Real estate lenders and borrowers everywhere are trying to figure out what to do with properties that are either sitting vacant or underperforming pre-pandemic expectations. In New York, a number of mezzanine foreclosures have been pursued with varying degrees of success when challenged in court. Some lenders have been shopping their loans, mostly at discounts to par that are not large enough to create substantial deal flow in the marketplace. Many lenders and loan purchasers have no interest in owning an empty or underperforming building, so lenders have adopted a strategy of “extend and pretend.” For property owners who want to hand over the keys, one of the biggest obstacles can be a carry guaranty — but they do have options to overcome this and other hurdles.
Carry guaranties have a long life span
Particularly in construction projects, creditworthy entities and individuals often guarantee ongoing carrying costs related to the property through completion or stabilization, including loan interest, real estate taxes, insurance premiums and other operating expenses.
An experienced borrower will negotiate for the ability to cut off any further carry guaranty obligations, but this comes with conditions. One of those conditions is the payment of transfer taxes. Ironically, in many carry guaranties, the transfer tax payment amount must be presented to the lender in order for the guarantor to be released from the carry guaranty, even though the lender is under no obligation to accept the tender of the deed.
An owner who would like to hand a property back to the lender has a tough decision to make. Is it worth coming up with the cash now to pay the transfer tax and cut off the carry guaranty, or should the owner wait to see if the lender forecloses, in which case the carry guaranty is typically released? Foreclosures can take a long time, however, and time might not be on the owner’s side. The lender also might not be interested in foreclosing and owning a property that produces little or no income. Furthermore, the transfer tax payment might dissuade distressed investors who would otherwise be interested in buying the asset.
Cooperative solutions include Chapter 11 plan, restructuring
In situations where a lender and borrower are willing to work cooperatively, there are options that protect the parties' interests without triggering transfer taxes.
a. Chapter 11 plan
Under the Bankruptcy Code, a sale of assets pursuant to a Chapter 11 plan is exempt from transfer taxes under Section 1146(a). This means that if the assets are sold, including to a secured lender who is the successful winning bidder under a “credit bid,” the transfer taxes would not be payable. Depending upon the amount of transfer taxes that might otherwise be triggered outside of bankruptcy, it may be worthwhile for the borrower and lender to agree upon a sale process for the sale to be consummated under a confirmed Chapter 11 plan. The costs of the bankruptcy could be funded by the lender and included in the amount of the lender’s credit bid. The credit bid, in turn, can be a stalking horse bid subject to higher or better third-party bids. As part of the Chapter 11 plan, the guarantor could be released from all guaranties. The “all in” cost of funding the bankruptcy will in many cases be materially lower than the transfer taxes that otherwise would be payable.
Of course, going through the bankruptcy process has certain implications. It might trigger defaults under other agreements to which the investor is a party, even if the agreements are unrelated to the project that is the subject of the bankruptcy. Any future loan application by the investor may also require the disclosure of the bankruptcy. Handing over the property to the lender could also have negative income tax consequences for the borrower, as it typically would give rise to either cancellation of indebtedness income (COD) or, if the debt is nonrecourse for tax purposes, capital gain to the extent the debt exceeds the property’s tax basis. A bankruptcy restructuring would potentially avoid taxable COD, because COD is excluded from taxable income if it arises in bankruptcy or to the extent the borrower is insolvent, though the exclusion is not available to a partnership or LLC whose equity owners are not in bankruptcy or insolvent.
There is another way for the parties to protect their interests without triggering transfer taxes in New York and at the same time not requiring the lender to take ownership of the property. This can be useful for properties that are temporarily not producing significant income or any income at all but have a hope of recovery in the future. The solution involves restructuring the borrower entity to allow the lender to become a minority equity investor. In this case, the loan would remain outstanding, but the lender could exercise control of the property as a member of the joint venture entity. The existing equity investors would in exchange be relieved of some guaranty liability and could receive a “hope note” in the event the property ultimately generates sufficient returns. The lender would also have the right to foreclose or cause a sale of the property at any time.
A lender’s exercise of control over its borrower may, however, raise the specter of potential “lender liability” claims. In addition, seeking to sell the property or exercise remedies based on the equity interest while the mortgage exists could raise issues of “clogging the equity of redemption.” In the case of regulated lenders such as banks and insurance companies, there may also be policies against equity investments. Likewise, some funds are set up to invest only in debt, so they cannot invest in equity unless certain conditions are met. Finally, transferring a portion of the equity to the lender may have negative tax consequences for the borrower.
Negotiated solutions can provide better outcomes
Working through today’s difficult real estate environment requires threading the needle on various issues. In circumstances where an owner is ready to give up on a property, there are critical considerations that impact whether a transition is feasible. If the owner and lender are ready to negotiate, the main impediments to a successful restructuring can be navigated. Careful structuring of these workouts, however, is essential.