Although Chicago-based REIT General Growth Properties and Australian limited property trust Centro Properties Group have been so far able to work out a series of loan extensions and temporary deals with lenders, there remain persistent fears that one or both companies may get pushed over the edge. The industry has never experienced the bankruptcy of a REIT the size of either General Growth, which has $29.7 billion in assets, according to its financial statements, or Centro, which has a true asset book value of $8.3 billion. But if credit conditions remain as they are and the recession plays out as badly as some economists fear, the likelihood only increases that one or more REITs may eventually need to file for Chapter 7 or Chapter 11 bankruptcy protection.

Corporate bankruptcies (both Chapter 7 liquidations and Chapter 11 reorganizations) have increased substantially over the past two years. In 2008, 42,000 businesses filed for bankruptcy, a 45 percent increase from the 28,000 filings in 2007, according to a recent report by Paris-based Euler Hermes, the world’s largest credit insurer. This year, Euler estimates that an additional 62,000 U.S. companies will be forced to file for bankruptcy protection. If Euler is right, those numbers would mark the largest increase in corporate bankruptcies in more than 16 years.

Among those ranks are a growing number of retailers. That’s creating even more pressure on retail REITs as centers lose tenants while the ones that remain push aggressively for rental reductions. The difficulties in refinancing debt add another pressure. Put it all together and it creates a series of pressures on retail REITs. The industry seems profoundly worried about these developments. Retail REIT stock valuations have languished at 52-week lows for months and are off 70 percent from apexes reached in early 2007.

All this is leading observers to consider it a matter of when, not if, the industry sees a major player file for bankruptcy protection.

And that has a lot of people nervous.

What would a REIT bankruptcy look like? How could a firm reemerge from such a reorganization while still living up to the stringent rules imposed on REITs? Is it possible that the current wave of difficulties will lead firms to de-list from public markets altogether, like what small retail REIT AmREIT is currently doing?

Bankruptcy experts, however, say that many of the worries may be unfounded. The sector may not have been tested by a big bankruptcy yet, but enough is known about how the companies are structured and how a bankruptcy proceeds that experts think the industry should emerge fine, even from a series of bankruptcies. Further, there is reason to believe that because REITs control a tangible base of assets through large portfolios of real estate, these firms may be more likely to survive bankruptcies than other companies that’s value is harder to pin down or could be subject to liquidation.

In any case, bankruptcy is a costly, lengthy process, and the final outcome is hard to predict.

Learning from history
One reason for nervousness about REITs and bankruptcy is that the era of large, publicly traded REITs is still relatively young. Although the structure has been around for decades, it really didn’t take off as a dominant model for commercial real estate ownership until the mid-1990s when changes in regulation made it much more attractive for owners to seek REIT status. Since then, there have been some ups and downs in commercial real estate—most notably the brief debt crisis triggered by the Russian default in 1998 and a brief downturn in property fundamentals in the early 2000s—but nothing on the scale of the current credit crunch and recession. During that time, no major equity REIT was forced to seek bankruptcy protection.

However, there is some precedent for bankruptcies among mortgage REITs. In fact, the most high-profile REIT to declare bankruptcy was Criimi Mae, a REIT specializing in non-investment grade commercial mortgage investments, in 1998. Criimi Mae had a portfolio of $2.7 billion at the time of its bankruptcy. Mortgage Realty Trust and Wedgestone Financial were two more mortgage REITs that filed for bankruptcy in the 1990s.

Similar to the conditions today, REITs then were highly leveraged and were pushed into bankruptcy by a credit crunch, says John Wilcox, senior vice president of Savills Granite, a New York City–based real estate investment banking firm. Wedgestone, for example, bought mortgages with money raised in the commercial paper market. When the commercial paper market froze in the early 1990s, the company filed for Chapter 11 reorganization in 1991 and emerged from bankruptcy in 1992. It had $100 million in assets at the time. However, it lost its REIT status and eventually got out of the mortgage business altogether.

Looking a bit further back, a number of mortgage REITs also filed for bankruptcy during the 10-year period from 1971 to 1981. Several traditional equity REITs, many sponsored by banks, also sought bankruptcy protection after seeing the value of their portfolios crater during the real estate bust of 1973 and 1974. For example, Chase Manhattan Mortgage and Realty Trust Co. ended up in Chapter 11 reorganization when the REIT began running out of operation funds and started to sell off assets to meet its subordinated debt obligations.

The REIT ran into real trouble when creditors holding a first debt position found out that subordinated debt holders were being paid before them, according to John Jerome, a partner with New York City-based law firm Saul Ewing LLC who worked on the REIT’s bankruptcy. Burdened by inter-creditor squabbles, Chase Manhattan’s REIT eventually bypassed Chapter 11 reorganization and ended up in Chapter 7 liquidation. It sold off all its assets, raising $1 billion, to pay its creditors and ceased to exist.

It’s hard to predict whether REIT bankruptcies will ratchet up over the next couple of years, but they’re certainly more likely to occur during recessions and credit shortages, Jerome says. “When a REIT’s cash flow is impacted because the properties themselves aren’t performing and that decreased cash flow makes it impossible to meet the obligations to its creditors, it may find itself resorting to bankruptcy,” he warns. “The same is true if a REIT cannot refinance its debt and defaults on its loans.”

Best-case scenario bankruptcy
All that said, what is likely to happen in today’s market?

As long as a company has a viable business model, more often than not it will choose Chapter 11 reorganization over Chapter 7 liquidation. Both Chapter 7 and Chapter 11 allow debtors to get creditors off their backs—a process officially known as the automatic stay—but Chapter 11 allows debtors to create a plan to emerge from bankruptcy as a debt free, financially healthy and operationally strong company.

REITs, in particular, have an incentive to file Chapter 11 over Chapter 7—the value of the underlying real estate may be higher than the company’s market capitalization, providing it a potential road to recovery. In a Chapter 7 liquidation scenario, a trustee is appointed by the bankruptcy court and the business winds down with every asset sold through an auction. In that case, all creditors—secured and unsecured—would likely end up with less than they would in a Chapter 11 reorganization, especially in today’s market where real estate values have dropped.

For example, a creditor that forces a REIT with assets valued at $100 million burdened with $150 million in debt to liquidate is going to lose $50 million. Instead, that creditor could wait for the REIT to reorganize and potentially get back $150 million and all the interest. That’s why most creditors generally are willing to support a Chapter 11 bankruptcy filing over a Chapter 7 bankruptcy filing.

Pamela Smith Holleman, a partner with Boston-based Sullivan & Worcester LLP, who specializes in bankruptcy, says a REIT entering into Chapter 11 usually lines up debtor-in-possession (DIP) financing before it files for bankruptcy protection. DIP financing, often called war chest financing by bankruptcy and restructuring experts, is an infusion of cash from a new lender. The lender that provides DIP financing is awarded a super priority creditor position—meaning that it will be paid back before all other creditors, secured or otherwise.

DIP financing would allow a REIT to continue to operate and provides essential funds needed for continued operation, such as payroll. DIP financing is critical to the success of a Chapter 11 reorganization because it’s likely the company does not have the cash it needs to continue operating even on the most basic level.

“If a REIT cannot work out its covenants to avoid default with its lenders, it has nowhere to go but bankruptcy,” Jerome says. “Then the question becomes, does the REIT have enough cash flow to reorganize itself during bankruptcy. If not, it would have to liquidate.”

In normal credit conditions, a REIT in bankruptcy reorganization would likely be able to find DIP financing, says Pat Dinardo, also a partner with Sullivan & Worcester LLP. But, financing terms would not be “great because you’re asking someone to come into a situation that is in great disarray.”

Depending on the amount of DIP financing needed, the terms can vary. In general, DIP financing has a hefty interest rate. In mid-2007, DIP financing rates were London Interbank Offered Rate (LIBOR) plus about 5 percent. Today, DIP financing can be more than 10 points above LIBOR. This financing is also short term—typically covering the length of a proposed restructuring plan. Legally, restructurings are supposed to last 12 months, though that period can be extended with approval of the courts. Lastly, DIP financing is less available than in the past.

“What used to be a highly competitive segment of the banking industry is dead,” Jerome says. That means a REIT in bankruptcy would need to find an alternative source of DIP money—a white knight, in fact. DIP financing is typically provided by investment banks, commercial banks, private equity firms, hedge funds and opportunity funds. Some experts speculate that sovereign wealth funds will emerge as new white knights, but that hasn’t happened so far. Some sovereign wealth funds have provide equity infusions to troubled companies, but not gotten so far as to provide DIP financing. If a company can’t find a bank or white knight, it would need to bootstrap its reorganization—something that few could do.

Unfortunately, if a company cannot line up financing before it files for bankruptcy, it’s even less likely to do so after filing (although the super priority position does sweeten the deals for lenders). In that case, sometimes a bankruptcy filing might just be window-dressing or delaying the inevitable. I think a lot of the bankruptcy filings are dead on arrival and filed just to frustrate creditors,” says Chad Paiva, head of Greenspoon Marder’s bankruptcy practice area.

Credit where credit is due
Once a company has filed for bankruptcy, the court will assign a judge to the case. In most situations, executive management will stay in place (unless of course, the management team is suspected of mismanagement or something illegal). The company has the exclusive right for 120 days to propose a reorganization plan—a road map that details how it will pay back its creditors and how it will return to solvency. Although bankruptcy code requires companies to emerge from bankruptcy within one year, extensions are routinely offered by the courts.

Dinardo says the bankruptcy code works to maximize value for secured creditors (usually lenders), as well as unsecured creditors like the deli that caters the staff cafeteria or the company that provides utilities for its properties. To that end, the plan must deal with every class of creditors including secured and unsecured; it must even address equity and bond shareholders.

But, the plan does not have to pay back everything owed to creditors—who could receive pennies on the dollar, depending on the final creditor vote and judgment from the court. That is why there are a number of technicalities for a bankruptcy plan to be approved. Most importantly, every class of creditor must accept the plan and every creditor must be assigned to a specific class. In order for a class to accept the plan, two-thirds of creditors (in terms of dollar amount) and a majority of creditors (real number) must vote yes. For example, if one lender holding less than one-third of the debt votes no and the rest of the class votes yes, the plan can go through.

“Bankruptcy can be a way to work around the dissenting creditors,” says Gary Eisenberg, a partner with Newark, N.J.–based law firm Herrick, Feinstein LLP. However, he notes that inter-creditor rights are the biggest source of litigation tied to the bankruptcy process.

Even if all creditor classes approve the plan, no creditors are repaid until the bankruptcy court also signs off on the plan. And, in most bankruptcy situations, secured and unsecured creditors are paid well before equity shareholders, say Thomas Califano, cochair of Chicago–based DLA Piper’s Restructuring Practice Group. The bottom line—if a company only has $1 million in assets and $5 million in debt, shareholders won’t get anything.

It’s not common for REITs to have CMBS debt. REITs usually work with portfolio and balance sheet lenders. If a REIT goes bust, creditors would include both secured and unsecured creditors. Secured creditors would be those that made loans that are secured by assets such as commercial property, but they could also include office furniture, equipment such as computers, printers and copiers, etc. The list of unsecured creditors is almost infinite—everyone from the food vendor that provides coffee for the break room to the janitorial staff and the electricity company. Unsecured creditors are any company/vendor that provided services or consumable goods to the bankrupt firm.

Likewise, shareholders will be left out in the cold if creditors take new equity positions as payment for existing debt or in exchange for DIP financing. In a slightly better case scenario, established equity shareholders might be diluted by creditors who take a preferred position. Reportedly, this exact scenario is facing Centro Properties’ shareholders: lenders have agreed to take 90 percent of the company’s outstanding equity shares as a form of repayment for maturing loans.

“The general rule is that equity does not come out in good shape in a bankruptcy scenario,” Holleman notes.
However, Dinardo has been involved in a bankruptcy proceeding in which 100 percent of equity stayed intact. In that particular scenario, creditors were paid off over a five-year period and unsecured creditors voted to allow the equity class to retain its value.

Experts say REIT shareholders are more likely to retain some value simply because of a REIT’s underlying assets. “Most shareholders get nothing in a bankruptcy because most companies have no assets, and that’s not the case with REITs,” Jerome says. “It all comes down to valuation of the real estate assets. Even if those valuations have decreased, it’s going to come back up. And, if the REIT has to go into bankruptcy, it’s not the end of the story for shareholders as long as the company still has something of value.”

A retailer, for instance, may be valued (on paper at least) at $100 million, but that value is likely based on several intangible assets, as well as “real property” such as inventory or stores that might represent only a fraction of the overall value. REITs, on the other hand, derive their value almost entirely from tangible assets—portfolios of buildings.

Perhaps that’s why Citigroup, Pershing Square and Morgan Stanley all have made substantial investments in General Growth Properties stock over the past 90 days, spending millions of dollars to buy shares that are trading at roughly 97 percent less than they were in early 2008.

Business as usual
While Chapter 7 and Chapter 11 bankruptcy both focus on paying creditors, the Chapter 11 bankruptcy code emphasizes the preservation of a company’s core business, according to Dinardo. To that end, the bankruptcy courts allow companies in reorganization to continue to operate under their purview, says Janis Schiff, section leader for Holland & Knight’s real estate practice group. Consider both Delta Airlines and United Airlines: the companies filed for bankruptcy protection yet continued to operate their airline routes and transport passengers around the world.

Similarly, a REIT in Chapter 11 would be able to continue to operate its properties as it had done prior to filing bankruptcy. Basically, it’s business as usual, Eisenberg says. “Things that are part of the ordinary course of business don’t require the court’s approval,” he explains. In the case of a mall operator, for example, the center would be open to shoppers, employees would be paid, rents would be collected, new lease deals would be signed and so on.

Moreover, Chapter 11 gives a REIT the ability to assume or reject contracts—essentially the opportunity to revisit all components of its operations and cherry-pick among the good and the bad. For example, a shopping center REIT might be locked into contract with a security firm at a high price or be paying top rates for garbage removal. Under bankruptcy, the REIT can reject those burdensome contracts and the amount that is owed to those companies becomes an unsecured debt.

However, REITs are not able to disavow leases that aren’t favorable—leases with under-market rents, for example. While tenants in bankruptcy are allowed to reject leases—pretty much for any reason—the bankruptcy code has special protection for tenants if landlords file for bankruptcy. The code says tenants have the power and can choose to stay even if a REIT wants them out. A tenant’s ability to reject leases is a powerful bankruptcy tool that is weakened for REITs.

Another problem—one that is particularly relevant today—is how many retailers are requesting modified leases to deal with the recession and weak retail sales. If the REIT landlord is in bankruptcy, the bankruptcy court could decide that lease reworking is not part of the “normal course of business” and that it is detrimental to the REIT’s ability to deal with its creditors.

At that point, the REIT would be hamstrung by the bankruptcy court and be unable to work with its tenants to hammer out a new lease. This lack of flexibility could expose the REIT to increased vacancies and dark stores.

And, even as bankruptcy protects a REIT from creditors and gives it tools to strengthen and streamline its business, it can also impact the very thing that makes it a REIT—its ability to pay shareholder dividends equal to at least 90 percent of taxable income. “With a typical company, there is no dividend because you’re insolvent,” Dinardo says. “But in a REIT situation, it becomes increasingly complex and very specific to the REIT.”

The elimination of dividends endangers the enterprise’s tax status as a REIT. Once disqualified, the company has lost this valuable benefit for at least five years and must pay corporate income tax. Many companies in bankruptcy that have previously paid dividends end up suspending that divident because they have no profit to pay out to shareholders. In the case of a REIT, the rule relates to taxable income and depending on how dire the REIT’s operations, it might not have any taxable income.

But, if a REIT can overcome these challenges, bankruptcy can be the beginning of a better enterprise, experts say. “We used to call bankruptcy a shield against the sword, but now it’s more of a corporate tool,” Jerome contends. “It might have a stigma, but it isn’t the end of the world by any stretch of the imagination.”

SIDE BAR

One Bad Apple
A single mortgage default can bring down an entire company.

As the credit freeze continues, many retail property owners might be forced into bankruptcy or pushed into giving back properties to lenders because their portfolios are cross-collateralized.

Cross-collateralization has become the real estate industry’s double-edged sword, according to many bankruptcy experts. The concept of cross-collateralization—where several properties are used to guarantee loans for other properties—was initially presented as a solution to make lenders feel more comfortable about lending money.

Essentially, lenders saw cross-collateralization as a way to reduce risk and diversify. And, as long as the borrower didn’t default on the mortgage, cross-collateralization wasn’t a problem. It becomes dangerous when a mortgage goes into default. Lenders have the right not only to foreclosure on the property with the mortgage, but also the properties that collateralize the mortgage.

“If the properties are cross-collateralized, it’s like a house of cards—they all collapse,” says Janis Schiff, section leader for Washington, D.C.–based Holland & Knight’s real estate practice group.

Lakewood, N.J.–based Lightstone Group LLC is one company that has lost assets because of cross-collateralization. In October 2008, the company defaulted on a $141 million loan for Macon Mall in Macon, Ga. The loan was collateralized by the 1.4-million-square-foot mall, as well as the 431,000-square-foot Burlington Mall in Burlington, N.C.

Both malls were turned over to lenders. And, recent reports suggest that another four malls will likely be returned to lenders because Lightstone is in danger of “imminent default” on a $73.6 million mortgage that is cross-collateralized by: Martinsburg Mall in Martinsburg, W. Va.; Mount Berry Square Mall in Rome, Ga.; Shenango Valley Mall in Hermitage, Pa.; and Bradley Square Mall in Cleveland, Tenn.

In Lightstone’s case, foreclosure is the only option because the mortgages are structured in such a way that prevents the company from seeking bankruptcy protection. The mortgages were securitized as commercial mortgage-backed securities (CMBS), and CMBS mortgages are structured as bankruptcy remote vehicles. As such, if a borrower defaults on the mortgage, he has no option but to let the property (and any other properties that collateralize the mortgage) go back to the lender.

Bankruptcy is an option for REITs like General Growth Properties because they usually chose to finance their properties with balance sheet lenders rather than CMBS, experts explain. A REIT could choose to seek bankruptcy protection just for the subsidiary or entity that holds the mortgage, but might be forced to put the parent company and all its subsidiaries into bankruptcy if the parent company guarantees any of the loans.