Bankruptcy Courts Need Tools To Help Real Estate Debtors

Lowenstein Sandler LLP
Contact

Bloomberg Law - May 3, 2021

It has been quite the year. We are experiencing a once-in-a-lifetime economic recession as a result of a pandemic, and we are not done yet. There appears to be a time lag between the pandemic and its fully felt impact on real estate.

We’ve seen a retail apocalypse, hospitality and travel came to a halt, and office occupancy has plummeted and we may never go back to the five day in-the-office work week. These factors have taken their toll on commercial real estate.

According to Moody’s forecasts, the vacancy rate for the office sector will rise to 19.4% this year. The average effective office rents are not expected to reach to reach their pre-pandemic levels until 2026, according to the forecasts. Further, it’s projected apartments in New York City will see an effective rent decline of 6.4% this year, compounding their 12.2% decline last year. The brick-and-mortar retail sector has so far been the sector most affected by the pandemic and the subsequent rise in e-commerce sales. Moody’s projects shopping center vacancy rates to reach a high this year of 12.7%, up from 10.5% at the end of 2020.

The Federal Reserve recently warned of steep drops in commercial real estate prices. It said that commercial real estate prices “appear susceptible to sharp declines” from historically high levels and that could particularly prove to be the case if the pandemic leads to longer-term declines in demand.

We are about to see billions (maybe trillions) of dollars of real estate go through several years of restructuring. In anticipation of the flood of pandemic-forced real estate bankruptcies, bankruptcy courts should be a place where worthy debtors who are forced into restructuring due to “macro” or systemic factors that have disturbed real estate fundamentals can seek relief to preserve equity.

Effectively Off Limits

However, bankruptcy court—the place where reorganization and value preservation are supposed to trump liquidation—is effectively off limits for these debtors. As currently written, single asset real estate (SARE) debtors cannot seek meaningful refuge in bankruptcy court because in 1995 the Bankruptcy Code was amended in favor of mortgagees.

As a result, SAREs are especially vulnerable to foreclosure and surrender at the bottom of an inordinately dislocated market. A SARE is a single property that generates most of a debtors gross income.

Savvy investors see the opportunity to pounce. Private equity firms and hedge funds are closing commitments on billions of dollars in order to invest in direct and indirect real estate assets. Owners’ equity is being flushed at the bottom of the market due to widespread, systemic dislocation.

Requirements for SARE Debtor

The automatic stay, which is triggered upon the commencement of a bankruptcy case, gives the debtor a breathing spell from creditors. It stops all collection efforts, all harassment, and all foreclosure actions. To maintain the automatic stay (injunction against continued action), Section 362(d)(3) of the Bankruptcy Code requires a SARE debtor to either:

  • File a plan of reorganization that has a reasonable possibility of being confirmed within a reasonable time; or
  • Begin making monthly interest payments to the lender at the original contract rate.

These actions must be made within the later of 90 days from entry of the order for relief (or a later date as the court may determine for cause by order entered in that 90-day period); or 30 days after the court determines a debtor is a SARE debtor.

The voting requirements for confirmation of a plan of reorganization also effectively make it impossible to confirm a plan and pay the mortgagee less than the full amount of its claim. Further, regardless of the cause of the owner’s difficulty or the projected time for value recovery, the Bankruptcy Code requires that the debtor begin servicing the mortgagee’s debt starting 90 days after the petition date.

Bankruptcy Courts Need Discretion

Despite the bankruptcy court’s business and financial expertise, it lacks discretion to distinguish between a debtor which commences a case due to mismanagement, lack of capital investment, or changing local demographics from a debtor that commences a case due to a macroeconomic or systemic rupture which will pass and is likely to end in a “V” shaped value recovery.

Moreover, the court cannot take into account the amount of equity or “cushion” that exists above the existing mortgage debt on the property.

In a scenario where a the debtor’s mortgage constitutes only 20% of the property value, with no other debt attaching to the property, if the debtor cannot commence payment within the time frame specified under 362(d)(3) of the Bankruptcy Code, the automatic stay may be lifted, allowing the mortgagee to foreclose on the property. This cannot be the right outcome where a significant cushion exists to protect the mortgagee from any loss.

Creative Equitable Relief Available

Bankruptcy courts must be given the tools to allow SAREs to effectively reorganize and preserve equity where adequate protection exists, either by modifying Section 362(d)(3) of the Bankruptcy Code, or having the court utilize section 105(b) to grant SAREs necessary relief.

Bankruptcy courts are more than capable of fashioning creative equitable relief, such as requiring the SARE debtor to pay all the payments that would have been required under Section 362(d)(3) to be paid on the effective date of any confirmed plan, and lifting the automatic stay if the adequate protection cushion depletes below a certain threshold. This would allow the debtor time to find alternative financing or to effectuate the sale of the property in a commercially reasonable manner to maximize value.

The counterargument is that lenders should be able to get paid timely or else obtain stay relief in order to quickly monetize their loans. The response is that the financial markets are sufficiently liquid for them to sell their loans. The court is capable of determining adequate protection of the lender’s claim and rates of depreciation and appreciation.

Economists agree that the current market temporarily “spiked” downward. If the concern is that unworthy debtors will keep lenders at bay for unreasonable periods of time, the response is that bankruptcy judges are sophisticated enough to know when bankruptcy abuse is occurring.

Reprinted with permission from the May 3, 2021, issue of Bloomberg Law. © 2021 The Bureau of National Affairs, Inc. All Rights Reserved.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Lowenstein Sandler LLP | Attorney Advertising

Written by:

Lowenstein Sandler LLP
Contact
more
less

Lowenstein Sandler LLP on:

Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
- hide
- hide

This website uses cookies to improve user experience, track anonymous site usage, store authorization tokens and permit sharing on social media networks. By continuing to browse this website you accept the use of cookies. Click here to read more about how we use cookies.