the hope better days are not far off, allowing the cash flow and value of their properties to recover.
But what of those properties where the borrowers and lenders have not been able to find a modification solution, whether due to the pre-and/or post-pandemic prospects for the property, regulatory pressures, or otherwise? Therein lies the opportunity for investors looking to take advantage of situations where lenders prefer to sell off their debt rather than continue to try to work things out or take over the real estate. If you are one of these potential investors, here are some considerations for when opportunities to purchase distressed debt are available.
Be prepared to assess based on less information
Debt typically is “distressed” because the underlying real estate is having issues, so one key in valuing the debt is understanding those issues. In a “normal” real estate purchase or financing transaction, the owner of the real estate has built in motivations to be cooperative and forthcoming with information about its property and operations. So if it wants to sell, or it wants to get a new loan, it will provide potential buyers and lenders much, if not all, of the information it may be requested to provide. This may not be the situation potential investors interested in purchasing distressed real estate secured debt will encounter.
First—be prepared for a situation where on-site due diligence is not available. In addition to the pandemic related widespread “shelter in place” or “stay at home” orders which may limit traditional on-site property diligence, the borrower may not be willing to grant access for due diligence purposes, and the selling lender may not want to signal to the borrower it is considering selling off the debt even if the borrower might be willing to provide such access. As for documentary diligence, if previously or currently engaged in workout discussions with its borrower, the lender may have received updated financials on the property, the borrower and any guarantor(s). But depending on the extent and tenor of those negotiations, some of the information a selling lender may have could be incomplete and/or relatively “stale” by the time the potential investor gets it. The lender may not even have information on the property beyond what it is entitled to receive under the regular reporting provisions of the loan documents (e.g., monthly, quarterly and/or annual financial reports) – and if the borrower is uncooperative, even some or all of that information may be unavailable. Additionally, the lender may not have copies of all of the leases (or any modifications entered into without its consent, especially if such consent was not required), and is even less likely to have copies of other relevant property-level contracts, unless it has been able to acquire these items during any workout discussions. A copy of the lender’s title insurance policy, and maybe even a relatively recent title update, should be available, but an updated survey beyond that obtained at origination is unlikely, particularly in light of the property access issues noted above.
So potential investors should be prepared to “make do” without the array of documentary diligence materials it typically expects to obtain and review in buying or financing the real estate. Be aware this all could have to be done in a relatively compressed timeframe compared to “regular” real estate transaction as well. Further, although the lender may be willing to provide certain representations regarding the debt itself in the loan purchase agreement (as discussed below), an investor should not expect a selling lender to provide any representations regarding the underlying real estate to fill in “gaps”, as a seller/borrower might in a property sale or loan origination transaction.
This is not an insurmountable hurdle, just one for which the average real estate investor who has not had much (if any) experience in the recent economy in purchasing distressed real estate secured debt must prepare. This may mean, for example, digging in deeper into the materials which are available—the monthly and/or quarterly financials, rent rolls, the available major leases, etc. – and doing more cross checking and extrapolating to gain an understanding of the current and future prospects of the underlying real estate (including, if applicable, its tenants). The less clarity provided by the available data, the more likely the investor may be compelled to build a bigger discount factor into its pricing in purchasing the debt.
How “good” are the sponsors?
Another key in valuing the debt is evaluating the strength of the sponsorship. The available information regarding the borrower, guarantors and underlying real estate obviously will be used to assess the performance and value of the debt and the real estate. But this information also must be used to assess the sponsor’s ability to address the property’s issues and possibly maintain ownership of the real estate. Put another way, does the sponsor have equity or other exposure to protect, and the financial wherewithal to try to do so? This is important to assess for the investor whose primary motivation is to purchase the debt for yield purposes—i.e., can the investor, with a lower basis in the debt, figure out a deal with the sponsor on revised loan terms where the current lender could not? This is equally important for the investor whose primary goal is obtaining ownership of the underlying real estate—i.e., will the sponsor be motivated and financially capable of making it difficult for the new loan holder to exercise remedies to obtain the real estate, or is it more likely to be amenable to giving a deed-in-lieu of foreclosure?
Understand what can (and can’t) be done in enforcing the loan documents
Whether the primary goal is to turn the distressed real estate secured debt into a performing loan on revised terms, or ultimately to acquire the underlying real estate, the investor also must gain an understanding of what the loan documents provide, and the remedies which may or may not be available in the applicable jurisdiction to enforce those documents.
As noted above, the lender looking to off load distressed real estate debt may have limited or imperfect information on the underlying real estate and sponsor, but it should have a complete set of loan documents for the loan it is selling. The investor should insist on receiving a complete set of fully-executed loan documents (and should confirm each was executed by the proper parties), and confirmation the lender possesses the original note(s) evidencing the loan, before becoming too enmeshed in this process; absence of these basic elements could create significant enforcement and other issues for the holder of the loan. The investor also should obtain access to the lender’s and any servicer’s loan file, including all correspondence between the lender and the sponsor, which also may impact enforceability of the loan documents (e.g., facts giving rise to potential lender liability claims or other defenses).
Some of the questions to consider in reviewing those loan documents include:
- Are there provisions requiring cash management, and have they been implemented?
- What other defaults may exist beyond any payment default, and what rights and remedies do those defaults create for the lender?
- What reserves are provided for, are they properly funded, and what use can the lender and sponsor make of those funds while a default exists?
Once access is obtained, the investor must assess not only the economic terms, but also the legal terms and remedies available under the documents and applicable state law. For example, for debt secured by California real property, the state’s relatively unique “one action” and “anti-deficiency” statutes will impact how those remedies may be enforced. The intricacies of the California framework is beyond the scope of this article, but in simplest terms the “one action” provisions will require a foreclosure (judicially or non-judicially) of the real estate under the mortgage/deed of trust; the “anti-deficiency” statutes, and whether there is a judicial or non-judicial foreclosure, will affect the ability to recover from the borrower and guarantors if the property sells for less than the outstanding debt at the foreclosure sale. If available in the applicable jurisdiction, a non-judicial foreclosure sale usually may be completed much quicker and more cost-effectively than a judicial foreclosure, but the requirements and ramifications of the options available should be considered carefully. Also, appointment of a receiver may be advisable to protect the collateral while a foreclosure is pending.
Given the proliferation of lenders requiring special purpose entities (SPEs) own only the subject real estate as borrowers, the guarantor(s) and guaranty(ies) which are part of the loan package are very important. If there is a guarantor with assets from which to recover, the guaranties supporting the loan can be a source not just of potential value/revenue to support the debt purchase, but also as leverage in accomplishing the investor’s goals. As noted above, the information available hopefully will provide some indication of the financial viability of any guarantor. A credit worthy guarantor with exposure under one or more guaranties may be very motivated to facilitate a workout, or to prevent the holder of the loan from exercising remedies, or to facilitate the transition of ownership of the property. The loan may include a completion guaranty (if the loan has a renovation component, even if the loan otherwise is not a construction loan), a full or partial payment guaranty, an interest and carry guaranty, and/or an environmental indemnity, all of which must be reviewed to determine whether they are enforceable and whether recovery rights have been or may be triggered.
The same goes for any non-recourse carveout guaranty, which may require the most scrutiny, both as to what the document says, as well as to determine whether any facts exist which may trigger any of the carveouts. The factual aspect of this assessment may not be fully possible until after the debt is acquired, so the investor’s initial diligence should be directed towards what “bad acts” are covered by the guaranty, and what level of liability is triggered by each act (e.g., liability only for losses attributable to the carveout, or full recourse for the entire loan). Some examples of relevant carveouts include bankruptcy/insolvency-related events, which often (although not always) trigger full recourse for the debt against the guarantor. Similarly, a carveout for interfering with the lender’s exercise of remedies may trigger recourse (full or losses/damages recourse). These may prove to be sufficient to discourage the sponsor from taking such actions and interfering with or delaying the investor’s desired outcome in purchasing the debt.
Carveouts for “waste” or misapplication or misuse of funds, before or after an event of default exists, also could prove relevant; events triggering one or more of these recourse provisions may or may not be discernable from the financial and other information available – but those facts may not always be obvious. A real world example: while engaged in workout discussions with the original lender, a borrower was able to lease space to a new tenant (which the original lender approved). The lease required tenant improvements to be paid for by the landlord/borrower; not having enough cash on hand, the borrower’s investors advanced funds. Ultimately, the debt was sold, and the new debt holder discovered the borrower had re-paid the equity advances from available cash flow while still in default – a violation of the loan documents which triggered recourse for recovery of that cash. The threat of potential liability for the guarantors created tremendous leverage for the new holder of the debt, and ultimately resulted in the borrower giving a deed-in-lieu of foreclosure (and also paying back some of the funds).
Ultimately, the loan documents, the remedies available under the applicable state law framework, and the facts around the loan and sponsors will affect the outcome for a given loan, so all must be assessed as thoroughly as possible in determining whether and how much an investor is willing to pay to purchase the distressed debt given the investor’s desired outcome.
Other potential factors to consider
Purchasing distressed real estate secured debt also could involve a number of other considerations, some of which could include:
- Others in the Capital Stack: Although this article is focused on potential purchase of a real estate secured loan, mezzanine lender(s) and/or preferred equity holders in the capital stack may have rights and motivations which could affect attaining the investor’s goal. Such players in the capital stack could prove a positive (e.g., another party motivated to step up to help turn the mortgage debt into a performing loan) or a negative (e.g., by invoking rights or taking other actions which could delay exercising remedies to gain ownership of the underlying real estate).
- Loan Purchase Agreement: Negotiating an acceptable agreement to purchase the loan also may prove to be a process different than a typical purchase agreement for real estate. Although real estate purchase and sale agreements commonly state the property is being sold “as is, where is,” just as commonly the seller will provide a “market” set of representations and warranties the buyer can rely upon (with limitations on survival and liability). In the context of a loan purchase and sale agreement, expect there will be much fewer reps from the selling lender (sometimes limited only to organizational and authority reps, ownership of the subject loan, and the outstanding balance of the loan), with few (if any) reps relating to the underlying real estate or the related information provided, and very limited survivability and exposure for breaches to the selling lender.
- Taxes: Acquisition of the underlying real estate, via foreclosure or deed-in-lieu of foreclosure, may trigger transfer taxes or a reassessment of real estate taxes (although the latter may not necessarily be a negative if the property’s value has declined from the most recent assessment). These factors should be reviewed in the applicable jurisdiction.
- Management: In situations such as the current pandemic, or other general market declines, a third party manager may have been doing a very capable job, but for those circumstances. Investors should assess whether continuing current management, under existing or revised terms, makes sense for a given property. In the context of a hotel, for example, an otherwise well-performing management company which knows the property and the market, and has good relationships with a franchisor, could prove to be an asset. Of course, if the management company has a management contract which cannot be disturbed by a foreclosure/deed-in-lieu or workout, its continued management of the property will have to be factored into the assessment of the property and debt.
Conclusion
In challenging, uncertain times such as these, all investment decisions carry a greater degree of uncertainty and risk. Even in “normal” times, however, the most successful investors are those who best assess and value assets and the attendant risk. For investors pursuing distressed real estate secured debt, those best prepared and able to execute their strategies by carefully considering the limitations and challenges such as those described above will have the most success.
Chauncey Swalwell is a partner in Goodwin’s real estate industry group. Goodwin is global law firm consisting of more than 1,200 lawyers with offices in Boston, Cambridge, Frankfurt, Hong Kong, London, Los Angeles, Luxembourg, New York City, Paris, Santa Monica, Silicon Valley, San Francisco, and Washington, D.C.
