From PLI S Course Handbook s5

From PLI’s Course Handbook Real Estate M&A and REIT Transactions 2009 #18093

RETURNING TO FUNDAMENTALS: STRUCTURING COMMERCIAL PROPERTY ACQUISITIONS IN A TOUGH CAPITAL MARKETS ENVIRONMENT

Everett S. Ward Quarles & Brady LLP

By: Everett S. Ward1

October 15, 2008

1 ©Everett S. Ward, 2008. All rights reserved. 3 Everett S. Ward is a Partner in the Chicago office of Jenner & Block LLP. Mr. Ward has practiced law in the area of commercial real estate and financing since 1986. He is a member of the American Bar Association Section of Real Property, Probate and Trust Law and is a past Vice Chair and the immediate past Chair of the Section’s Real Estate Investment Trust Committee. He is also a Fellow of the American College of Real Estate Lawyers (ACREL). Mr. Ward is a graduate of Princeton University (1983) and Harvard Law School (1986). He can be reached at [email protected]. RETURNING TO FUNDAMENTALS: STRUCTURING COMMERCIAL PROPERTY ACQUISITIONS IN A TOUGH CAPITAL MARKETS ENVIRONMENT

“Money alone sets all the world in motion.”2

Introduction.

Even the most seasoned veterans of the commercial real estate business state that the current capital markets environment is the most difficult that they have ever witnessed. The lack of liquidity in the capital markets, combined with (some would say) unrealistic seller expectations regarding property capitalization rates (and the resulting effect on property bid/ask spreads), have slowed the property acquisition pipeline to a trickle during 2008. And despite the recent passage by the U.S. Congress of the Emergency Economic Stabilization Act of 20083 as a means of helping to increase liquidity in the capital markets, some analysts expect property acquisition activity to remain slow well into 2009.4

Although “cash is king” in challenging economic times, the current condition of the capital markets and the pricing expectations of property sellers create problems even for real estate joint ventures and/or real estate funds that have significant cash available to acquire real estate assets. Joint ventures or funds that do not have significant liquidity and that own assets that are in need of capital infusions are finding difficulty raising new equity or borrowing debt. Also, as new joint ventures and funds are being formed to purchase distressed or soon-to-be distressed real estate,

2 Publius Syrus (42 B.C.). John Bartlett, Familiar Quotations (10th ed. 1919). 3 Pub. L. No. 110-343, Division A (2008). 4 See, e.g., Commercial Real Estate Investing is Stalled Despite Long Term Investor Optimism, Finds PriceWaterhouseCoopers’ Third Quarter 2008 Korpacz Real Estate Investor Survey, GlobeNewswire, September 18, 2008, http://www.globenewswire.com/newsroom/news.html. 1 those new entities confront current real estate market conditions where low pricing, quick and cheap debt and easy profits are not available.

How then, can a joint venture or real estate fund successfully complete property acquisitions in the current financial climate? This article briefly explores some of the challenges that joint ventures and real estate funds must recognize and address in order to successfully acquire, finance and operate property in these very tough times. Despite the challenges, this article also identifies some of the meaningful acquisition opportunities available for well-positioned joint venturers and real estate funds. Finally, this article concludes by discussing the basic real estate acquisition fundamentals that joint ventures and real estate funds must utilize in order to successfully pursue property purchase opportunities.

The Challenges .

In this real estate bear market joint ventures and real estate funds face, in no particular order, the following significant challenges to successfully completing property acquisitions:

 Unrealistic Seller Return Expectations. Currently, seller-expected low capitalization rates do not reflect the lack of activity in real estate sales (i.e., sellers continue to expect that sale prices will or should be higher than what prospective purchasers now are willing to pay). The resulting market disconnect has many prospective purchasers with available cash (either in the form of equity or committed bank credit facilities) remaining inactive until such time as sellers lower bid/ask expectations.

 Meeting Fund Deployment Deadlines. All real estate funds and many joint ventures have timelines for deploying investment capital to acquire assets. An inability to find good transactions (i.e., those that are consistent with the

2 would-be purchaser’s investment guidelines) prior to the end of the mandated deployment period may result in both the sponsor’s promoted interest and the investors’ return on investment not meeting pro forma expectations.

 Meeting Exit Expectations. Just as all funds and many joint ventures have deployment deadlines, such entities also may have asset disposition timelines. Asset disposition within stated timelines allows for an orderly return of capital and profit to investors, as well as payment of the sponsor’s promote. Given the present difficulty in acquiring assets and the current uncertainty regarding when the capital markets will rebound, joint ventures and funds that are acquiring assets today may need to build longer property disposition terms into their governing documents.

 Product Availability. Current pricing expectations and financing availability have created fewer economically viable acquisition opportunities for prospective purchasers. Capital constrained purchasers are likely to forego purchasing development projects and value added properties that may require significant post-closing capital in favor of acquiring stabilized properties and distressed real estate assets that may require little or no post-closing funding.

 Lack of Equity Capital. Prospective purchasers may lack sufficient equity capital to purchase assets without the necessity of obtaining acquisition financing at high loan to value levels, and the constituent partners or investors, as the case may be, may not be able to make additional capital contributions to the entity.

 Capital Markets Constraints. Banking industry consolidation, more stringent loan underwriting 3 standards and loan terms, and the lack of funds available for lending at major financial institutions all have adversely affected the availability of debt financing for prospective borrowers. In particular, the collapse of the commercial mortgage backed securities (CMBS) market has dramatically decreased the amount of debt financing available to real estate borrowers.5 The inability to borrow money restricts a joint venture’s or real estate fund’s ability to: (i) boost returns on equity through leverage, (ii) obtain equity from owned assets (through refinancing) and use that equity to acquire additional assets, (iii) finance new construction on development projects or capital improvements to value-added assets, and (iv) return capital to investors.

Current conditions are resulting in lenders charging higher interest rates for loans, and many lenders now may require some or all of the following items as basic terms of loan transactions: (i) higher loan fees, (ii) lower loan to value ratios and higher debt service coverage ratios than at any time in recent memory, (iii) loan amortization, (iv) recourse to the borrower for all or a portion of the loan amount, and/or (v) increased capital reserves and impounds for taxes and insurance. In addition, some lenders either are revising the non-recourse provisions in their loan documents to create additional recourse liability to borrowers upon the occurrence of certain defaults.6

5See, e.g., Elaine Misonzhnik, Six Months Into 2008, The CMBS Market Has Failed To Recover, RetailTraffic, July 2, 2008, http://retailtrafficmag.com/finance/analysis/cmbs_failed_recover_ 0702. Through the first six months of 2008, CMBS issuance was $12.1 billion, a 91% decline from the first six months of 2007. 6For example, Fannie Mae recently issued Update 08-04 -- "Update to Underwriting Requirements" to its Delegated Underwriting and Servicing (DUS) Guide. Among other changes, the update added a borrower bankruptcy as an event of default under the Fannie Mae loan documents and, for voluntary bankruptcy proceedings, as a trigger to recourse liability to borrowers and any key principal (i.e., guarantor). 4 The Opportunities .

For joint ventures and real estate funds with available equity capital and borrowing capacity, there are attractive property acquisition opportunities currently available. Due to the present upheaval in the stock markets, prospective investors currently may find real estate a more attractive investment that buying stocks.7 Specifically, the following circumstances may provide joint ventures and funds with opportunities to acquire real estate assets that satisfy their respective return on investment expectations:

 Distressed Assets. The number of underperforming properties (across all property types) will continue to increase as the U.S. economy slows and companies downsize or go out of business. The resulting increase in vacancy rates in office, commercial and industrial properties, and the substantial slowdown in condominium sales, could lead to a decline in property values and/or the owners of those properties not generating sufficient income to (a) service applicable mortgage debt, (b) refinance existing mortgage debt, and/or (c) meet investors’ return on investment expectations. In either case, property owners may be willing to sell those properties for lower prices than would be the case under better economic circumstances. In the case of unsold condominiums, developers may choose to “fracture” the condominium regimes and sell those properties to purchasers as apartment properties.

 Distressed Owners. A property owner may be in distress because of over leverage on its overall portfolio, and as a result may need to quickly sell otherwise performing assets to pay down mortgage debt. General Growth Properties, Inc., the large shopping center REIT, is an example of a 7See 2008 Real Estate Capital Markets Industry Outlook-Top Ten Issues, Deloitte (2008), at 4. 5 property owner currently in financial distress because analysts are concerned about the company’s ability in the current capital markets environment to repay more than $3 billion in mortgage debt that matures in 2009.8 In the short term, General Growth’s inability to refinance its debt may force the company to market performing assets to purchasers at attractive prices.

 Development and Value-Added Properties. Properties that require development or renovation in order to be repositioned in the marketplace also may provide excellent acquisition targets for joint ventures and funds, provided that the acquirers have the capital, skill and patience to undertake and successfully complete the repositioning process.9 Value-added properties may include existing construction, new construction and developable land.

 Purchasing Mortgage Debt. Some joint ventures and real estate funds may elect to purchase mortgage debt at an appropriate discount from lenders, both as a means of earning an acceptable return on investment (especially if purchasers can acquire the debt at a substantial discount), as well as a step to the potential ownership of the underlying asset in the event that the purchaser acquires the property by foreclosure or deed in

8See General Growth’s Stock Falls, 42%, ChicagoRealEstateDaily.com, October 7, 2008, http://chicagorealestatedaily.com/cgi-bin/news. See also, Alex Frangos, Commercial - Property Players Find Their Pressures Growing, WSJ.com, September 24, 2008, http://online.wsj.com/article /SB122221997903469917.html. 9 See Tom Heath, Value Added: Federal Capital's $230 Million Fund, Washingtonpost.com, October 8, 2008, http://washingtonpost.com/washbizblog/2008/10/value_added_9.ht ml. 6 lieu of foreclosure following a owner/borrower default on the payment of the mortgage debt.

Returning to Fundamentals .

During the next 12 to 15 months, those joint ventures and real estate funds that have the following characteristics will be best positioned to make prudent and profitable real estate acquisitions:

 Available Equity Capital. Simply put, liquidity is everything right now. Entities that either have significant equity available, or that can call upon investors quickly to obtain cash to fund acquisitions, have the advantage of being able to forego financing contingencies in purchase and sale agreements. The lack of such contingencies can serve as additional comfort to a seller of the purchaser’s ability to actually close the acquisition transaction.

 Investing Discipline. Joint ventures and funds that have a clear vision of the types of assets they want to purchase, the patience to find the proper opportunities, and the discipline not to overpay for those assets will be successful property acquirers in the current economic environment. Having a track record of successful, disciplined investing in real estate will make it easier for sponsors to obtain investors and acquisition financing.

 The Ability to Execute Transactions Quickly. Once a joint venture or real estate fund identifies a potential property acquisition, the acquirer must have the ability, if necessary, to act quickly in (i) negotiating letters of intent or term sheets, confidentiality agreements, purchase and sale agreements, financing documents (if applicable) and other transaction documents, (ii) undertaking and completing due diligence activities, (iii) obtaining any required internal or third party 7 approvals to closing the transaction, and (iv) actually closing the transaction.

 Exceptional Due Diligence Skills. This category includes physical, legal,10 and financial due diligence activities. Undertaking and completing timely and comprehensive due diligence will permit a purchaser to identify issues that may require (i) purchase price adjustments (including “complexity discounts” for properties that have significant economic or physical condition issues), (ii) adjustments to the purchaser’s pro forma property performance underwriting, (iii) appropriate budgeting for property repairs, capital improvement expenditures, and expenses in connection with re-tenanting of the property, and (iv) additional attention from the purchaser in connection with any related acquisition financing.

 Well-Drafted Organizational Documents. Joint venture and fund organizational documents that provide for, among other things, the following: (i) clear guidelines for sponsor authority to undertake and complete acquisition and disposition transactions, (ii) comprehensive and transparent financial reporting to constituent investors, (iii) acquisition and disposition mandates (e.g., asset types and any geographical restrictions) consistent with the sponsor’s market expertise and experience, (iv) flexible timelines for property acquisitions and dispositions, (v) any restrictions on the timing and use of debt (including maximum loan to value ratios) in property acquisitions, (vi) a sponsor compensation structure (including asset management fees and promotes) consistent with the joint venture’s or fund’s investment strategy, and (vii) appropriate remedies following the

10 See Everett S. Ward, Legal Due Diligence Issues in Real Estate Purchase Transactions, The Real Est. Fin. J., Spring 2007, at 9. 8 occurrence of a sponsor or investor default under the entity governing documents.

 Access to Debt. Because of the virtual shutdown of the CMBS market, borrowers that have long- standing relationships with lenders such as insurance companies, savings banks and commercial banks are at an advantage in obtaining debt.11 The ability to obtain debt financing in the current capital markets, even at interest rates, loan fees and leverage levels that are substantially less favorable to borrowers than 12 months ago, creates a substantial advantage for potential property purchasers.

Conclusion .

These tough times in the capital markets require that purchasers adhere even more strictly to solid real estate fundamentals in order to successfully acquire commercial real estate. “Given prevailing conditions, it may be time for investors to consider formulating a new game plan which concentrates less on financial engineering and more on fundamentals.”12

11 See, e.g., Michael Stoler, The New Masters of the Lending Universe, The New York Sun, January 10, 2008, http://www.nysun.com/real-estate/new-masters-of-the-lending- universe. 12 Real Estate Capital Markets, supra note 7, at 2. 9