Real Estate Forum - May/June 2009

from a bank, or a bank is thinking of selling its assets, it needs to consider its risk-based capital and how all of this will impact its accounting.

The low-interest rate environment may reduce the cost of financing, but it doesn’t change the asset picture—prices and debt levels are still high. “For those that chose to maximize yield and lever up aggressively, they’re still dealing with overexposed portfolios,” Grinis says. “Asset values have come

“The silence is deafening. There are
so few transactions because you
only sell today if you have to.”

MICHAEL STRANEVA

GLOBAL DIRECTOR, TRANSACTION REAL ESTATE

down, yet debt hasn’t defaulted on a large scale because property cash flows have been sufficient to service the outstanding debt. There has been a fundamental change in how people perceive the risk of owning real estate. Investors are examining what is an appropriate yield and the amount of leverage that you can obtain. Unless we return to the same availability of debt and equity capital of the past few years, investor returns will have to come down, or the value of real estate has to reprice.”

A trigger event, such as a debt maturity, default on debt covenants, going-concern opinions or foreclosure actions by senior or mezzanine lenders often require borrowers and lenders to renegotiate pricing, restructure, file for bankruptcy, foreclose, deed-in-lieu or auction the property. All of those are potential outcomes of a deleveraging process.

As the distressed market evolves, Grinis expects to see a good deal of activity on the restructuring side of the business—namely, workouts and asset transfers.

According to Horton, if a borrower is nearing default on its loan, the E&Y team can help them work with their lenders to create a modification. “We restructure their loan facilities to avoid foreclosure and to allow the projects to continue at some level in a way that works best for the bank and borrower alike,” he says.

Transaction services—in effect, diligencing transactions— is one of the main components within the distressed services group. The team handles everything from debt transactions and equity investments to bank M&A deals. Joe Rubin and Michael Straneva work with lenders as well as investors, such as real estate funds, that have put capital into now-distressed assets.

According to Straneva, the tension in the marketplace today is palpable. Commercial real estate fundamentals are declining at the same time liquidity is slowing, and deal volume is coming down drastically. “The silence is deafening,” he says. “There are so few transactions because you only sell today if you have to. The discounts people are demanding are very high; they’re buying on the current cash flow, which includes all these concessions. On the flip side, you have banks that are saying we just got an appraisal and our loan needs to be remargined, meaning we need a principal pay-down. Unfortunately, because of the shutdown in the CMBS

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market, you don’t have other sources of capital.” As borrowers are increasingly unable to come up with additional capital, the volume of restructures will ultimately increase.

The same is true with investment funds, which typically acquire transitional assets—they buy a property, reposition it and lease it up again. “That last part, the leasing up, that’s where you’re going to get stuck today,” says Rubin. “If properties are not able to be leased, the business plan can’t be effectuated, at least in the timeframe they had hoped. That means the cash flow back to the fund from that asset is pushed out to the future. It means that they’re going to have to keep the loan going longer, so they have more debt service. They also may have to spend more money on the property to attract tenants, so now it’s all cash outflow instead of inflow.”

Since these vehicles typically finance their deals with short-term paper, the debt may mature before the fund is able to carry out its business plan, and it’s very difficult to obtain new financing. Compounding that are decreasing values and rising cap rates. “So you’ve got cash issues and valuation issues, and when you bring that together, the fund probably has a liquidity problem because it’s got all these requirements to put money out, but there’s no money coming in,” Rubin explains. So the fund now has to look at its portfolio and decide which assets to keep and which to shed, and where they want to concentrate their limited capital.

“Our advice to sellers of troubled
loans is to limit the uncertainties
by providing as much pricing-
relevant information as possible.”

CHRISTOPHER SEYFARTH

PARTNER, TRANSACTION REAL ESTATE

In helping investors overcome these issues, there are three main areas to consider: data integrity, liquidity planning and restructuring strategies. Reliable, realistic data is key to determining the future cash flow of assets, as well as the details of the debt agreements, such as covenants, guarantees and recourse provisions, on the loans that are coming due. This gives management a higher level of confidence when approaching a bank to restructure debt, while being fair to creditors. In liquidity planning, all of the investment-level data is gathered and loaded up into a single model that can show, on a weekly or a monthly basis, what the liquidity needs of the entire fund are to manage all of its investments. The investor can then use this to decide how to best allocate capital.

Finally, there’s restructuring, which is getting a handle on all the claims against the fund, how they work and how they are linked. It’s important to understand the client’s position, as well as those of all the lenders involved. Depending on the case, what the investor can do in a restructure situation “is a little bit more hamstrung than we’ve seen before because the agreements for lenders are a lot stronger this time around,” says Straneva.