As the Evergrande Real Estate Group (The Evergrande Group), a Chinese Conglomerate, has recently been in serious debt, which leads to declining rate of stocks and foreseeable bankruptcy, the global market has increasingly feared the “domino effect” in other sectors. Not surprisingly, for those engaging in real estate business as core business activities would be adversely affected one way or another. As a result of the increasing outbreak of Covid19 and lengthy lockdown, it would become even worse than expected. Once affected, these real properties become distressed and need to be worked out.
Distressed Properties
In normal economic situations, property developers are often faced with two types of distressed property:
- The first is real estate under construction, where costs go beyond budget, which will not be sufficient cash to complete the project without injection of new capital, whether debt or equity.
- The second type is an existing income property that is failing to generate sufficient cash flow to pay debt service and operating expenses, rapidly approaching the cash flow break-even point, or otherwise having difficulty attracting and keeping tenants.
During the pandemic and as a result of the lengthy lockdown and social distancing, the second type of distressed properties has hit project developers and property owners so badly.
Work-out Team
Once a property reaches the level of distress, the parties involved, property owner, lender, and its stakeholders, and others would undoubtedly make a significant effort to “work out” the problems facing the property through cooperative efforts, rather than immediately resorting to the ultimate legal remedies of foreclosure or bankruptcy.
As a real estate project is conceived and operated through the collective efforts of investors, contractors, lenders, architects, lawyers, accountants, engineers, and other real estate professionals, a workout must also be a group endeavor. While it is not necessary to invite all participants at the early stages of the workout, it is crucial to gather a team at the very start that can initiate the process of analyzing the real estate assets and the owning and/or controlling entity, identifying and tackling its strong and weak points, and eventually formulating a comprehensive workout plan.
A typical team should consist of at least three professionals who possess expertise and specialization in the following:
- construction and property management, marketing, and leasing;
- financial analysis; and
- relevant legal issues.
Detecting Problems at an Early Stage
As the economy has continuously been in lockdown month after month, more income properties move from stress to distress. Property owners may be well-advised to review the warning signals that a distressed property would become intense, so that immediate preventive action may be taken. These warning signals often develop into a variety of the following pattern:
- deferred maintenance;
- over-financing;
- rising vacancies and declining rent receipts;
- tax delinquencies; and
- default in debt service payments.
During the pandemic, rising vacancies and declining rental income are two major concerns forproperty owners. These problems are likely to go beyond property owners’ control, but rather curable. And if a squeeze on cash flow is due to temporary factors (assuming Covid-19 would be controlled sooner or later), property owners may be more willing to work out a forbearance program if debt capacity cannot be maintained and managed.
Distress Signals from Existing Properties
It is reported that the real estate market has shown a significant drop in the rent of residential properties. Similarly, office buildings and retail centers may experience the same drop level in commercial leasing activities since prospective tenants turn to a wait-and-see attitude once rental rates begin falling. The sooner a property owner sees the beginning of the problems, the easier it will be to remedy the problems. If the property owner being the borrower is financially stable and the property is well-situated and strongly competitive, the borrower should be willing to fund deficits through the short period.
On the other hand, if the borrower is undergoing financial difficulties, and the reporting requirements imposed on the borrower by the loan documents are not being satisfied, a careful and critical review of the asset and the borrower’s plight should be undertaken. These steps are critical to the property owner, which is concerned not only with the loan but also with the prospect of ownership if the borrower fails to comply with the loan documents.
Other early warning signals include late interest payments, tax arrears, mechanic’s liens, partnership disputes, lawsuits, problems with property owners and projects, mounting payables and/or receivables, intercompany and affiliate loans, a change in attorneys or accountants, late or inadequate financial reporting, sudden or unexpected staff departures, missed amortization payments, overdrafts, and construction overruns and delays.
Retaining Outside Professionals, including Lawyers
Some of the most important decisions made by a workout specialist involve the hiring of professionals, such as lawyers, appraisers, architects, engineers, environmental consultants, accountants, property managers, and leasing agents. The objective in hiring a professional is to use a specific expertise in making informed judgments and decisions regarding the real estate asset. The process must be taken seriously and requires a thorough investigation of the party being considered to render services. First of all, the property owner must decide whether to retain the firm for purposes of the initial workout negotiations and later seek additional counsel if it becomes necessary, of choose a firm with specialists in all the relevant areas. Although the choice of retaining the firm may ultimately depend on legal costs, it is best to increase the likelihood that a workout can be negotiated, because foreclosure and bankruptcy frequently are not in the best interests of either the property owner or the borrower. Nevertheless, if it appears that a workout is not likely to be achieved, a litigation specialist should be consulted so that no tactical mistakes are made during negotiations that might later prejudice court proceedings.