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90 Second Lesson: Distressed Real Estate vs. Operating A Business In Distress

Question

Charlie M. wrote asking a question about distressed real estate, “I have been investing for more than 70 years, and while I have enjoyed great success generally, I certainly have had some losers along the way. I have less experience with real estate and have, up until now, never had any of my those investments go bad. Now one of my investments, a developer with numerous projects in the Midwest and Southwest, is facing issues. Can you elucidate to me some of the ways in which distressed real estate is different from when an operating business is in distress?”

Answer

Charlie, this is your lucky day (other than for the distressed real estate). Financial Poise Faculty Members and prominent attorneys, Adam Nach and James (Beau) W. Hays, authors of the Real Estate Workouts1 chapter in Strategic Alternatives For and Against Distressed Businesses, wrote the following (footnotes omitted):

“Distressed real estate projects present several issues that are different than issues facing distressed operating businesses. One issue is that the typical structure will involve each real estate project having its own ownership entity and capital structure. Even where a holding company or fund provides capital for multiple projects, the parent will usually segregate ownership of its real estate projects into separate subsidiary entities. These subsidiaries are typically created for the sole purpose of owning the land, improvements, and rights associated with a specific project. There are many driving factors behind forming a so-called “single purpose entity” or “special purpose entity” (SPE). For example:

  • The ability to raise capital on a project-by-project basis;
  • The ability to structure joint ventures or bring in operating partners for single projects;
  • Segregating assets in order to avoid inadvertent cross-collateralization; and
  • Segregating assets in order to allow for mortgage financing.

One result of this structure is that the parent can treat each project on a stand-alone basis, including in times of distress. Thus, the parent need not make a portfolio-wide decision if one property (or one type of property) is suffering a crisis. Rather, the parent can take action, including bankruptcy, with respect to specific SPEs while simultaneously minimizing the risk to its other assets.

Certain lender mandates have given rise to the proliferation of SPEs for real estate projects. Mortgage lenders prefer to have projects owned and financed through an SPE primarily because it helps segregate collateral and also because the use of an SPE enables the lender to limit a borrower’s ability to seek bankruptcy court protection.

Lender controls in the form of covenants in the organizational documents and loan documents transform an SPE into a “bankruptcy remote” vehicle for property ownership by requiring that the SPE: (a) may not file bankruptcy without the consent of its members; (b) may not directly or indirectly assist other parties in filing an involuntary petition against it; and (c) must have at least one independent director whose affirmative vote is required to seek bankruptcy protection. These controls will usually make it more advantageous for an SPE to use non-bankruptcy alternatives in a distressed situation.

Moreover, the lenders usually require guarantees, and the guarantees are structured as non-recourse, but the guarantees convert to recourse guarantees upon the filing of bankruptcy by the borrower; these clauses are known as “Bad Boy Clauses.”

If, despite having established such controls, a borrower still decides to pursue relief in bankruptcy, the Bankruptcy Code has special provisions for dealing with so-called “single-asset real estate cases.” In a single-asset real-estate bankruptcy case with a lone mortgage lender seeking to foreclose on its collateral, there may be very little to reorganize, very few unsecured creditors to protect, and very little, if any, equity for the estate. Most mortgage lenders loathe the prospect of bankruptcy because it can often lead to unhappy or unexpected results once they lose the control that they have outside of bankruptcy.”


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[Editors’ Note: This 90 Second Lesson is based, in substantial part, on material reprinted from “Commercial Bankruptcy Litigation 2d” and “Strategic Alternatives For and Against Distressed Businesses,” with permission of Thomson Reuters. Both books are written for a primary audience consisting of people who are not bankruptcy specialists. This is part of our irregular series in which we answer readers’ questions. If you have a question, submit it to [email protected], and we will try to answer it.

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©2023. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.

  1. If you are a Westlaw subscriber, you can jump right to the chapter by clicking this hyperlink.

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The editors and editorial board of DailyDAC include preeminent restructuring and insolvency professionals, journalists, and editors. They are devoted to providing reliable and plain English education and deal intelligence about assignments, corporate bankruptcy, receiverships, out-of-court workouts and similar topics.

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