Distressed Real Estate During
COVID-19: Options Beyond PPP Loans

Businesses in many sectors have suffered major drops in revenue as a result of the pandemic, with many struggling to meet their mortgage payments. Without government assistance, widespread foreclosures may be imminent. The HOPE Act seeks to address this problem by allowing real estate owners to issue government-backed preferred equity to financial institutions on favorable terms. If it becomes law, the HOPE Act will direct the Secretary of the Treasury to establish the HOPE Preferred Equity Facility.

The HOPE Act
As the bill currently is written, only certain businesses will be eligible. The program targets commercial properties, and owner-occupied properties are not eligible, which makes sense because the Main Street Lending Program is available for real estate borrowers that are not passive businesses. The property owner also must have experienced at least a 25% decline in revenue compared to the previous year during any three-month period after March 1 of this year. Properties acquired through foreclosure after March 1 also are ineligible, as are property owners who already have received aid through the program with respect to the property in question—a property owner cannot take advantage of the program more than once with regard to a single property.

Moreover, the bill imposes two additional eligibility requirements based on the property owners’ pre-pandemic financial condition. First, the property owner must not have been in monetary default under its mortgage loan during the preceding year if the default remained uncured on March 1, 2020. Second, the property owner must have had a debt service coverage ratio of at least 1.3 times on an annual basis either during 2019 or during both 2017 and 2018.

The terms of the preferred equity will be highly favorable to the issuer/property owner. The dividend rate will be 3% per annum, calculated monthly, with 2.5% to be paid to the financial institution and the remaining 0.5% paid to the Department of the Treasury. The aid will formally be an issuance of equity rather than debt. This means that the financial institution will be effectively subordinated to both secured and unsecured debt on the property. The preferred equity will not be secured by a lien on the property, and accordingly the financial institution will not be able to foreclose on the property in the event of nonpayment. However, the financial institution may insist on other forms of security, such as personal guarantees or liens on other assets. The preferred equity will not provide for any form of voting rights in relation to the property owner’s business.

The financial institution will make the proceeds of the issuance of the preferred equity available to the property owner in an account that the property owner will be able to draw down at any time during a one-year period and for any purpose that it deems “may help the property.”

The preferred equity enjoys a grace period of at least two years during which no payments are required to be made on the preferred equity. The first payment will be due no less than two years after the earlier of the date on which the account is drawn down or when a year has passed after the issuance of the preferred equity. The preferred equity’s liquidation preference will then fully amortize during the seven-year period after the first payment is required to be made. The property owner will also have the right to redeem any portion of the preferred equity at any time, without penalty. Mandatory early redemption is required if a change of control of the property owner or the property occurs.

If property owner fails to make payments during the first year in which payments are required to be made, the dividend rate will increase to 3.5%, and during each subsequent year the dividend rate will increase by an additional one percent, up to 13% per annum. All but the initial 2.5% per annum dividend will be paid to the Treasury.

To incentivize participation from financial institutions, the Treasury will pay an origination fee of 5% of amounts less than $350,000, 3% of amounts between $350,000 and $2 million, and 1% of amounts more than $2 million. In the event that a property owner does not pay the liquidation preference corresponding to at least 10% of the amount drawn down, the financial institution will be required to return this fee. Financial institutions are permitted to charge certain additional fees.

A property owner who issues approved equity will need to agree to limitations on its ability to pay dividends to its parent and on the terms of affiliate transactions, such as the payment fees or other compensation to property managers that are affiliates. In addition, an approved guarantor must indemnify the financial institution and the Treasury for certain liabilities, including fraud, misapplication of funds, or waste.

Once the financial institution (as purchaser) and property owner (as issuer) have come to an agreement on the terms of a proposed preferred equity issuance, the Treasury will have 30 days to approve. The Treasury is required to purchase its share of the preferred equity within 14 days after it grants its approval.

A financial institution that purchases preferred equity may sell it to the Treasury at any time after 10 years have passed. In addition, if a mortgage creditor forecloses on the real property to which a preferred equity instrument relates, the financial institution must sell its preferred equity to the Treasury at the initial liquidation preference plus dividends and origination fees.

Of course, the Treasury will have the authority to promulgate additional regulations or guidance related to the program within 30 days of the law’s enactment.

How The HOPE Act Stacks Up
Many of these provisions are modeled after the Paycheck Protection Plan (PPP) passed by Congress earlier this year, and the bill’s sponsors intend the HOPE Act to provide the same kind of relief to commercial real estate owners. If this bill passes, it will be a significant help to that sector. Eligible businesses should strongly consider participating.

In order to take advantage of the program, property owners will have to seek out participating financial institutions to act as purchasers of preferred equity. They will also have to ensure that the purchase of preferred equity complies with the terms set out in the statute and submit the transaction to the Treasury as soon as practicable to allow time for approval. The terms of the HOPE Act seek to ensure that if a property owner’s economic circumstances improve and it no longer needs the additional investment, it can redeem the preferred equity in full before having to make any required payments, subject only to the 3% dividend rate. Therefore, even property owners who are unsure what their financial needs will be should consider participating in the program and issuing preferred equity in the full amount available under the program.

There is still considerable uncertainty surrounding the HOPE Act. Passage is not guaranteed, and even if it does pass it may be amended in significant ways. It also is unclear how the Treasury will administer the statute, although there is no obvious reason why the Treasury would not approve transactions that comply with the Act’s requirements. However, the bill does have bipartisan support and it has been endorsed by industry groups like the ICSC and the American Hotel and Lodging Association. Thomas Schatz, president of spending watchdog Citizens Against Government Waste, has praised the bill’s targeted spending. Thus, there is some reason to be optimistic that the HOPE Act will become law.

Main Street Lending Program
Even assuming that the law passes in its current form, it will provide for aid only up to an amount equal to10% of a property owner’s outstanding mortgage, and property owners will be able to participate only once with regard to each property. Owners of commercial properties that have been particularly affected by the pandemic might therefore want to consider other, already extant government aid programs, most notably the Main Street Lending Program.

Nevertheless, not all commercial real estate owners are eligible for MSLP loans. Eligible businesses must (i) be based and incorporated in the United States, (ii) have been established before March 13 of this year, and (iii) have either fewer than 15,000 employees or annual revenues of $5 billion or less. Moreover, these businesses must meet the same eligibility requirements as those seeking assistance under the PPP.

This means that passive real estate companies, such as special purpose entities that own a single asset, are not eligible for loans under MSLP. Companies primarily engaged in lending, such as mortgage lenders, also are not eligible. For companies like these, relief from the federal government will have to come either by means of the HOPE Act or another act of Congress.

On the other hand, holdings companies are potentially eligible for MSLP loans, including holding companies that are engaged in the real estate sector. Commercial and residential real estate brokers and agencies also are generally eligible for MSLP loans, as are real estate management companies.

MSLP currently provides three loan facilities—New, Preferred, and Expanded, which Pillsbury has discussed in client alerts and in other guidance. Loans through any of MSLP’s facilities also come with certain restrictions. For example, while the MSLP loan remains outstanding, the borrower cannot repay the principal of or interest on any other debt, beyond what is mandatory and due. The borrower also must make annual financial disclosures to the lender.

Borrowers under the MSLP are also subject to restrictions with regard to executive compensation while the loan is outstanding and for one year afterwards. Specifically, a borrower may not make repurchases of public stock (unless contractually required before March), make dividends and capital distributions (other than pass-through entities paying dividends or distributions to owners for certain tax purposes), pay any individual making more than $425,000 in 2019 more than his or her salary in that year, or pay that individual more than twice his or her 2019 salary in severance. If an individual made more than $3 million in 2019, he or she may not be paid more than $3 million plus 50% of the amount he or she earned above $3 million in 2019.

Conclusion
Despite these restrictions, MSLP remains an attractive option for eligible businesses that have been adversely affected by the pandemic. Unfortunately, many companies, such as passive real estate companies, are not eligible under the MSLP. If the HOPE Act passes, it will help close this gap and give more property owners access to much-needed relief.

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

Pillsbury is closely monitoring and analyzing the global legal, economic, policy and industry impacts of COVID-19. For our latest insights, visit our COVID-19 and Economic Impact Resource Center.