Navigating the choppy waters of distressed US retail real estate
Weather can be unpredictable. Even the saltiest of sailors understands that sometimes, to survive, one needs to respond swiftly and with creativity.
Owners of distressed US real estate can learn valuable lessons from sailors navigating choppy waters. Real estate owners face unprecedented challenges stemming from the coronavirus pandemic. Sectors such as retail and hospitality have borne the brunt of the impact, largely due to government-mandated shutdowns and travel restrictions. These shutdowns and restrictions have often resulted in tenants failing to make rent payments and, in turn, landlords failing to make debt service payments.
Owners confronting distressed real estate due to the COVID-19 storm are encouraged to: first, evaluate current climates and where they think markets are heading; and second, develop forward-looking strategies to overcome the challenges presented by a difficult market: jump ship, call for help, embrace the storm, or try something else entirely.
Various options are available to owners of distressed real estate experiencing turbulent times, particularly focusing on the retail segment, which often includes mixed-use properties. There are also a number of considerations for key stakeholders when implementing those options.
1. Evaluate current climate and future markets
Owners of distressed retail real estate should begin by evaluating the prevailing winds - economic, political and social - and then determine where they believe the market is heading, and what impact it will ultimately have on property operations.
For example, the COVID-19 pandemic has seen many customers turn to e-commerce in place of in-person shopping. The last decade has already seen a general trend away from in-person shopping. The pandemic has accelerated this shift, which may adversely affect shopping centers and other retail properties permanently. Going forward, retailers would be wise to account for other possible behavioral changes of consumers, such as adjusting how physical spaces are used and complying with local health mandates.
Such considerations will be heavily market-driven, and owners will need to carefully evaluate their specific situations before deciding on the path forward. Here’s a short example to illustrate the point.
A retail strip mall in an urban market is owned by a joint venture (JV) comprised of two partners: local entrepreneur Joe, who owns 10% of the JV and acts as the asset manager of the mall, and high-net-worth individual Jane, who owns the remaining 90% and is generally not involved in management of the asset other than certain “major” decisions.
To date, the mall has maintained good occupancy rates and sales and was viewed in the market as an attractive asset. The mall is also encumbered by third-party mortgage financing at 70% loan-to-value from a national institutional bank. In March 2020, the pandemic upends the local economy, resulting in half of the mall’s tenants closing operations and failing to make rent payments. The JV is therefore struggling to make debt service payments without obtaining cash from another source. Joe and Jane now must evaluate the best course of action to address their now distressed asset.
2. Forward-looking strategies to consider
Option 1: Jump ship!
Although not the preferred outcome, sometimes the smartest decision from an objective business perspective is to exit the investment and try to minimize any further losses. In this scenario, the JV described above has determined there are no economically viable options to reposition the asset, and adding additional capital to the asset to keep it running will simply result in further loss.
The first step the JV should take is to approach its lender to discuss options. These range from the lender and JV working out an amicable solution, such as a deed-in-lieu of foreclosure to the lender foreclosing on the property. The JV will also want to consider potential guaranties in place or deficiencies, to the extent permitted by applicable law, that the lender may enforce or seek in connection with or following such foreclosure action. There are also tax implications that may include cancellation of debt (COD) income that will need to be evaluated.
Option 2: Call for help!
A more attractive option for the JV may be to either have the current JV members invest additional capital or to identify a new source of capital to invest into the JV to improve the current asset position. The investment may be in the form of a debt paydown (where necessary to satisfy loan to value requirements and other financial covenants) or to add reserves (where the lender is willing to work with the JV to weather the storm so long as additional interest/payment or leasing reserves are posted) to protect the lender’s position. The additional capital may come from a variety of sources. This example focuses on two sources: existing investors and white knights.
Existing investors: based on the JV’s evaluation of current market conditions and the likelihood that the property can rebound with additional cash contributions, one or more of the existing investors may decide (or be required under the JV documents) to invest additional capital to keep the JV operating during the hardship.
It is important to evaluate the terms of the existing JV agreement with respect to the conditions, timing and mechanics surrounding additional capital contributions from its members. The requirements will vary greatly from joint venture to joint venture. For example, discretionary versus non-discretionary funding requirements, and waterfall implications if one member covers the other member’s contribution (or a member loan), including automatic ownership dilution for failed funding. Typically, any new capital coming in will be on a LIFO basis (last dollars in, first dollars out), so when the project recovers, the additional capital contributions will be repaid to the member putting in the additional capital before any other distributions will be made.
White knights: an alternate source of additional capital is to bring in a white knight investor where existing members do not have the ability or desire to invest additional funds. Typically, a new investor will either acquire an ownership stake or a preferred equity stake in the JV and will likely require some level of managerial and decision-making powers, or at least some significant consent rights. The white knight will also typically require that its investment funds are on a LIFO basis. Friction can arise between the existing partners when they cannot agree on whether a white knight should be brought in and the existing JV agreement does not permit any such third-party investments to be made without unanimous or other super-majority approval. This possibility should have been considered during negotiations of the JV agreement from the outset to allow maximum flexibility if financial hardships arise.
Option 3: embrace the storm
Where there is no default or a default on the mortgage debt that is less substantial, a possible third course of action for the JV is to wait it out and allow for time to bring operations back to normal levels. In this scenario, the investors believe the underlying issues causing the market volatility will lessen or cease altogether, either naturally or due to change in management or strategy, without the need to invest significant additional capital.
A crucial aspect of this strategy is to get the lender on board by convincing the lender that exercising remedies under the loan documents and potentially having the lender take control of the asset would not be in the best interests of the lender or any of the other parties. Revisiting our example, Joe would approach the lender with the mindset that the JV partners are in a better position to continue operating the property based on their understanding of the local market (and often a party in Joe’s position will have a significant track record with other assets). In many scenarios, it is true that the lender is not in the business of owning real estate (nor does it want to be), and the lender may therefore defer to the local operator to run the show.
In this third scenario, conflicting interests exist because the lender needs to preserve its collateral during the hardships. This illustrates the importance of developing a forward-looking strategy on how to manage the asset and on working together with the lender to formulate a plan that is acceptable and works for all.
Despite its name, distressed real estate, when managed strategically, can restore smooth sailing for owners, investors and other key stakeholders. Owners are encouraged to carefully evaluate the current climate, try to predict future conditions and strategically chart a course of action to navigate challenging waters. Once a plan has been devised, owners should work with key stakeholders to ensure that plans are implemented successfully.