Due Diligence and “Recapitalization” Transactions

Many real estate fortunes were amassed following the savings and loan (S&L) crisis of the late 1980s when the Resolution Trust Corporation (RTC) sold loan portfolios owned by defunct S&L entities at what later proved to be distressed pricing. At the depth of the Great Recession, distressed asset firms quickly raised huge amounts of capital in anticipation that that history would repeat itself.

The thesis behind this business plan was that loans originated during the height of the credit bubble had been based on inflated valuations using projected rental income increases. Moreover, lenders often then extended loans of up to 90% of the inflated property value. With property values plummeting and underwriting standards returned to more traditional loan-to-value ratios, these so-called vulture funds began circling banks like sharks smelling blood in the water, hoping to snatch up portfolios of non-performing loans at “bottom-feeding” prices.

But the great “sell-off” never occurred. Lenders refused to sell defaulted loans at distressed pricing to avoid having to recognize the losses on their already stressed capital reserves. Moreover, Federal regulators facilitated this approach by allowing banks to adopt “extend and pretend” practices whereby the lenders would simply extend loans where borrowers were current on their debt service even if the properties were valued below the loan principals. With real estate prices now firming or at least no longer plunging, some banks are starting to sell defaulted loans though not at the bargain rates that the distressed investments funds had anticipated.

Another reason why we have not seen a flood of distressed loan sales are that banks are allowing borrowers to restructure loans through recapitalization. At current asset valuations, borrowers who financed properties between 2005-2007 cannot meet current loan-to value ratios. To plug this gap, many borrowers have been selling “partial interests” where investors obtain a minority interest in the entity that owns the real estate in exchange for their capital infusion. This model allows borrowers owners to retain control over properties that lenders might sell to a distressed debt fund. Indeed, by some estimates, nearly 50% of the real estate transactions inNew York Cityduring the past year have been recapitalizations.

Because these investors are not taking title to the underlying real estate but instead are relying on the income stream generated by the property, they may not necessarily do environmental due diligence. Obviously, if a property has an environmental issue that could impair the cash flow or perhaps cause tenants to vacate, this could have a detrimental impact on the investment. Moreover, when properties become distressed, environmental compliance is often ignored to preserve cash. Wastes may accumulate, environmental investigations or remedial activities postponed and pollution control equipment may be turned off. Unfortunately, the “animal spirits” often overcome investors and they frequently will often overlook or irrationally discount environmental issues when they feel smell a potential quick 30%-50% profit.

If you have a client contemplating a distressed debt or recapitalization deal, it is important to understand the nature of the deal, learn where your client will stand in the capital stack or layering of debt and equity since their positioning may influence their degree of tolerance about environmental concerns.

Scroll to Top