Winning the Loan Restructuring Battle
New Approaches to Lower Rates and Improved Terms
By Jay Maddox
In today's highly distressed economy many commercial mortgage lenders and borrowers find themselves locked in a frustrating battle to find common ground on long term debt repayment plans. What many borrowers don't realize is that there may be unexploited opportunities to substantially improve their negotiating position which oddly enough, arise directly from the primary source of their anxiety: namely, the lack of reasonable alternatives to refinance their projects elsewhere.
In many cases, the biggest source of frustration and risk to both parties is the loan interest rate. A difference of just 1.00% in the interest rate can translate into millions in cash flow and tens of millions in potential equity value. Moreover, the winner of the interest rate battle often determines whether the borrower maintains control of his property or loses it to foreclosure, especially in a bankruptcy.
This article will share some insights to the latest innovations of how the interest rate battle is waged, and how the war can be won even when it appears all may be lost. While very effective in a bankruptcy, our approaches can be equally effective in a non-bankruptcy setting.
Assembling the Troops for Battle
A financially distressed borrower typically seeks to modify the terms of the mortgage debt in order to preserve ownership and control of its property and, in some bankruptcy cases, may even seek to do so over the objections of the secured lenders (a "cram-down"). The mortgage lender, on the other hand, expects a reasonable (or perhaps unreasonable) rate of return to compensate for its perceived risk, and has no incentive to subsidize the debtor's reorganization plan. So begins the battle.
The bankruptcy court's determination of the appropriate interest rate on mortgage debt is often critical to the overall success of the debtor's plan. Determining the appropriate interest rate can be a daunting challenge and is frequently one of the most contentiously litigated matters in a real estate bankruptcy confirmation proceeding. This judgment becomes especially difficult in today's illiquid financing market where there may be no alternatives for 3rd party financing, making it difficult or perhaps even impossible to find benchmark reference rates that may help the Court to establish what that appropriate interest rate should be.
Fortunately, there is a key US Supreme Court ruling and other legal precedents that a distressed or bankrupt borrower can rely on to build a case for the appropriate interest rate and loan terms, absent an efficient credit market for financing. Such an approach can be especially effective because the burden of proof falls on the secured lender, not the borrower, to demonstrate its case in a bankruptcy proceeding.
A deep understanding of the bankruptcy scenario can be an important leverage point in consensual restructuring discussions as well. If the borrower can build a strong case that there is a credible threat in a bankruptcy scenario that the court may successfully "cram down" the secured lender (by forcing it to accept a low interest rate, long loan term, and other onerous terms), that implied threat by itself, if properly exploited, can create significant negotiating leverage in a non-bankruptcy situation, and thereby help to avoid high cost and uncertainty of a bankruptcy altogether.
Finding the High Ground
The difference between the appropriate interest rate argued by the debtor and mortgage lender can be vast, often making the difference in terms of feasibility of the restructuring or reorganization plan, and leaving the bankruptcy court in a very difficult position.
A comparison of the typical borrower and lender motivations helps shed light on just how far apart these combatants can be:
For example, KGI was engaged as the interest rate expert in one recent case by a borrower who owned nine apartment projects located in the Southeast with $162 million of senior mortgage financing from a major financial institution. When the projects got into financial trouble, the borrower had filed for Chapter 11 bankruptcy. The mortgage lender's foreclosure motion was denied by the Court, and subsequently the Court approved a value of $92 million for the properties, significantly below the mortgage debt. In effort to block confirmation of the borrower's reorganization plan, the lender elected a special provision of the bankruptcy code allowing it to assert a $162 million secured claim subject to a present value recovery of its $92 million secured claim. The lender then argued for a 12.5% interest rate on its $92 million secured claim based upon a 100% loan to value ratio that, if approved, would have been catastrophic for the borrower, as it would have doomed the feasibility of its plan and resulted in foreclosure.
KGI worked closely with bankruptcy counsel and provided expert witness testimony to help the borrower achieve its goal of a low 6% fixed interest rate with a 10 year term, effectively "cramming down' the senior lender and helping to ensure Court approval of its proposed reorganization plan, and avoiding a lender foreclosure of the properties. The borrower's plan when confirmed would potentially create over $5 million per year of additional cash flow compared to the lender's proposed interest rate, and increased the net present value to the owners by $30 million or more.
Outflanking the Enemy
Borrowers and creditors often employ independent, third party interest rate experts to provide written declarations and testimony in bankruptcy proceedings that help buttress their arguments as to the "appropriate" interest rate. This is due to the complexity of the issues, as well as the specialized knowledge of financial markets and legal precedents necessary to construct a credible argument.
KGI stands alone among 3rd-party advisors because of our unique combination of expertise in complex real estate developments and valuation, our decades of experience in the workout and bankruptcy arenas, and our deep understanding of the real estate capital markets. While our approach can be very effective in a bankruptcy setting, the knowledge of this highly technical area alone, if properly handled, can be used very effectively as a point of negotiating leverage to avoid bankruptcy in the first place. There is only one chance to do this right. It takes careful preparation and a clear understanding of how the bankruptcy process works in this area before any effective negotiation can begin.
Whether a Company is struggling financially or on the cusp of breakthrough growth, KGI can help. Our seasoned experts work alongside management to solve complex cash flow issues, operational challenges and other business crises. If liquidity or sale is needed, KGI provides a powerful combination of services and expertise to achieve outcomes that cannot be duplicated by other standalone consulting firms.