By Mitchell Regenstreif and Skyler Anderson

Law360 (August 14, 2020, 5:42 PM EDT )

Mitchell Regenstreif

Skyler Anderson

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 U.S. real estate stand to learn valuable lessons from sailors navigating choppy waters. Real estate owners face unprecedented challenges stemming from the COVID-19 pandemic; some 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: (1) evaluate current climates and where they think markets are heading, and (2) develop forward-looking strategies to overcome the challenges presented by a difficult market — do they jump ship, call for help, embrace the storm or try something else entirely?

In this article, we will explore some of the options available to owners of distressed real estate who are experiencing turbulent times, particularly focusing on the retail segment, which often includes mixed-use properties. We will also discuss considerations for key stakeholders when implementing those options.

Evaluate Current and Future Climates

Owners of distressed retail real estate should begin by evaluating the prevailing winds (i.e., economic, political and social) and determine where they believe the market is heading and what impact it will ultimately have on property operations.

For instance, due to the COVID-19 pandemic, many customers have turned to e-commerce in place of in-person shopping. The last decade has already seen a general trend away from in-person shopping; the COVID-19 pandemic has accelerated this shift, which may well adversely affect shopping centers and other retail properties permanently.

Further, 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.

These considerations will be heavily market-driven, and owners will need to carefully evaluate their specific situations before deciding on the path forward.

Consider the following example.

A retail strip mall in an urban market is owned by a joint venture comprised of two partners: (1) local entrepreneur Joe B., who owns 10% of the joint venture and acts as the asset manager of the mall, and (2) high-net-worth individual Jane W., who owns the remaining 90% of the joint venture and generally is not involved in the 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, the COVID-19 pandemic reaches the mall's market and upends the local economy, resulting in half of the mall's tenants closing operations and failing to make rent payments, which results in the joint venture 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.

Strategies

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 your best to minimize any further losses. In this scenario, the joint venture has determined that 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.

Here, the first step the joint venture should take is to approach its lender to discuss options. These options range from the lender and joint venture working out an amicable solution, such as a deed-in-lieu of foreclosure to the lender foreclosing on the property.

The joint venture will also want to consider any 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 income that will need to be evaluated.

Option 2: Call for Help

A more attractive option for the joint venture may be to either have the current members invest additional capital or identify a new source of capital to invest into the joint venture in order to improve the current asset position.

Note that 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 joint venture 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 places, but for our example, we will focus on two sources — existing investors and white knights.

Existing Investors

Based on the joint venture'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 joint venture documents — to invest additional capital to keep the joint venture operating during the hardship.

It is important to evaluate the terms of the existing joint venture agreement with respect to the conditions, timing and mechanics surrounding additional capital contributions from its members. The requirements relating to additional capital contributions will vary greatly from joint venture to joint venture: for example, discretionary versus nondiscretionary funding requirements, 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 "last dollars in, first dollars out" basis, meaning that 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 for the joint venture would be to bring in a white knight investor to supply additional capital 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 joint venture 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 "last dollars in, first dollars out" basis.

Friction can arise between the existing partners when they cannot agree on whether a white knight should be brought in and the existing joint venture agreement does not permit any such third-party investments to be made without unanimous or other supermajority approval. This possibility should have been considered during negotiations of the joint venture 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 joint venture is to wait it out and allow for time to bring operations back to normal levels. In this scenario, the investors are of the mindset that 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 joint venture partners are in a better position to continue operating the property based on 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 they may therefore defer to the local operator to run the show.

In this third scenario, there are conflicting interests 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 to work together with the lender to come up with a plan that is acceptable and works for all parties.

Conclusion

Despite its name, distressed real estate, when managed strategically, can restore smooth sailing for owners, investors and other key stakeholders alike. 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.

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Mitchell Regenstreif is a partner and Skyler Anderson is an associate at DLA Piper.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

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