In today’s real estate climate, many commercial transactions involve property that is subject to foreclosure, loan default, bankruptcy, litigation, property value decline, tenant problems or has experienced other significant difficulties. When dealing with distressed property, parties must be aware of certain issues and possible pitfalls that may not arise in normal transactions. This article will discuss some basic considerations that parties should consider when purchasing distressed property or in connection with receivership and workout situations.
Five Issues for Parties Considering the Acquisitions of Distressed Property
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Normal Due Diligence Activities:
In any real estate acquisition, due diligence plays a vital role. Thorough due diligence is even more important when purchasing distressed property. A complete investigation of the status of the property is critical to protect the buyer from unknown risks, but the issues and problems ascertained can also be used to negotiate a lower purchase price. Normal activities include the following:
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Building Inspection:
If the property has been neglected due to abandonment or inability to pay for normal maintenance and repairs, a proper building inspection will help disclose these items and identify future expenses not factored into original valuations.
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Title Review:
When conducting title review, the buyer should pay special attention to any development agreements, CC&Rs or similar encumbrances that impose assessments, development restrictions, timelines for construction, etc. The owner, due to financial inability or other constraints, may have failed to comply. If so, such failure could result in significant costs, potential litigation and/or have an adverse impact on the viability of the buyer’s planned development or use of the property.
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Tenants:
It is imperative to review the terms of all leases, operating contracts and similar documents. The length of the leases and viability of each tenant should be closely scrutinized. Lease defaults and lease expirations (that cannot be immediately renewed) will have a dramatic impact on the value of the property. Tenant estoppel certificates should be obtained from each tenant whereby the tenants and the existing owner certify the terms of the leases and that the instruments are in full force and effect without existing or potential defaults. The leases should be scoured thoroughly for any terms and conditions that would give the tenants an exit right or ability to reduce rent. For instance, a co-tenancy clause may allow a retail tenant to reduce rent or terminate a lease when an anchor tenant leaves the property.
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Other Standard Due Dilligence:
Of course, an ALTA survey, Phase I environmental site assessment and other standard due diligence activities should also be considered.
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Existing and Potential Claims and Disputes:
The buyer should ask its lawyer or a consultant to conduct a litigation search and have the seller to disclose all existing and potential claims and disputes. The lawyer may wish to consult with knowledgeable attorneys regarding real estate, environmental and bankruptcy issues that exist or may arise. In many distressed property cases, the owner not only has problems with its lender, but possible litigation may be looming between the investors, partners and members comprising the ownership itself. Beware of situations where the owner’s prospective development or operations were funded by passive investors who are now disgruntled.
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Zoning Issues:
A buyer typically should conduct a thorough investigation of the current zoning and land use of the property, including any pending approvals or outstanding zoning or site plan stipulations.
Owners of distressed properties often have obtained zoning or site plan approvals based on specific stipulations that must be fulfilled. Some of these stipulations may have time restrictions and these time restrictions may not have been met. Failure to conform to these stipulations within the required time could cause the entitlements to lapse. If the buyer fails to adequately investigate the land use and zoning requirements of the property, the buyer may find itself in a position where the recently acquired property is unusable for its prospective use.
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Valuations:
The buyer should strongly consider obtaining multiple appraisals and/or professional opinions with respect to the valuation of the property. Accurate valuations are very difficult in the current economic market as there is little in the way of true arm’s length transactions. By obtaining multiple appraisals, a buyer can obtain a better understanding of the fair market value.
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Surrounding Development:
Determine whether all off-site improvements and infrastructure serving the development have been completed. In many cases, buyers acquire property only to learn that the master developer is unable to complete roads, utilities or other improvements that are necessary in order for the property owner to obtain building improvements and building permits for its parcel. If there is uncompleted infrastructure or improvements, the buyer should consider demanding a hold-back of the purchase price or other security to ensure that all improvements are made.
When buying a parcel within a larger development, the buyer should determine whether the center is viable and whether assessments from the other occupants are current. If the center is not being maintained, this can greatly impact the viability of the center and value of the property being purchased.
Workout Agreements
Decreased property values and the lack of willing purchasers have made foreclosure a very unattractive option for many lenders in today’s market. Because of the current economic conditions, many lenders prefer to provide loan extensions in hopes of receiving some repayment and eventually benefiting from a future economic turnaround. It is for these reasons that workout agreements have become a sought after alternative for many lenders.
Workouts are agreements between defaulting parties and the parties to whom they owe obligations that provide for payment of the obligation, while affording the defaulting party the opportunity to benefit from the value of the project. Since most real estate projects are owned by single asset entities, any security or assurance the lender or landlord would demand in the event of default is usually not available. The demand itself may increase the likelihood of bankruptcy, which is an unpalatable risk for most lenders or landlords. Therefore, the landlord and lender will sometimes seek some kind of resolution, known as a workout.
Common types of workouts include: (i) loan or lease renegotiation; (ii) redesign projects to a more manageable size; (iii) for loans, all or a portion of the property could be sold or refinanced while the lender forebears all or part of the regular payments; (iv) borrower or tenant could be recapitalized with a new partner contributing additional equity and possibly expertise which reduces risk to the lender; (v) deed in lieu of foreclosure in return for releasing borrower or guarantor; and (vi) termination of lease in exchange for a payment by the tenant.
Whatever type of workout is performed, it is important that the lender require the distressed party to fully disclose its financial condition, both at the time the agreement is executed and on a continuing basis during the term of the workout. A lender should typically have the borrower or tenant waive any claims against the lender or landlord, and the consideration for the accommodations made to the distressed party should be clearly explained. Parties should affirm the terms of the original agreement. Unlike normal transactions, if the negotiations concerning the workout fail, the parties usually cannot simply walk away from each other; litigation will be a probable outcome. Therefore, lenders are increasingly weary of workouts because, if the attempted workout fails, the lender faces the prospect of claims being brought by the borrower. One method of limiting a lender’s risk of potential liability is through a pre-workout agreement.
Pre-Workout Agreements
A pre-workout agreement can increase the likelihood of successful negotiations and limit the parties’ liabilities as it sets the parameters of the negotiations and helps prevent misunderstandings.
The agreement should specify the intentions of the parties in their attempt to agree on terms for restructuring the loan. It is important that the agreement provide a statement allowing any party to terminate negotiations without risk of liability. A lender should insist that the pre-workout agreement mandate that the borrower continue to pursue other prospects during the negotiation, as the negotiations may not end in an agreement.
A poorly drafted pre-workout agreement, or even worse no agreement at all, puts the lender at risk that its statements will be understood (or at least argued by the borrower to be) default waivers or acceptance of the restructuring terms. Therefore, from the lender’s perspective, the pre-workout agreement should explicitly require that any agreement resulting from the negotiations be in writing and signed by both parties. This should help prevent the borrower from claiming that during the negotiations the lender orally agreed to certain terms or waived various remedies.
Although a pre-workout agreement is not always necessary, it is important to consider the overall negotiations and what leverage a pre-workout agreement may provide. In many situations, a pre-workout agreement can serve as a means to limit lender liability during attempts to workout a loan.
Receiverships
Lenders need to be aware that taking title to distressed property through a deed in lieu of foreclosure will cause the lender to take the property subject to other existing liens, including mechanics’ liens. Lenders also need to be aware that taking title to distressed property through foreclosure may cause the lender to take on unknown liabilities that are associated with the property. The liabilities greatly increase if the distressed property is in a construction phase as the lender will need to decide whether or not to complete construction. A lender will want to consider the appointment of a receiver to reduce exposure and preserve the collateral. When a party in interest in an asset demonstrates that the property is in need of protection or preservation, a court may appoint a receiver to take control of the property and administer the property, regardless of whether or not the debtor is present in the jurisdiction or gives consent to the receivership. The receiver (who is appointed by the court and therefore has quasi-judicial immunity) will insulate the lender from liability as it will allow the lender to delay taking title to the property. Additionally, the receiver will assume daily management and operation activities such as the collection of rents and property management.
The appointment of a receiver will not invalidate a mechanic’s lien. Rather, the receiver takes the property subject to all valid liens, properties, and encumbrances. 1 Clark on Receivers § 272 (1959). However, it is important to note that although the appointment of a receiver does not invalidate a mechanic’s lien, should the receiver get authority to borrow money during its control, that new loan may be considered a higher priority than any previously acquired mechanic’s lien.
Asking a court to appoint a receiver will likely save the lender time and money as it will allow the lender to focus primarily on their area of expertise. Further, a receiver may increase the value of the property as the receiver will collect rents, pay for maintenance and improvements and prevent decay of the property. Most importantly, the receiver will likely protect the lender from liabilities and obligations associated with taking title to the property.
This article only provides a brief overview of the issues to consider when acquiring distressed property and the basic elements of receiverships, workout and pre-workout agreements. In today’s market there are many opportunities involving undervalued land, but parties must be aware that distressed property carries many potential problems that are not found in normal transactions. Therefore, anyone interested in a deal involving distressed property should consult an experienced real estate attorney that deals with distressed property, along with experienced environmental and bankruptcy attorneys if appropriate.
James J. Sienicki 602.382.6351 jsienicki@swlaw.com
Jim Sienicki is a partner with Snell & Wilmer in Phoenix, Arizona, where he is the head of the firm’s construction practice group. His practice has been concentrated on a wide variety of construction matters since 1983. Jim is a member of many construction trade associations.
Contributing writers in this article include Jonathan E. Frank, Partner Snell & Wilmer and Byron Sarhangian, Associate Snell & Wilmer
