Commercial Real Estate, Chapter 11 Bankruptcy
Cram Down Interest Rates (Part I of II)
In this two-part series the author provides an overview of the issues confronted by courts and financial experts involved in a commercial real estate (CRE) bankruptcy. In this first part, the author discusses how a financial expert may go about to determine the appropriate interest rate for the underlying claims and analyze the CRE market. In the second part of this series, the author continues this discussion and provides examples that illustrate the approaches discussed in this two-part series.
Commercial real estate (CRE) is an important component of the United States economy. Yet, not all CRE projects work out as initially planned. When faced with insolvency and/or foreclosure, CRE owners may seek protection under Chapter 11 of the U.S. Bankruptcy Code.¬† The reorganization of a CRE property may be complicated by high loan-to-value (LTV) ratios, insufficient cash flow, and the personal bankruptcy of the persons providing loan guarantees for the CRE projects. Due to these complications, the debtor may not be able to negotiate an acceptable interest rate or payment terms for the repayment of each specific claim. To settle these differences, the bankruptcy court will be asked to hold a cram down hearing at which both sides will argue the structure, terms, and interest to be paid on the debt. As a part of the assignment for this hearing, a financial expert may be sought to determine the appropriate interest rate to be paid on the debt.
This article addresses issues specific to analyzing the CRE market and methods that courts have accepted for determining the appropriate interest rate for these claims. The following four will:¬†
- ¬†¬† Define commercial real estate
- ¬†¬† Discuss how CRE is financed
- ¬†¬† Explain how the bankruptcy code addresses commercial real estate
- ¬†¬† Demonstrate how to apply the blended rate method based on the formula approach to determine the cram down interest rate
Defining Commercial Real Estate
The term “commercial real estate” has several definitions. One generally accepted definition is any nonfarm, nonresidential property and some multi-family property (for example, apartment buildings, not stand alone duplex houses) (Board of Governors of the Federal Reserve System, 2009). To qualify for this definition, the property must have certain characteristics: 1) income producing, that is, generating rental or other income, and 2) having a potential for capital appreciation. Unlike residential property, the value of commercial property depends largely on the amount of income the property is expected to generate (Congressional Oversight Panel, 2010). Most CRE properties generate income by leasing or renting space for individuals or businesses to inhabit. This is exemplified by retail, office, and apartment units. Commercial real estate can also include properties where the owner may be conducting an active business on site. As an example, a company may operate a tool and die shop and own the building from which it operates. The income generated by the tool and die shop’s operations is the other income generated by the property.
Although different, CRE properties share many similarities with residential property, not the least of which is the importance of location. Location is a well-known factor influencing property values of both commercial and residential properties.
Financing Commercial Real Estate
Debt financing for CRE normally takes one of two forms, interim or permanent. Interim financing generally provides for the acquisition of the land and development and construction of improvements for the property. These loans are usually short-term, on average three years in duration, but may vary in length from six months to five years. Interim financing usually bears an adjustable interest rate priced at a set number of basis points over a specific benchmark rate (for example, the prime lending rate or the 30 day LIBOR).
When the property has been acquired, developed, construction completed, and the property leased (or is in the process of being leased), permanent financing may be sought. Funds from the permanent financing are generally used to repay the interim loan. This removes the secured lien created by the interim loan transferring it to the permanent loan. The loan terms and interest rate on the permanent financing will be based on the income the property is expected to generate, the initial leasing data (both occupancy and actual monthly rates), the general economic conditions, the demand for properties in that CRE sub-sector, and the strength of any supporting guarantees. The LTV ratio will also have an impact on the loan’s interest rate or whether or not the property qualifies for a loan.
The LTV ratio is a factor showing how much equity an owner has in the property. It is measured by dividing the amount being borrowed or the current debt by the property’s appraised value. As an example, if a CRE property is worth $1,000,000 and the debtor has an outstanding loan of $800,000 against the property, the LTV ratio is 80 percent ($800,000 divided by $1,000,000). This means the owner has a 20 percent equity stake in the property.
The LTV ratios for CRE are typically less than ratios seen for residential mortgage lending. In addition, the duration for most commercial mortgages is generally shorter than standard residential loans. Maturities for these CRE loans generally run from three to ten years. The amortization schedules used for these loans may be for a longer period of time (for example, 25 years).
Applying a longer amortization schedule to a shorter maturity debt means a balloon payment will be due when the loan matures. This balloon payment is required because the periodic payments, based on a longer term amortization schedule, will not fully amortize the loan. Therefore, a single lump sum payment will be due at maturity for the remaining principle balance. This final payment is called a balloon because it is greater than the monthly periodic payments.
At the loan’s maturity, the borrower has three options; pay the outstanding loan balance, refinance with the current lender, or refinance with another lender. Whether converting from interim to permanent financing or refinancing the permanent debt, the current lending environment will be a critical factor determining the willingness of lenders to extend credit and the interest rate and repayment terms offered.
The Bankruptcy Code and CRE
Unfortunately, not all CRE loans will be paid as agreed. This may lead to the property’s foreclosure and liquidation or the property’s owner seeking bankruptcy protection. For CRE properties that are owned through business structures, Chapter 11 of the bankruptcy code may be used to emerge as a reorganized entity. ¬† Most bankruptcies will move forward under the broader definition of Chapter 11, but a smaller group will fall under the narrower Chapter 11 definition known as Single Asset Real Estate (SARE) properties (Bankruptcy Abuse Prevention and Consumer Protection Act, 2005).
The Bankruptcy Code defines SARE as
“[R]eal estate constituting a single property or project, other than residential real property with fewer than four residential units, which generates substantially all of the gross income of a debtor who is not a family farmer and on which no substantial business is being conducted by a debtor other than the business of operating the real property and activities incidental” (11 U.S.C. 101 (51B)).
To further define SARE, courts have stated that the owner’s income must be passive in nature.
“In order to be single asset real estate, the revenues received by the owner must be passive in nature; the owner must not be conducting any active business, other than merely operating the real property and activities incidental thereto. Under the prior jurisprudence, those passive types of activities are the mere receipt of rent and truly incidental activities such as arranging for maintenance or perhaps some marketing activity, or mowing the grass and waiting for the market to turn” (In Re: Scotia Pacific Company, LLC).
SARE status brings its own set of rules during bankruptcy and, generally, moves the debtor more quickly toward resolution (either in the restructure of debt or the loss of the property to creditors). As an example, when the Chapter 11 bankruptcy petition is filed the debtor receives an automatic stay. This stay provides a period of time in which all judgments, collection activities, foreclosures, and repossessions are suspended and may not be pursued by the creditors on any debt or claim that arose before the filing of the bankruptcy petition.¬† If a real estate property is found to fall under SARE, it cannot count on Chapter 11’s automatic stay to remain in force for an extended period of time. To maintain the benefit of the automatic stay, Section 362(d) of the Bankruptcy Code requires a SARE debtor to file a plan that has a reasonable possibility of being confirmed or commence regular payments to the secured creditor at the non-default rate within 90 days of the bankruptcy filing.
Regardless of how the CRE property is being defined under the Bankruptcy Code, the analysis for the appropriate cram down interest rate should be the same. The key factors in this analysis are “the circumstances of the estate, the nature of the security, the duration and feasibility of the plan” (Till). These along with a general understanding of the CRE market and knowledge of current market conditions (the overall economy, sub-sector trends, and market interest rates) should provide the information necessary to assess the ability of the debtor to repay this specific claim and the appropriate interest rate to be applied.
The Formula Approach and Blended Interest Rates
Over the years, courts have looked to various approaches for determining the proper interest rate. The formula approach has found great support in Chapter 11 matters since the Till decision.
“In both the literature and in many of the cases there is much unfortunate discussion of ‘market rates’. ¬†Markets by definition imply a willing buyer and willing seller. But by definition cram down implies an unwilling seller who is compelled by the court to make a loan to the debtor under the plan; also implied is the debtor’s inability to refinance elsewhere (else that would be the plan approach). But not every Chapter 11 plan involving a non-consenting secured creditor is doomed to failure because the debtor cannot refinance. So, more appropriately, markets such as they exist are but one reference point among many in an attempt to find a suitable proxy where no real market exists. That is why most of the case law in this area involves some kind of “formula” approach as discussed by the U.S. Supreme Court in Till v SCS Corp., 541 U.S. 465, 479-80, 124 S, Ct. 1951, 158 L/ Ed. 2d 787 (2004)” (In Re: North Valley Mall, LLC).
The formula approach is based on the build-up method that is commonly used in finance. It is an additive model in which the rate of return (for example, interest rate) is estimated as the sum of a risk-free rate plus one or more risk premia. This risk premium is based on the risk of default. “The appropriate size of that risk adjustment depends, of course, on such factors as the circumstances of the estate, the nature of the security, and the duration and feasibility of the reorganization plan” (Till).
For most CRE bankruptcies, an analysis of the circumstances of the estate and the nature of the security will be focused on the same asset, the CRE property. The circumstances of the estate will be assessed based on the current condition of the property.
Is it under construction or completed?
Is it producing income?
Is it in need of repairs or maintenance?
How does the property fit in its local market?
Are the owners/investors willing to invest additional funds to improve the property?
What is its future regarding occupancy?
These are only a few of the questions whose answers will determine the estate’s circumstances. Because the property (and the income produced by it) provides the vast majority, if not all, of the collateral securing the loan, these questions may also reflect the nature of the security as well.
One of the problems faced in assessing a CRE bankruptcy is the debtor’s LTV ratio. The lack of an equity cushion normally sought by lenders may cause a creditor to seek a greater risk premium and therefore a greater interest rate. This will, in turn, lead to a cram down hearing as the debtor seeks a lesser interest rate.
SJT Ventures shows how a risk-free rate can be used as the foundation for applying a straight forward build-up approach to such a situation. In this case, the court found the LTV ratio to be 82 Percent. The creditor asked for an interest rate of 8.69 percent. The debtor sought a rate of 6.35 percent.¬†
“To blindly apply the formula from Till in the present commercial lending context, beginning with the prime rate and adding in a percentage for risk would be ‚Ä¶ to use a starting point that ‘no one speaks in terms of.’
Therefore, with regard to over secured commercial loans, this court will employ the formula ordinarily used by the market to derive the appropriate interest rate. Employing such a ‘market formula’ will achieve the Supreme Court’s underlying purpose in Till of ensuring that secured creditors are compensated for the ‘time value of their money and the risk of default’ by the way of objective assessment, while at the same time employing the on-the-ground insight of an effective market, where it exists.” (In Re: SJT Ventures, LLC)
The court agreed with the debtor’s expert who took the risk-free rate and added 450 basis points (4.50 percent) for risk. The resulting cram down interest rate was 6.35 percent.
Risk-free Rate (5 Year Treasury Note)¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬† ¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬† 1.85%
+ Risk Factor (65% -70% LTV)¬†¬†¬†¬†¬†¬†¬†¬†¬† ¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬† 3.00%
+ Risk Factor (Remaining LTV)¬†¬†¬†¬†¬†¬†¬†¬†¬†¬† ¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬† 1.50%
= Cram Down Rate¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬† ¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†¬† 6.35%
Many bankrupt properties show LTV ratios not only in excess of those applied in standard lending practices, but equal to or greater than 100 percent. To analyze these unique situations, courts have relied on what is called a “Band of Investment” method more often referred to as the blended rate approach (In Re: Cellular Information Systems, Inc.).
Allyn Needham, Ph.D., CEA, is a principal at Shipp, Needham & Durham, LLC (Fort Worth, Texas). For the past 17 years, he has worked in the area of litigation support. Prior to that, he worked more than 20 years in the area of banking and risk management. Dr. Needham has also been an Adjunct Professor of Economics at Texas Christian University and Weatherford College. As an expert, he has testified on various matters relating to commercial damages, personal damages, business bankruptcy and business valuation. Dr. Needham can be reached at email@example.com and (817) 348-0213.
Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, (BAPCPA)
Board of Governors of the Federal Reserve System, Mortgage Debt Outstanding, (Dec 2009)
Congressional Oversight Panel, Commercial Real Estate and the Risk to Financial Stability, February Oversight Report, 2/10/2010
Eisnebach, III, Robert L, Who’s SARE Now? Bankruptcy’s Single Asset Real Estate Rules and Their Impact on Commercial Real Estate, 2/17/2010, http://bankruptcy.cooley.com
Needham, Allyn, Schroeder, Kristin, Cram Down Interest Rate Analysis in Chapter 11 Bankruptcy Matters: An Overview, The Earnings Analyst, Volume 12, 2012, 21‚Äď40
In re: Cellular Information Systems, Inc., 171 B.R. 926 (Bankr. S.D.N.Y. 1994)
In re: North Valley Mall, LLC, Bankr. LEXIS 1927, *; 53 Bankr. Ct. Dec. 109 (Bankr. C. D. Cal. 2010)
In re: Northwest Timberline Enterprises, Inc., 348 B.R. 412, (Bankr. N.D. Tex. 2006)
In re: Prussia Associates, LP, 322 B.R. 572 (Bankr. E.D. Pa. 2005)
In re: Rainbow 215, LLC, BK-S-09-23414-BAM, Memorandum Opinion, 3/25/2011 (Bankr. Nevada 2011)
In re: Scotia Pacific Company, LLC, 508 F.3d 214 (5th Cir. 2007)
In re: SJT Ventures, LLC, 2010 WL 3342206 (Bankr. N.D. Tex. 2010)
In re: Texas Grand Prairie Hotel Realty, LLC, 710 F.3d 324; 2013 U.S. App. LEXIS 4514; 57 Bankr. Ct. Dec. 177 (5th Cir. 2013)
In re: Village at Camp Bowie I, LP, 454 B.R. 702; 2011 Bankr. LEXIS 3033; 55 Bankr. Ct. Dec. 84 (Bankr. N. D. Tex. 2011)
Till v SCS Credit Corp., 541 U.S. 465, 479-80, 124 S, Ct. 1951, 158 L/ Ed. 2d 787 (2004)