The Pain Spreads

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Courtesy General Growth Properties

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Not so long ago, General Growth Properties Inc. was a classic success story. The company had morphed in 55 years from a family-owned grocery business in Iowa to the second-largest owner of shopping malls in the United States.

The Chicago-based company’s roster of more than 200 malls included such marquee establishments as Water Tower Place on the city’s Magnificent Mile, Faneuil Hall Marketplace in Boston, South Street Seaport in Manhattan and Honolulu’s Ala Moana Center, the largest open-air shopping center in the world. GGP’s annual earnings exceeded $3.3 billion, and its assets were nearly $29.6 billion as of Dec. 31, 2008.

Less than four months later—on April 16, 2009—General Growth Properties filed for bankruptcy.

General Growth Properties owns more than 200 shopping malls in 44 states.

The company had borrowed heavily to finance its expansion, and it was hit hard by the collapse of the real estate market and the freeze in the credit markets that followed.

“The collapse of the credit markets has made it impossible for GGP to refinance our maturing debt outside of Chapter 11,” the company acknowledged in a press release.

Courtesy General Growth Properties

GGP’s Chapter 11 filing is the biggest real estate bankruptcy in U.S. history. It may, however, be only a taste of what lies ahead.

Commercial real estate companies throughout the United States are in similar straits: confronted with plummeting real estate values, falling occupancy rates and a shrunken credit market that offers refinancing only on terms that many borrowers cannot meet—if loans are available at all.

“The scale of this problem is virtually unprecedented in commercial real estate,” states an April 23 report on the American market issued by Deutsche Bank, a worldwide financial services provider. The report, The Future Refinancing Crisis in Commercial Real Estate, estimates $1.97 trillion in commercial loans will mature between now and 2018. More than half of these loans could “face formidable refinancing problems,” the report warns.

These loans “are unlikely to qualify for refinancing without substantial equity infusions from the borrowers,” the report states, but “commercial real estate borrowers will, for the most part, either be unable or unwilling (or both) to put additional equity into these properties.”

The wave of defaults likely to follow could be devastating, and not merely for those in the commercial real estate, or CRE, industry. Many hotels, restaurants, stores and other commercial tenants would be forced to close when their landlords go out of business or the buildings they occupy are foreclosed.

“There will be a lot of empty buildings,” says Neil S. Kessler, a partner at Troutman Sanders in Richmond, Va., who chairs the Commercial Real Estate Transactions Group in the ABA Section of Real Property, Trust and Estate Law. “Think of all the unemployment that might result.”

The inability to refinance commercial real estate loans also “could drive another wave of bank failures,” especially among the thousands of small and midsize banks that have portfolios bulging with commercial real estate loans, says professor David H. Downs, who heads the real estate program in the business school at Virginia Commonwealth University in Richmond.

Moreover, many commercial real estate loans were securitized and sold to hedge funds, pension funds, mutual funds and other financial entities that will take a hit if the underlying loans default.

To make matters worse, these blows are likely to strike while the country still is trying to recover from its worst economic shock since the Great Depression. Many experts fear the refinancing crisis in commercial real estate could tip the nation back into a recession, or worse.

“This is a perfect storm,” says William G. Rothschild, a partner in the real estate practice group at Sutherland Asbill & Brennan in Atlanta.

• • •

A primary cause of that storm is that commercial real estate is even more reliant on ready cred-it than residential real estate, which still has not recovered from its own implosion.

A typical residential property mortgage has a term of 20 to 30 years and is fully amortizing—the borrower repays the loan principal in full over time. Commercial real estate loans have much shorter terms (often five to seven years) and the borrower frequently repays little, if any, principal. Instead, at the end of the loan term, the borrower is expected to make a large balloon payment covering the outstanding loan principal—which the borrower gets by taking out a new loan.

This method of CRE financ-ing worked fine until the housing market collapsed in 2007, sending the economy into a tailspin and the financial sector into near-collapse. The credit markets dried up, and they have yet to recover. As a result, says Downs, “money is more difficult to get—it is not just more expensive, it is sometimes unavailable.”

One important source of CRE financing has largely disappeared. Commercial mortgage-backed securities account for 21 percent of the nation’s outstanding commercial real estate loans and 45 percent of new CRE loans made in 2007. But “the CMBS market is dead right now. Securitization has just stopped,” Downs says. Other traditional sources of financing such as banks and insurance companies also are often refusing to make new loans, he notes.

And companies still willing to lend are now demanding much tougher terms.

“We’ve already seen some of that,” says Susan G. Talley, who chairs the real estate practice group at Stone Pigman Walther Wittmann in New Orleans and serves as secretary of the ABA’s real property section. “Lower loan-to-value ratios; personal guarantees; escrows for taxes, insurance, repairs and maintenance; and testing for coverage ratios—is the property generating enough income to service the debt? Attorneys for lenders are being much more careful and are retooling their loan documents to cover these additional requirements.” (Talley is the section’s liaison to the ABA Journal.)

The lower loan-to-value ratio has become a major obstacle to efforts by CRE owners to refinance loans. Not so long ago they could get loans equal to 80 percent of the value of their properties, sometimes even 100 percent. Now they are able to borrow far less against their collateral.

Their ability to borrow has been further damaged by the steep drop in real estate prices. Commercial property values have fallen 35.5 percent from their peak in late 2007 and will likely fall a bit further, to approximately 40 percent below their peak value, according to a report issued on Sept. 3 by Moody’s Investors Service.

“Of course, when your property value falls so much, you will have a problem refinancing your loan that was sized on rosy valuations from the salad days,” notes the report, Is U.S. Securitization on the Road to Recovery?

Rothschild provides an illustration of how these factors affect property owners: “Take a property that was worth $100 million in 2005, and the owner obtained a conservative 80 percent loan on the property. Then property values dropped 40 percent. If the owner tried to refinance the loan, the lender would give 80 percent of the property’s current value, which is $48 million, but the loan is $80 million. The borrower would have to go out of pocket $32 million in order to get a new loan.”

Courtesy General Growth Properties

The combination of lower loan-to-value ratios and plummeting property values has put many CRE owners in a bind. They can’t borrow enough to refinance their existing loans, so they must pay off significant chunks of their current loans out of their own funds. Many cash-strapped CRE companies won’t be able to do this. Others will refuse to do so, recognizing that their properties are now “upside down” (worth less than the loans).

The likely result is that at least two-thirds of the commercial real estate loans maturing between 2009 and 2018, totaling some $410 billion, “are unlikely to qualify for refinancing at maturity without significant equity infusions from borrowers,” predicts the Deutsche Bank report.

• • •

This is strange and frightening new territory for commercial real estate owners and developers, say lawyers in the field.

“Many clients have not been in a situation before where they have done nothing wrong and they can’t refinance because of market conditions,” says Alexandra Cole, a partner in the Chicago office of Perkins Coie who chairs the firm’s real estate practice group. “People are shell-shocked. They’re saying, ‘What do I do?’ ”

Seeking modifications in the terms of existing CRE loans is one route property owners may pursue—and in some cases that may even involve discussions about paying off a loan at a discount.

“There are lenders who are happy to be taken out at 70-80 cents on the dollar on paying loans that are not yet due,” says Bernard B. Kolodner, a partner at Philadelphia’s Kleinbard Bell & Brecker who is vice chair of the Commercial Real Estate Transactions Group in the ABA’s real property section. “Anyone with enough lead time should find out if a lender wants to get out of the loan and what the lender would do to make the loan go away. That, of course, assumes there’s someone at your lender you can talk to.”

If a CRE loan is securitized, it is particularly difficult for a borrower to modify. The loan has been combined with other loans into a large pool and the borrower has no idea who purchased ownership shares in the pool. The loans in the pool are managed on a day-to-day basis by a master servicer under the terms of a pooling and service agreement. If a loan defaults or is in imminent danger of default, it is then handled by a special servicer. The borrower usually has little contact with the servicer, so requesting a modification often is an exercise in frustration, Kolodner says.

Even if a servicer wants to modify a loan, however, it may be unable to do so without incurring big penalties under federal tax law. The Tax Reform Act of 1986 authorized a new type of entity—real estate mortgage investment conduits—to hold static pools of mortgage loans. The law defines REMICs as pass-through entities, so they are not taxed on their income. Instead, security holders in a REMIC are taxed on the income they receive via their shares in the entity.

This favorable tax treatment, however, comes with some strings attached. If a REMIC makes a “significant modification” to a loan that it owns, the entity can be hit with a 100 percent penalty tax on the gain it receives from the modified loan and risks losing its status as a pass-through entity.

There are some exceptions to this draconian restriction. A REMIC, for instance, may safely modify a loan that is in default or where default is reasonably foreseeable.

Servicers have interpreted this exception narrowly; to avoid risk-ing the pass-through status of their REMICs, they will modify only loans that have defaulted or where default is imminent. This has stymied borrowers seeking modifications in order to handle balloon payments that still are some months off.

The Internal Revenue Service recently tried to fix this problem by issuing new regulations and some general guidance. The regulations, Modifications of Commercial Mortgage Loans Held by a Real Estate Mortgage Investment Conduit, issued on Sept. 16, expand the types of permitted modifications. They allow REMICs to make certain changes in collateral, guarantees and other credit enhancements on an obligation; allow loans to be changed from recourse to nonrecourse (and vice versa); and allow liens to be released when collateral is changed.

More generally, the IRS indicated in Revenue Procedure 2009-45, issued on Sept. 15, that it would not impose any adverse tax consequences on a REMIC for modifying a loan provided the servicer reasonably believes, based on all the facts and circumstances:

  1. There is a significant risk the loan will default upon maturity or at an earlier date.
  2. Modifying the loan will substantially reduce the risk of default.

The IRS said this safe harbor applies even when a default is not imminent as long as a reasonable belief exists that it will occur.

Servicers, however, may be leery of relying on this guidance. If a proposed modification isn’t specifically allowed by the regulations, a servicer may not want to risk a REMIC’s tax status on the hope that a modification satisfies the somewhat vague criteria of the IRS revenue procedure.

Moreover, many pooling and service agreements were drafted with language that tracks the old IRS stance on modifications, thus prohibiting servicers from making modifications.

The IRS actions will enable some REMICs to modify loans before they come due, but the effects will be relatively minor, many experts assert. The basic issue remains unsolved: Borrowers need to put up large amounts of money or additional collateral to qualify for new financing, and many borrowers simply can’t or won’t do this.

• • •

Many borrowers and lenders hope to finesse the refinancing problem by extending existing loans and pushing off final balloon payments in the hope commercial real estate values will rise significantly and make it possible to refinance. Unfortunately, there are some problems with this strategy.

For one, it will be difficult to extend many securitized CRE loans for more than a few years. Pooling and service agreements typically cap extensions at a maximum of two to four years.

In addition, extensions of securitized loans are likely to become mired in disputes between junior and senior security owners. Extensions generally are favored by those who hold junior securities (and would be first in line to take any loss). Extensions postpone foreclosures, which could wipe out their interests, and enable them to keep getting income from borrowers.

Those who hold senior securities (and are best protected against loss) have a different perspective: They don’t benefit from extensions because they could recover most, if not all, of the sums due them by foreclosing.

There is a more basic problem, however. Extensions can give borrowers and lenders some extra time, but during this time, property values are unlikely to rise enough to enable most CRE borrowers to refinance loans. Property prices would need a huge spike in order to enable widespread refinancings under lenders’ tougher loan-to-value ratios. Expecting such a price surge “is tantamount to predicting that the market will be saved by the next rent bubble,” the Deutsche Bank report states.

Extensions might even prevent significant rises in property value, thus ensuring that the refinancing crisis will continue.

“With hundreds of billions of dollars of distressed mortgages building up over time via maturity extensions, the likelihood of significant property price appreciation is remote,” states the Deutsche Bank report. “After all, hundreds of billions of dollars of extended mortgages represent potentially hundreds of billions of dollars of distressed real estate ready to flood the market.”

In the bank’s gloomy view, “The belief that maturity extensions present any sort of real solution is naive. In fact, maturity extensions do little more than push the problem down the road.”

There is another, harsher option: If a borrower is unable to make its final balloon payment, a lender can move against the mortgaged property by foreclosure, deed in lieu of foreclosure or other means.

This tactic may be welcomed by borrowers whose properties are upside down. Lenders, however, often are less than keen on this idea.

“If a property is upside down, a lender doesn’t want to foreclose because what is it going to do with the property?” Kolodner says. Selling in the current distressed market would bring in some money, but the lender wouldn’t recover the amount due. And until the lender can resell the property, it is stuck paying for insurance, taxes and upkeep.

There is another downside for lenders. “There’s a lot of money invested in commercial real estate that has been wiped out on paper, but the losses haven’t been realized yet. If someone wants to move against the asset or sell it, the loss would be realized,” says Dominic J. De Simone, a partner in the real estate department at Ballard Spahr in Philadelphia. Realizing the losses can hurt lenders’ financial stability, require them to set aside additional reserves to protect against future losses, and significantly diminish their current earnings, perhaps even pushing them into the red.

• • •

Another option is bankruptcy. If a property owner files under Chapter 11 of the U.S. Bankruptcy Code or if creditors file an involuntary bankruptcy petition, the bankruptcy court may reorganize the debts, write down loans and set a repayment schedule. It also is possible under Chapter 11 for the owner to keep the property.

But the bankruptcy process can be costly and time-consuming. A debtor must prepare and submit detailed reports on its financial condition. The debtor must negotiate with creditors, and it must pay for all the attorneys, accountants and other professionals used by creditors in the bankruptcy process. Moreover, the debtor loses a certain amount of control over its business and will have more difficulty borrowing in the future.

Bankruptcy can be bad for lenders, too. Unsecured lenders and those with junior security interests may see their claims wiped out. Even lenders whose claims survive may find the court slashes the amount they are owed, and payment can be delayed for months as the bankruptcy process drags on.

On the other hand, De Simone says, “senior secured lenders may see bankruptcy as clearing out the decks for them.”

But secured lenders may not be as safe as they thought. In many cases they loaned money to special purpose entities that were supposed to be “bankruptcy remote.” Each SPE was intended to be walled off from the vicissitudes of its corporate parent or siblings. If the parent or siblings filed for bankruptcy, the SPE was supposed to be unaffected, continuing to receive income from its property and continuing to repay its loans.

Thanks to General Growth Properties, however, these arrangements have run into trouble. When the real estate giant filed for Chapter 11, so did 166 of its subsidiaries, many of which were special purpose entities. Some of the SPEs were financially strong, so creditors asked the court to dismiss their bankruptcy petitions. But on Aug. 11, these motions were denied by Judge Allan L. Gropper of the U.S. Bankruptcy Court for the Southern District of New York in the case of In re General Growth Properties Inc.

Gropper ruled the directors of each special purpose entity properly considered more than just the condition of his own entity in deciding whether to file for bankruptcy. The directors correctly recognized their SPEs were part of a larger family of affiliated companies, and the SPEs would be harmed if the members of the larger corporate family were in trouble because they could not obtain refinancing.

Moreover, each SPE director was obligated to protect the interests of the corporate family’s shareholders, the judge ruled. Thus, the court concluded, these bankruptcy-remote entities could participate in the parent’s bankruptcy proceedings.

But participate how? A long line of precedent holds that an SPE’s assets, income and liabilities may not be substantively consolidated with those of affiliated corporate entities for the benefit of all creditors.

Gropper’s conclusion was that GGP and its subsidiaries could be viewed as a family of companies. Accordingly, each special purpose entity’s assets and income were available to help other family members—but only to the extent that those assets and income were not needed to protect the SPE’s creditors.

“Income from one property can be used to fund the operations of another property because the secured creditors were adequately protected. They had replacement liens and other protection,” says Cheryl A. Kelly, a partner at Thompson Coburn in St. Louis who handles real estate workouts. “This ruling is not particularly shocking because the bankruptcy code allows this. It has ‘adequate protection’ provisions.”

But the ruling shocked many lenders and their legal counsel, who believed financially healthy SPEs couldn’t be dragged into bankruptcy and used to prop up related corporate entities.

“It shows that these entities are bankruptcy remote, not bankruptcy proof,” says Cole of Perkins Coie. “We fooled ourselves into thinking they were bankruptcy proof when they’re not.”

The ruling is expected to push lenders to revise loan agreements and demand changes in SPE structures to make SPEs more bankruptcy remote. Lenders will also boost their interest rates on loans to SPEs to compensate for the increased risk.

The GGP ruling may be disturbing news for lenders, but it could be good news for CRE companies trying to restructure their debts. And in recent weeks, there has been some other good news.

“Some buyers are appearing,” Cole notes. “Mortgage modifications are speeding up.” The loan modifications, however, may only postpone the looming refinance problem.

“In most of the modifications I’ve seen, the loans come due in 2014,” Cole says. “We are just kicking the can down the road to 2014.”

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The magazine and initial online version of "The Pain Spreads,” January, misquoted St. Louis lawyer Cheryl A. Kelly in her comment on whether one corporate subsidiary's assets may be used to cover the debts of another entity within the company. Kelly’s quote should read: “Income from one property can be used to fund the operations of another property because the secured creditors were adequately protected.”

The ABA Journal regrets the error.

Steven Seidenberg is a lawyer and freelance journalist in Fanwood, N.J., who contributes regularly to the ABA Journal.

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