Recent increases in interest rates, the downturn in the economy and the tightening of available credit have created stress in the real estate market. Owners with adjustable-rate mortgages, partially completed projects and smaller commercial and retail rental properties are facing cash-flow problems and foreclosure notices from their lenders. Credit and/or venture equity is no longer readily available for real estate, cutting off a resource that has kept problem real estate afloat. While not comparable in severity to the real estate crash of the late ’80s and early ’90s, a pool of distressed real estate has been created and is increasing in size. An increase in real estate bankruptcies has resulted.
While not a panacea, a bankruptcy proceeding presents opportunities, both for the owners of distressed real estate and for those interested in acquiring or investing in distressed real estate. Bankruptcy can provide an effective way to restructure the debt against and equity interests in an underperforming asset and return it as a productive part of the economy. Bankruptcy proceedings can also present a trap for the unwary or uninformed. Below are four points, applicable to the owners of distressed real estate and those interested in acquiring distressed real estate from bankruptcy proceedings.
• Have a plan going in. It is easy to get into bankruptcy; getting out is the trick. Each bankruptcy proceeding has a period of time during which the bankrupt company is given the opportunity to implement its restructuring plan. The Bankruptcy Code sets various deadlines – such as deadlines for the filing of a plan of reorganization – that bankruptcy companies must meet. In addition to those statutory deadlines, each case has its own shelf life, the time during which a bankrupt company must show progress or lose credibility with the bankruptcy court and creditors. That second, unwritten deadline depends on a number of different factors, including the debt structure, the reason for the financial distress and the likelihood of a successful financial restructuring. For owners of distressed real estate, it is vital to have a restructuring plan going into bankruptcy, to describe the plan clearly and implement the plan promptly. The chances of a successful reorganization shrink dramatically if the bankruptcy court and creditors do not believe in the bankrupt company’s chances of reorganization or do not see progress towards that reorganization. For potential acquirers or investors, it is important to both understand the bankrupt company’s plan and how it fits into the deadlines in bankruptcy. This is necessary to formulate and implement the acquirers or investors’ own plan. Whether the goal of that plan is a hostile acquisition of or investment in the distressed real estate, success will depend on positioning oneself during the early parts of the bankruptcy case. Owners and potential acquirers or investors must first have a feasible business plan for the property. The Bankruptcy Code cannot increase the inherent value or override the economics of real estate. Once the business plan is determined, the legal strategy can be formulated.
• Know the legal issues. The Bankruptcy Code provides powerful tools to adjust the debtor/creditor relationship, modify contractual rights and transfer assets. Bank loans, service contracts, leases and other contracts are all subject to some, but not complete, adjustment. The Bankruptcy Code has many deadlines, rules and restrictions of which bankrupt companies and potential acquirers and/or investors must be aware. Property rights in bankruptcy, however, are determined by non-bankruptcy law. Particularly where real estate is involved, it is necessary to understand the interplay between bankruptcy and non-bankruptcy law.
For example, suppose that Company A wishes to acquire the real estate of bankrupt Company B. Company B wishes to sell its real estate, and utilizes the bankruptcy code’s ability to sell real estate free and clear of liens against and interests in the real estate, a powerful tool to provide a purchaser with clean title to the real estate. A sale through the bankruptcy court is consummated and Company A acquires the real estate, only to discover that the bankruptcy code does not permit the sale of real estate free and clear of encumbrances, such as easements, that run with the land. Company A then realizes that it purchased the real estate subject to the town utility easement, with a high pressure water pipe that services several hundred homes, that runs underneath its planned commercial office building. In this real life example, Company A spent substantial funds to negotiate with the town and move the water pipe and easement.
Without an understanding of the bankruptcy and non-bankruptcy legal issues, the business plan for the distressed real estate will not be successful.
• Know who has the leverage. Each bankruptcy case involves a blend of creditors and parties in interest with differing amounts of leverage. Lienholders, unsecured creditors and even equity interests all have a say in the bankruptcy case. Knowing which party has the most leverage is a must for a successful reorganization of distressed real estate.
The owner of the distressed real estate must know which creditors stand in the way of its restructuring plan, and must deal with those creditors either through a settlement or through litigation. Reaching a settlement with a powerful creditor gives the bankrupt company an important ally and, potentially, the ability to restructure over the objections of other creditors.
The party interested in acquiring or investing in the real estate must know which creditors stand in the way of the bankrupt company’s restructuring plan and the likelihood that the company’s plan will be approved over the objection of the creditors. In bankruptcy, virtually every asset and claim is for sale at some price. It may be more cost effective for a potential acquirer of the real estate to buy the debt with the most leverage in the bankruptcy case, and then seek to implement its own bankruptcy plan or simply force a sale of the real estate.
• Know when to let go. Owners of distressed real estate, having spent time and money to develop or improve the real estate, invariably attach more value to the real estate than actually exists. Potential acquirers of or investors in distressed real estate in bankruptcy frequently commit more to the bankruptcy process than they would outside of bankruptcy. In either case, one must know when to let go of or stop bidding on the distressed real estate before committing too much money to the process. It is, after all, just distressed real estate, and there is no shortage of distressed real estate.
