December 2008 Perspectives on Real Estate Our Real Estate Practice provides legal services to real estate professionals across the globe Article Highlights For more information on Pillsbury’s Real Estate Practice, please contact: In Order to Win, You Must Participate 1 Eminent Domain Post-Kelo 3 William S. Waller John Engel Construction Corner 5 213.488.7326 202.663.8863 Greenwashing 6 [email protected] [email protected] CDARS—An Investment Safeguard Strategy 7 The Cost to Borrowers of Buying Time in a Loan Workout or Restructuring 8 HELP US GO GREEN! If you would like to receive this newsletter via email California’s Foreclosure Reform Law 9 rather than hard copy, please email [email protected]. Strategies for Real Estate Outsourcing 10 In Order to Win, You Must Participate by James M. Rishwain, Jr., and Stacey L. Hall Pick up any newspaper, turn on any news station or browse any website, and the consensus is clear: These are dire financial times. The U.S. economy is facing tremendous headwinds and challenges the likes of which have not been seen since the Great Depression. The subprime mortgage meltdown has decimated residential real estate, leaving more than 10 percent of U.S. homeowners with no equity in their homes, and the numbers are ominously mounting as residential property values continue to tumble. As the credit crunch continues, investors must seek out alternative means to finance their commercial real estate projects. Despite the recent turmoil in the residential real estate market, the picture for commercial real estate looks relatively rosy. While that may sound overly optimistic, consider the following factors: The demand for central business district office buildings, resort hotel projects and other well-positioned commercial proper- ties still outweighs supply; interest rates on loans for real estate remain at historically low levels; and institutional investors, continued on page 2 December 2008 In Order to Win, of the property, thereby enabling investors “an association of two or more persons You Must Participate to undertake real estate projects that to carry on, as co-owners, a business for (continued from page 1) otherwise would have been unaffordable. profit.” Courts generally look to four fac- tors to determine whether a partnership The market today is certainly much dif- exists: (1) the intent of the parties; (2) the ferent than it was in the 1980s. However, sharing of profits; (3) the sharing of losses; pension funds and sophisticated real estate the benefits of the participating mortgage and (4) the degree of control of the parties developers are awash in capital as folks remain the same. Participating mortgages over the affairs of the enterprise. were fleeing the stock market even before provide today’s risk-averse lenders with the recent market downfall. a critical incentive to extend credit by The intent of the parties is paramount. If enabling them to receive, in addition to a the parties truly intend for the relation- So, what is the problem in an environment fixed rate of return, a participation in the ship to be a partnership and are using in which there are historically low interest current cash flow and future apprecia- the loan documents as a means by which rates, a strong demand and tremendous tion of the underlying real estate. Great they are creating form over substance, capital? The credit crunch! Simply stated, reward comes with great risk, however, the relationship is at serious risk of being there are not enough benefits and rewards and lenders and borrowers alike must be characterized as a partnership. In order to to outweigh the risks for lenders to lend. aware of several important legal consider- mitigate against this risk, the loan docu- Banks and brokerages have tightened ations before entering into a participating ments must, at a minimum, contain an lending standards and made it difficult for mortgage. explicit disclaimer of any intent to form a commercial borrowers with even excellent partnership relationship between the bor- credit to get a loan. rower and lender. Characterization as a Partnership As the credit crunch continues, investors The biggest risk with a participating The sharing of losses is another major red must seek out alternative means to finance mortgage is that the relationship between flag. If the lender bears responsibility for their commercial real estate projects. the lender and the borrower could be even a part of the borrower’s losses, this One particularly noteworthy alternative characterized legally as a partnership. will automatically trigger a partnership financing mechanism exists that has been If this occurs, the lender could become characterization. The last two factors sitting unused in the marketplace toolbox jointly and severally liable for the debts are questions of fact. Courts look at the for many years. The tool is called the of the borrower incurred on behalf of the extent to which the lender is involved in participating mortgage. partnership, including the claims of third the day-to-day operations of the enter- parties against the partnership. prise and its level of participation in A participating mortgage is a loan in the profits of the project to determine which the lender lends at a fixed rate whether a partnership relationship exists. of interest and supplements it with a Participating mortgages The lender must always act as a lender “participation,” usually expressed as a provide today’s risk-averse and never as an owner. contingent interest, in the cash flow from lenders with a critical operations and/or appreciation in value of the underlying property. Despite seeming incentive to extend credit by Usury relatively simple, participating mortgages enabling them to receive, in Another risk with the participating mort- are highly complex instruments. Specific gage is that it may potentially violate state participation features and mortgage terms addition to a fixed rate of usury laws. Under a participating mortgage, are usually heavily negotiated and unique return, a participation in the the amount of contingent “participating” to each transaction structure. interest the lender receives may be added current cash flow and future to the fixed rate of interest for purposes of determining whether the loan is usurious. An Old Tool Put to New Use appreciation of the under- When aggregated, the total interest may Participating mortgages have historically lying real estate. exceed the usury limit. been used as popular financing tools during periods of high interest rates. In the early A careful examination of the state’s usury 1980s, for example, high interest rates made In structuring a participating mortgage, it laws (and any exemptions thereto) by real estate development too expensive for is essential to be aware of the factors that the real estate lawyers involved in the many investors. With the participating could cause the relationship between the transaction is essential when structuring a mortgage, however, lenders were willing to lender and the borrower to be charac- participating mortgage. lend money at a lower fixed interest rate in terized as a partnership. The Uniform exchange for a participation in the profits Partnership Act defines a partnership as Perspectives on Real Estate | 3 Structuring Approach We have discussed two fundamental con- cerns related to participating mortgages, namely characterization as a partnership and potential violation of usury laws. In consideration of these concerns, we recommend that you look at these loans as having two fundamental components. The first component is the actual loan itself, which we will label the hard money loan. The second component is the portion that represents the lender’s right to partici- pate in the net income or profits from the project. We will call this the participating portion. In structuring these loans, in order to protect and preserve the hard money loan, we recommend that it be documented with a separate promissory note secured by a first deed of trust. With the same logic in mind, we recommend that the participating portion be docu- mented by an independent note secured by a second deed of trust. By so doing, in the event that issues of enforceability arise in connection with the participating portion, it should not affect the enforce- ability of the hard money loan, which is documented by a separate note secured by a first deed of trust. Re-emerging Trend The participating mortgage is a lending Eminent Domain Post-Kelo tool of the past that is worthy of seri- by Deborah B. Baum and David Tabibian ous consideration in today’s credit-tight market as a way to help infuse capital into real estate development. The participating The Supreme Court’s 2005 decision in the “economic development” rationale mortgage gives the lender an incentive to Kelo v. City of New London was no doubt was challenged as a mere pretext for a participate by giving more rewards to offset one of the most controversial high court different, improper purpose. the high risks. If you do not participate, decisions of our time. Politicians and you cannot achieve the gains you will need citizens alike quickly expressed their Rather than broadly easing the use of to succeed. Lenders, even in this economic distaste with the ruling. The Court in Kelo eminent domain to further economic environment, it is time to participate! upheld a local government’s right to take development projects, however, Kelo private property and transfer it to another spurred a wave of state legislation enacted private owner for economic development to limit the use of the state’s power of James M. Rishwain, Jr. purposes as a proper “public use” under eminent domain in other than “tradi- is Pillsbury’s firm chair and a partner in the the Fifth Amendment without showing tional” public uses.