Takeaways

Chapter 11 strategies may exist for valuable real estate assets that are not producing income.
Debtors should aim for a prompt resolution in bankruptcy or they risk losing negotiating leverage because of rebounding market values.
Lenders might consider strategies that will buy them time until property values rise.

This is the first in a series of alerts on insolvency topics affecting single asset and other real estate projects. We have selected the present topic because it may provide lessons for real estate projects with no or severely reduced cash flow (a condition many projects find or will find themselves in due to the impact of COVID-19). Single asset real estate debtors have always confronted unique challenges in chapter 11, and those challenges increased when Congress imposed the requirement (with limited statutory exceptions) that the debtor, within 90 days of the order for relief, either commence interest payments or file a plan reasonably susceptible to confirmation. We will examine the nuances of these provisions and other challenges confronting debtors and lenders, in future alerts.

In these unprecedented times, real estate investors and professionals search for precedent that may help solve the cash-flow crises arising from tenants not paying rent. A potential starting point is Three Flint Hill, Case No. 94-16079 (Bankr. D. MD.), a single asset real estate bankruptcy case filed in November 1994 that concluded in October 1998.

Three Flint Hill was an eight-story 180,000-square-foot office building in suburban Washington, DC, whose ultimate owners remain one of the most successful real estate families in the region. The building’s sole tenant was AT&T. Prudential Insurance Company of America held an approximately $20 million loan secured by the building and a limited recourse guaranty from the principals. At the time of loan-origination, the building appraised for more than $20 million.

In 1994, AT&T vacated the building at the end of its lease while the owner had yet to locate a replacement tenant. As a result, the owner’s cash flow from the building vanished. When the owner and lender could not agree on workout terms, the owner filed for chapter 11. The creditors in the case were Prudential and a handful of trade creditors who were owed a few hundred thousand dollars.

The debtor immediately asserted that the value of the building—empty, with no cash flow, and no replacement tenant in sight—had plummeted to $5 million, and that Prudential’s secured debt should be written down to that amount via plan confirmation (and “cram down,” if necessary). Prudential asserted that the as-is value of the building fell to only $12 million. During the first two years of the case, the parties could not reach a settlement at or between either asserted value. Instead, they litigated over exclusivity, which was not extended, and eventually filed competing chapter 11 plans.

In the meantime, in early 1996, the debtor, whose duty was to market the property, found a new tenant for the building. Prudential agreed to provide financing for tenant improvements on a secured and superpriority basis (the “TI Loan”). The debtor and Prudential filed competing chapter 11 plans, with the confirmation hearing held in June 1996, over the course of several days. The court took the disputes under advisement for almost a year. In the interim, office rental rates in the region began to spike.

By April 1997, the building’s value had increased to the point where even Prudential’s plan was no longer fair to Prudential. The court, apparently recognizing the market changes, held hearings at which it denied confirmation of the debtor’s plan and instead confirmed a modified version of Prudential’s plan. Although the saga continued for at least another year while the debtor appealed, the matter ultimately settled, with the debtor agreeing to pay Prudential all unpaid principal (approximately $18 million after payment on the personal guaranty), limited interest, and the TI Loan.

Three Flint Hill teaches that chapter 11 strategies may exist for valuable real estate assets that are not producing income. In hindsight, the debtor probably could have settled for approximately $12 million relatively early in the case. It was inevitable that the building would be relet, cash flow would resume, and the building’s value would increase on this basis alone. The cyclical nature of real estate values and the inevitable upswing also undermined the debtor’s write-off strategy.

The post-pandemic lesson is that chapter 11 may provide a vehicle for writing down mortgages to present values (recognizing it will take time for appraisers to determine how best to appraise properties with severely reduced or no cash flow in a COVID-19 market). It will also take time for many courts to entertain evidentiary hearings on valuation disputes.

Moreover, the uncertainties present in Three Flint Hill are accentuated by the COVID-19 pandemic. Unlike the owner in Three Flint Hill, today’s owners do not have “broom-swept” buildings vacated by tenants at the end of their leases. Many premises are still subject to leases, and the tenant’s possessions remain in place. Premises like food courts and restaurants, where tenants left without disposing of perishable items, may pose even greater challenges for owners and further impact property values. Consequently, unlike the owner in Three Flint Hill, most owners are not presently able to market the space to facilitate expeditious resumption of normal cash flow. Even if the owner can market the space, prospective tenants face palpable logistical and economic challenges.

Once lenders demand mortgage loan repayment, many owners will be confronted with difficult decisions. Recourse liability will likely be a gating issue for owners considering chapter 11. In the absence of an unsurmountable recourse liability problem, owners wishing to keep their property may consider a variation of the debtor’s strategy in Three Flint Hill—get in and out of chapter 11 quickly with the goal of reducing the secured debt to the present value of the property. As the untold story of Three Flint Hill demonstrates, single asset real estate cases can be challenging; and the single asset real estate provisions in the Bankruptcy Code that now apply to all single asset real estate cases may make chapter 11 even more challenging for some owners. (Before the 2005 amendments to the Bankruptcy Code, the definition of “single asset real estate” excluded real property if it had aggregate noncontingent, liquidated secured debts that exceeded $4 million.) For those whom chapter 11 is viable, the process enables parties to reach consensual resolutions based on their litigation positions.

The uncertainties are greater now than in 1994 when the tenant left Three Flint Hill with no cash flow. But when it comes to commercial real estate, past is always prologue and values will rebound. The lesson of Three Flint Hill for debtors is to balance aggressive valuation with the uncertainty as to when, not if, the market will rebound.

For more information, please reach out to your regular Pillsbury contact or the authors of this client alert.


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