Lender Survival and Protection Strategies with Real Estate Developers

Posted by in Education, Real Estate Business on Oct 22nd, 2010 | Comments Off

By Jay Kelley, Managing Director, and Juanita Schwartzkopf, Senior Consultant, Focus Management Group

Over the last decade, commercial real estate (“CRE”) lending saw significant growth as financial institutions competed vigorously for new loan and fee originations.  As a result, many lenders found themselves confronted with significant exposure to large real estate developers by the time the CRE market collapsed in 2008.  As average projects, borrowers and relationships grew larger, CRE loans became increasingly complex and each new project often incorporated multifaceted legal structures involving numerous entities. During boom times, many developers also managed to persuade lenders to eliminate personal and/or corporate holding company guarantees. Given current fallout in CRE values and the pull back from CRE buyers, lenders now face outstanding loan balances at a higher percentage of project value than expected while borrower liquidity has all but evaporated and many projects have stalled.  As a result, many developers are coming to their lenders with the “too big to fail” attitude – intent on garnering concessions from their lenders in a global settlement type of approach.

However, even in this current distressed CRE environment, lenders have options. Consider the case of a CRE developer with multiple projects, and multiple lenders:

  • It is typical for large CRE developers to use a single purpose entity (“SPE”) approach to manage the legal structuring side of their developments, and to provide lenders with a single corporate sponsor to guarantee the debt for all of the SPEs.
  • In these cases, there are usually a few lenders that have financed a majority of the projects and as a result, these lenders have a majority of the debt to the SPEs.
  • Within the group of larger lenders, certain lenders may determine that they are in a better collateral and/or legal position if the projects they have funded are isolated from all of the other projects in the developer’s portfolio.
  • There may also be single project lenders who demand interest, principal or full payouts exceeding the cash flows on the projects they have financed or lenders whose collateral positions are over-leveraged.  As such, these lenders may find themselves more reliant on the guarantor/sponsor to repay all obligations.

As a lender, if you determine that your projects with a given developer are in a better position compared to those held by other lenders, how do you protect the cash flows related to your collateral from the other lenders whose projects are in trouble?

The Silo Approach

The structural answer to protect a lender’s position may be a “silo”.  The silo concept involves isolating all projects related to a particular lender and transferring them into a new roll-up entity that is still 100% owned by the sponsor/guarantor. By such action, all of the assets specific to that lender’s loans are owned by the new mid-tier “silo” entity (see diagram below).  This provides the silo lender with the opportunity to:

  • Capture excess cash flow generated by assets within the silo;
  • Accumulate interest reserves;
  • Support less successful projects within the silo;
  • Make scheduled debt payments, and
  • Provide a safer mechanism for providing additional funding to certain projects.

The silo approach isolates the cash flow related to the silo lender’s collateral within the silo and effectively “cross collateralizes” the partnership interests owned by the parent/sponsor/guarantor within that silo.

Lender Survival and Protection Strategies with Real Estate Developers

From the silo lender’s perspective, this structure allows the lender to control its own destiny while at the same time reducing restructuring costs. The restructuring costs paid to third parties may be lower as the silo entity can be made to be bankruptcy remote should the developer or related entities file for bankruptcy protection related to other projects. The lender’s internal restructuring costs may also be lower due to the lender’s ability to focus attention only on the projects in the silo.

This approach also has benefits for the borrower. From the parent/sponsor/guarantor perspective, the silo structure segregates issues for the silo lender, and allows the developer to implement the business plan for the projects within the silo. It also extends the terms of the debt inside the silo, and often eliminates the need for the continued guarantee of the parent/sponsor.

Steps to Create a Silo
The first step when considering this approach is to receive and review project level cash flows for each of the individual projects in the silo lender’s collateral pool. An accurate assessment of project level cash flows and roll up models is required; therefore, the silo lender may find it prudent to involve a disinterested third party, such as a financial advisor, to develop the information. A thorough review of the project level cash flows and the roll up cash flow will be necessary, as certain projects may need to be left outside the silo due to the extent of losses or problems associated with these projects.

The next step is to negotiate a new loan agreement related to the new silo entity.  Once the silo roll-up financial projections are vetted, decisions can be made regarding the loan agreement related to the silo.  Items the lender should consider include:

- Requiring lock box arrangements to capture cash flow related to the silo projects.

-  Requiring interest reserves to be replenished or created.

-  Limiting transfers of cash outside the silo.

-  Requiring debt amortization based on an overall reduction in debt as opposed to a project level reduction.

-  Accumulating funds in the silo to support cash needs at underperforming silo projects with positive cash flow from other silo projects.

-  Providing additional funds to certain silo projects while protecting the silo lender’s overall risk structure.

It is critical to ensure that performance is closely monitored.  Upon agreement of the cash related terms of the restructure, the silo lender should consider the creation of an independent manager position for the silo projects.  This independent manager would operate with the best interests of the silo projects in mind; therefore, decisions are not clouded by the overall developer project portfolio results.  Typically the responsibility of the independent manager is to be a watchdog to oversee that the terms of the agreed upon silo arrangement are met.  This individual is constantly looking to improve the silo projects’ performance, which improves the lender’s collateral pool and ability to achieve reasonable debt service payments.

Summary

Developers often suggest a global settlement approach to all lenders from which they have borrowed funds for projects.  “Larger” lenders (i.e. lenders with disproportionately higher levels of debt compared to other lenders within the same developer relationship) are often asked to fund under-performing projects financed by “smaller” lenders who flex their muscles as a “squeaky wheel”.  Certain projects are in better financial condition than others, yet the global settlement approach fails to differentiate its use funds across projects and lenders.

The silo approach allows a lender in a net positive cash flow position – or in a position with stronger collateral – to isolate the cash flows from its projects from the demands placed on the developer’s cash flow by its other projects with third party lenders. The silo projects instead can pool cash flow to support each other’s needs before necessitating additional borrowings from the silo project lender to support cash shortfalls.

To accomplish this objective, it is imperative the silo lender have accurate, detailed cash flow projections by project, which are then rolled up to a lender specific cash flow. The silo structure should be created by competent restructuring counsel with experience in this arena. The appointment of an independent manager ensures the silo projects are managed to their best financial position, which in turn provides the best recovery to the lender.

_____________________________________________________________________________________________

Focus Management Group is a leading business restructuring firm headquartered in Tampa, with offices in Atlanta, Chicago, Cleveland, Columbus, Dallas, L.A. and Philadelphia.  Over the last two years, Focus has advised on real estate restructurings valued at over $6 billion.  For more information, contact Jay Kelley at (813) 281-0062 or visit www.FocusMG.com.

The Authors are Jay Kelley and Juanita Schwartzkopf

A link to the article :  http://www.focusmg.com/News/lendersurvivalstrategies.aspx

LENDER SURVIVAL AND PROTECTION STRATEGIES WITH REAL ESTATE DEVELOPERS



Comments are closed.