What Does Donald Trump Know About Real Estate Bankruptcy Law That You Need To Know?

Date: May 9, 2016

In recent months, Donald Trump has been quoted as saying that successful companies often use bankruptcy laws to their advantage.  Does he know something you should know?   Should you be paying closer attention to how bankruptcy law actually works?

The fact is that bankruptcy law can be extremely effective and important to both developers and investors in dealing with distressed commercial real estate.  Equally important, in the past five years, the judicial attitude toward real estate bankruptcies has improved dramatically for owners and investors.  Given the changes in the law, the stage is now set for the one of the most productive uses of bankruptcy for real estate developers and investors since 1978. 

A leading economist was recently quoted as saying there would be a wave of commercial real estate loans maturing in 2016 and 2017.  These maturing loans may find it harder to refinance.  There is some sentiment that the commercial mortgage-backed securities (“CMBS”) market has been hampered by new regulations. If a market is hampered by regulations, and less refinancing is available, then the stage is truly set for “white knights” to provide the financing.  Bankruptcy may prove to be the ideal vehicle for investors to acquire either the debt or the real estate of distressed projects. The fact is that bankruptcy law is not just for debtors and owners.  It presents opportunities for distressed investors, too.  

Just how much distressed real estate is currently out there?  We’re hearing reports of a modest uptick in the number of loan defaults but, as yet, nothing like a “wave.”  It’s been reported that, in March, the delinquency rate for CMBS loans inched up to 4.22%, and $1.7B in newly delinquent CMBS loans were added to an existing total of $21.2B.  If interest rates rise even 1%, then only 68% of existing CMBS loans would pass their debt service coverage ratio requirements.  

Growth in the Washington, D.C., Metropolitan area has been robust, but it is not immune from major defaults in commercial real estate.  One cause of concern?  The continuing impact of the 2005 Base Realignment and Closure (“BRAC”) plan and a consequent decline in government need for space.  A few recent developments in the DC area include:

  • The Washington Business Journal recently reported that the mortgage loan on the Warner Building in downtown Washington, owned by Vornado Realty Trust, had been moved into special servicing.
  • Of the five largest CMBS loans that went delinquent in March 2016, one of them was a $142.5 million loan on office properties in Fairfax, Virginia.
  • Eight suburban properties in Falls Church, Virginia, reportedly had been referred to special servicing as of at least November 2013, with a $678 million loan balance modified into two notes.  

Are we seeing a trend in the D.C. area?  If so, what are the larger implications?  Is bankruptcy an option?  What would be the consequences to owners, lenders and investors?  

A Quick Primer:  Three key elements of strategic real estate bankruptcy.

What does Donald Trump know that you don’t?  He may have discovered the following three key elements of real estate bankruptcy:  (1) the “mark to market” phenomena, (2) the resetting of interest rates and (3) the extraordinary ability of owners to retain their equity interest even if a large unsecured deficiency claim is not paid in full.  None of these can be replicated under state law.  

How does this all work?  

The first of these three key elements involves a familiar accounting concept:  “mark to market,” which requires that assets be carried on the financial books at the true market value, and not the purchase price.  A similar concept underlies a key bankruptcy provision.  Under the so-called “cramdown” provision, a borrower can exit bankruptcy with the principal on a mortgage debt lowered to equal the fair market value of the collateral.  The prior mortgage is actually extinguished.  Say, for example, a building loses a big law firm tenant, and the new capitalized value of the income stream makes the building worth just 60% of its former value.  A court will re-set the mortgage secured amount to that new value.  “Cramdowns” have been an important feature of bankruptcy law for over a century.  

The second key element involves the power to reduce an interest rate.  The Supreme Court has ruled that, in a bankruptcy case, the interest rate for the restructured loan can be reduced to a rate based on the “national prime rate” plus a risk of adjustment of roughly one to three percentage points.  This reduction is often the key to generating positive cash flow.  

Finally, the third key element involves the ability of the debtor to substantially reduce the unsecured deficiency balance, i.e., the difference between the old mortgage amount and the new amount that is based on the market value of the collateral. The Supreme Court has generally accepted that unsecured creditors can be given an amount that is less than their claim, as long as the owners make a capital contribution of “new value” to the borrower.  

In short, bankruptcy law provides a comprehensive system of penalties and protections to govern the orderly conduct of debtor’s affairs and creditors’ rights.  For commercial real estate, it has the power to forge a “collective” solution over dissenting creditors that simply cannot be found in any form of state law.

David R. Kuney is Senior Counsel at Whiteford, Taylor & Preston and Co-Chair of the firm’s Real Estate Bankruptcy Group, an Adjunct Professor of Bankruptcy law at the Georgetown University Law Center and author of “The Single Asset Real Estate Case” published by the American Bankruptcy Institute.