Caldera Asset Management

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Debt Restructuring: Which Inning are We in?

By Mike Kelly President
Caldera Asset Management, Denver
mkelly@calderaassetmanagement.com

An outsider looking at Apartment REIT performance or the low cap rates being paid in the market today would think it was 2007 all over again. There is no question that more optimism has entered virtually every aspect of the apartment market, and to an outsider, it makes sense to assume that we have turned the corner on “little evil outstanding debt issue”, and it’s going to be a clear sailing for the foreseeable future. Unfortunately, this optimism appears to be far ahead of the underlying fundamentals in many markets and in turn many existing apartment assets.

As professionals who are exclusively focused on apartment turnaround and consulting services, we spend a significant amount of our time working with clients or lenders in their strategy and renegotiations. Our observations and findings do not coincide with the newly found optimism evident in the market today.

For existing assets, debt issues are split into two separate camps:

•	Properties which are not covering debt service payments, and sometimes even have negative net operating income (“NOI”): Investors on these assets are wary of responding to capital calls to cover debt service payments, especially for assets with negative operating NOI.
•	Properties which were financed with short term bullet loans and will soon face debt maturity: These properties may be covering their current low debt service but do not have adequate cash flow (“CF”) coverage at the current agency underwriting standards to fully refinance without having to write a large check to cover all equity requirements.

Many investors seem to believe that banks and servicers will easily roll over and automatically provide extensions assuming that anyone should be excited to push the problems down the road. Unfortunately, the reality is not that simple since bank and servicers have to recognize and answer to multiple layers of constituents with varied interests and goals. It is critical to understand the constituents’ interests, goals and what the banks or servicers can and cannot do. Therefore, providing extensions on maturing debts may not always be warranted, however challenging the alternatives are.

A few things that investors need to consider:

•	Multifamily debt maturities are currently in a state of lull. Even though servicers are increasingly swamped with seriously delinquent assets (8.9% per Trepp 2010 on an outstanding balance of $112 billion), the actual CMBS maturities are relatively small until 2014, averaging $9.2 billion each year. However, from 2015 to 2017, the average jumps to $21 billion each year.
•	Who will be the new lenders refinancing these assets?
	In 2009, all government-backed agencies’ combined loan book increased by $21 billion (Fannie: $9.5 billion and Freddie: $7.5 billion) while the private sector’s (commercial banks, savings institutions, conduits and life companies) dropped by $18 billion. We all know about the lack of CMBS financing, and while life companies are back, they are active in much more fertile hunting grounds such as office, retail and industrial markets. In fact, the bigger risk is the possible slowdown of Fannie Mae DUS lenders in originating new loans. Since DUS lenders are on the hook for a certain percentage of the first lost loss positions, it appears that several of them have already concluded that they already have sufficient exposure on their balance sheets. These lenders are not pricing aggressively unless deals are right down the middle, i.e. low loan to value (“LTV”) in excellent markets with great sponsors. Freddie is a good lender but it is unfeasible to assume that it can single handedly pick up the slack for the upcoming maturities and handle on its own.

There are many things to consider for each type of renegotiation. It is always a good idea to bring in a professional who has not been previously involved with the asset. Having a sounding board as well as a mediator (if needed) will not only help to make the decisions cleaner, but also expedite the process.

Few Final Thoughts

Sponsors, Investors and Developers:

•	Create a realistic assessment on the current value of the property, and how that will change over the following two years. Understand the true effective rents, actual collections, and realistic capital needs. It sounds great that the markets are tightening but the key is to understand what that really means to the specific submarket and asset.
•	Communicate with your partners. This sounds cliché, (or even trivial), but most sponsors are not great communicators with their equity partners. In the booming years, equity partners did not pay attention to their illiquid assets. However, in these difficult times, it is critical for them to understand all the downsides.

Servicers and Lenders:

•

The one-size-fits-all negotiations where all projects and all players are painted with the same brush are not going to be effective in the long run. It is difficult and time consuming to get into the weeds during renegotiations and in most cases, it’s a tedious task. However, with some work, a reasonable judgment can be made as to the projects having a viable upside and sponsors who will be good borrowers versus the projects without a reasonable chance of recovery, or sponsors who are in the game purely due to cheap and aggressive debt.

•

Fully understand the submarket dynamics – The national research services do a good job in providing overall data, but there is usually a lag in providing market data and they are not submarket specific. Rents and occupancy are moving so quickly, particularly on assets where the borrower is trying to stay afloat, that data services usually cannot provide effective localized information. Additionally, it will benefit the servicers and lenders to understand which direct competitors are struggling. For example, we have recently been involved in two negotiations with solid borrowers where the servicers were convinced the properties were valued substantially higher than the loan. However, what they failed to realize was three of the seven competitors were also struggling with similar capital and loan structures. Since rents from one property have impact on the others, when competitors get foreclosed upon, it affects everyone in the neighborhood. We understand that servicers have different fiduciary responsibilities to different stakeholders, however, making decisions solely based on a spreadsheet does not work well since markets, debts, and other players are rapidly changing.

About the Author
Mike Kelly is the president and co-founder of Caldera Asset Management, a turnaround consulting and restructuring services firm specializing in multifamily assets. Caldera’s team has experience working with lenders, equity investors, lawyers and other consultants to solve complex problems associated with distressed multifamily assets including turnaround, refinancing, stabilization, restructuring, dispositions and property management. For more about Caldera, please visit www.calderaassetmanagement.com.