Fall 2010

Greetings!

Invotex® Group is pleased to share insights about current reorganization topics with companies, counsel, lenders and others who have an interest in reorganization. We welcome your feedback and invite you to share Reorganization Perspectives with your colleagues and business acquaintances.

In this Issue

1. Economic Recovery Eludes Real Estate and Construction Companies
2. Case Study: Rehabbing a Mixed-Use Real Estate Development Project
3. Who is Representing Debtors and Creditors in Recent Mid-Atlantic Chapter 11 Filings?

Economic Recovery Eludes Real Estate and Construction Companies
by John Kovacs and Neil Gilmour

The real estate and construction industries continue to struggle as the nation slowly emerges from a recession that technically ended in June 2009.

Many real estate and construction companies are experiencing shortfalls in working capital and liquidity. If such a company cannot weather the storm, management and other stakeholders may be faced with defaulting on company and project debt, necessitating restructuring and project work-outs. With increasing frequency, lenders are foreclosing and taking ownership of the defaulted projects because of borrowers’ inability to repay or refinance the debt. For example, in a recent bankruptcy case, Orleans Homebuilders proposed a plan whereby the company would be acquired by another national homebuilder, NVR. The proposed plan took a completely different direction when the original lending consortium sold the senior secured loans to a group of hedge funds. The new lenders determined that the proposed sale of the business to NVR was not in their best interests and formulated their own plan of reorganization that converted a portion of their secured debt to equity and also resulted in the resignation of the company’s CEO Jeffrey Orleans.

Tight credit conditions and conservative underwriting standards continue to impact recovery efforts, and difficulties in financing and refinancing will continue to impact all segments of real estate development, construction and management. Some commentators, however, believe that in many regions the commercial and residential markets have hit bottom and are starting to recover.

For the commercial market, the central business district office vacancy rate may have either peaked at 16.7% during the third quarter of this year or will peak soon, while suburban vacancy rates may not decline until 2011. For the residential market, consumers remain constrained by strict lending standards, depressed home values, weak jobs market and a general lack of consumer confidence. Since 2006, more than 130 homebuilders nationwide, ranging in size from small to some of the largest, have gone through some sort of restructuring, filed for Chapter 11 or have gone out of business.

While no one cause is attributed to the industry problems, prior to the financial crisis, aggressive lending made credit readily available at very favorable rates. Real estate and construction lenders approved financing at a 70% to 80 % Loan-to-Value (LTV) ratio. Today’s underwriting reflects a more conservative approach resulting in tighter credit as reflected in substantially reduced maximum LTV ratios. The reduction in market values has compounded the problem in both the commercial and residential real estate markets, leaving nearly half of the financed properties “underwater” with the borrower owing more than the property is worth, according to a February 10, 2010, Congressional Oversight Panel February Oversight Report: Commercial Real Estate Losses and the Risk to Financial Stability (COP report).

The commercial real estate market has the most cause for concern. According to the COP report, about $1.4 trillion of debt will mature between 2010 and 2014. When the existing debt matures, lenders may demand a complete repayment or a significant reduction in the principal amount of the loan. For most companies, this will require raising additional equity from existing and/or new investors, which, if feasible, will result in dilution or elimination of existing equity. With private funds continuing to purchase distressed loans from banks, the property owner is likely to see a new face across the table with different motivations and profit metrics. In today’s market, there are opportunities for distressed owners to work with lenders to extend maturities and wait for the markets to recover before committing to a debt repayment course of action, sometimes called “kicking the can down the road.”

Raising new equity capital is equally difficult as investors refrain from increasing their allocation of capital to real estate. In the residential market, homes have seen a significant decrease in market value, upwards of 50% in the areas hardest hit by the recession. In key national markets, the excess supply of existing homes needs to be absorbed before home building can hope to return to historic levels. Presently, residential land development projects are the most difficult projects to finance or restructure.

To protect the interests of owners and investors, a company with a looming debt maturity should proactively evaluate its options for restructuring the company, its operations, staffing and financing to deal with the debt maturities at both the company level and at the project level. While the refinancing market remains extremely limited, some options remain for well-managed companies. Utilizing outside professional and legal expertise may be the most effective way to develop the unique strategy required for the company and each project, wherein the solutions reflect the uniqueness of each property. For example, in a recent District of Maryland case, Gemcraft Homes, Inc., a large regional homebuilder, successfully navigated through a Chapter 11 filing and confirmed a plan of reorganization in which the owners remain in control of the company. While future risks exist for Gemcraft, the company was able to capitalize on excellent relationships with lenders and creditors to reorganize both its business and financial arrangements.

For many real estate and construction companies, both commercial and residential, market recovery cannot come soon enough.

For more information, contact John Kovacs or Neil Gilmour.

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Case Study: Rehabbing a Mixed-Use Real Estate Development Project
by John Kovacs and Neil Gilmour

The Problem
A developer that was rehabilitating historic buildings for mixed-use experienced significant cost overruns, could neither provide nor secure additional capital to complete the project and, consequently, defaulted on the loan. Market conditions further threatened the project because rental rates for both the commercial space and residential apartments were below pro forma and would not be able to support the loan even if the project was completed and was able to reach stabilization. To complete the project, a work-out plan between the lender and the investor had to be established. The investor was willing to provide additional capital to complete the project only if a work-out plan could be negotiated and resolved with the lender.

The Solution
To facilitate an acceptable work-out plan, a bifurcated loan structure — whereby the original loan would be replaced with a senior, performing loan and a second, non-performing loan — was proposed. The performing loan was modified in terms of both term and interest rate to allow the project enough time to reach stabilization and, eventually, allow the sale or refinancing of the asset. There was also an option to convert the commercial space and residential units into condos after the conclusion of the historic tax period if the market was favorable. This solution gave all project stakeholders the best alternative for maximizing the value of the real estate and ultimate return to the lender, investor and owner.

The Path to a Successful Conclusion
It’s no secret that the downturn in real estate valuations and coinciding contraction of the credit markets created a crisis for the entire spectrum of real estate stakeholders. While the issues confronting the owner of raw land compared to the owner of a cash generating apartment building or a shopping center lender may seem strikingly different, the analysis to build a consensus among lenders, investors and owners regarding the cash flows, values and equities of the property has more similarities than differences.

Occasionally, as in the case described above, an owner has a single, distressed asset; however, the most common restructuring situation involves an owner with a few to numerous properties, often located in different local, regional or even national markets, and, frequently, organized under multiple legal entities. The restructuring of such multi-asset real estate enterprises is particularly complex because of the unique cash flow characteristics of each property, the involvement of several lenders, each having security interests in specific assets, differing loan default provisions, the different cross-default provisions and, of course, corporate and personal guarantees.

The complexities of restructuring negotiations requires that all principal parties – owners, lenders, investors, management and legal and financial advisors – work from a common understanding of the legal and debt structure. A “Deal Structure Matrix” is an oft-used tool that summarizes the often tangled web of agreements and relationships so that the relative legal positions of each constituency is understood and can be agreed upon.

A well-designed matrix provides management, counsel and advisors with an understanding of the individual deals, the global relationship with each lender and the relative values of each entity. Often, counsel initiates the matrix development process during their review of the legal documents. Table 1 illustrates the basic elements upon which a matrix is developed.

It is not expected that all parties will agree on the deal structure matrix, but the development and negotiation of the matrix will bring attention to the points of difference that can be considered in developing the solution.

While the matrix development is progressing, the financial team is focusing on developing a comprehensive cash flow model, a crystal ball that can forecast the future. The cash flow model will include a separate section for each property that can roll up by legal entity, lender or both. Each section reflects the unique characteristics of the property and related debt. The complexity ranges from undeveloped land on which no development is proposed, where parties need to understand the holding costs such as taxes, insurance and debt service, to complex development properties such as residential subdivisions, shopping centers and office buildings. The elements of a more complex model for a residential subdivision could include:

1. Cash receipts on future home sales (both deposits and sales)
2. Borrowings on infrastructure and construction loan facilities
3. Infrastructure costs, e.g. ???
4. Home construction costs
5. Sales office expenses
6. Project management expenses
7. Other costs, e.g. taxes and insurance
8. Debt service

Table 2 (attached as link) is a simplified sample cash flow model for a residential construction project.

Using these foundational analyses, the restructuring team can work with the stakeholders to determine the right strategy for the project. Resolutions may include balance sheet restructurings (with senior security positions displacing junior interests), foreclosures, bankruptcy court auctions, and debt restructurings. The latter is sometimes called “kicking the can down the road” as the underlying problems are not resolved today, but the parties agree to deal with it when the market has hopefully improved.

Conclusion
In the above historic property rehabilitation case, a premature unwinding of the entity would have caused tax issues for the investors. Thereby encouraged to stay with the project, they agreed to invest in the project, and the senior lender agreed to defer debt service and interest payments for several years to allow time for the project to be completed and leased. The ultimate success of this restructuring remains to be seen.

For more information, contact John Kovacs or Neil Gilmour.

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Who is Representing Debtors and Creditors in Recent Mid-Atlantic Chapter 11 Filings?

The following is an overview of Chapter 11 cases recently filed in Mid-Altantic bankruptcy courts and the counsel who represent the debtors and creditors.

Selected, Recent Mid-Atlantic* Chapter 11 Bankruptcy Filings by Debtor Law Firm

Selected, Recent Mid-Atlantic* Chapter 11 Bankruptcy Filings by Creditor Law Firm

Sources / Notes: Daily bankruptcy filing report from TrollerBk.com and Pacer electronic case filing system (9/1/10-11/20/10).
*Jurisdictions: District of Columbia, Delaware, Maryland, New Jersey, Eastern District of Pennsylvania, Eastern District of Virginia