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Mounting pressures send more workouts to court.

Workouts are less likely to remain non-judicial proceedings than was the case only a few years ago. That's unfortunate, because staying out of court usually allows for faster, less expensive and more flexible solutions.

However, since mounting pressures from several sources seem to be conspiring against non-judicial resolutions, understanding those pressures can help property owners anticipate the kinds of problems they might encounter in the workout process. Let's briefly examine a few.

Tax Reserves

An especially ironic aspect of present-day workouts is the fact that many of them require large reserves to satisfy income taxes and - in New York State - the so-called "Cuomo" tax. The question is: if a property is doing so poorly that it can't service its debt properly, from where does all the tax liability arise?

The answer is seen in this simplified illustration:

Let's say an investor bought a property in 1980 for $10 million with an $8 million mortgage. It appreciated in value rapidly and was reappraised for $20 million in 1985, at which time the owner refinanced it with a $16 million mortgage. Then came the great real estate recession and the appraisal value dropped to $14 million in 1991.

Now we have a situation in which the debt on the property is greater than both the purchase price and the appraised value, and yet there is a substantial taxable profit. (Of course, let's not lose sight of the fact that the owner had the use of the refinancing proceeds.)

To the owner, who can't keep up with the mortgage payments, this may be the worst of times. But as far as the IRS and state tax department are concerned, the sale of that property at its appraised value would generate a $4 million gain, plus the depreciation recapture, resulting in a tax liability with no cash being, generated.

Unless a reserve to satisfy that liability is established, it may be necessary to forego a sale and pursue a bankruptcy filing.

Conflicting Multi-Lender Interests

Not so long ago, project financing typically was provided by only one or a handful of lenders; if the property fell into trouble, at least the money sources and the borrower usually could agree where their interests lie.

Today, of course, it's common for many banks - large and small, foreign and domestic - to participate in a financing on both a secured and unsecured basis. As the banking, industry's problems have accelerated, these entities have been showing less inclination to cooperate with one another in workout proceedings.

Banks usually are inclined to press their deficiency claims on an individual basis. Each secured lender would like to get enough additional collateral to solve its deficiency; each unsecured lender intends to obtain enough collateral to secure its position. They harbor these notions even though the borrowers may have carefully studied the economics and concluded that insufficient collateral exists to satisfy all the lenders. And by the time they accept this, the debtor has moved that much closer to a bankruptcy filing.

Another point about the financing, is that it may not all have come from banks. Portions of the debt may take the form of bonds, in which case, unanimous consent of the bondholders may be required to either waive a default or agree on a consensual plan.

Under such circumstances, it sometimes becomes necessary to file Chapter 11 proceedings to convert the need for unanimity to a simple majority requirement - and perhaps also for the opportunity to bring a semblance of order to a chaotic and unproductive situation.

"In-Substance" Foreclosure

Bank regulators and the accounting profession want to ensure that lenders report the consequences of impaired loans in their financial statements. In 1977 the Financial Accounting Standards Board issued rules stating in effect:

When a loan is so troubled that its owner substantially has given control of the collateral to the lender, the asset must be accounted for as if an actual foreclosure had taken place.

This concept is known as "in-substance foreclosure," and it sometimes serves as a disincentive to a successful workout. A lender may reason that if it must write down a loan to fair market value anyway, it might as well own the

Moreover, a proposed change in accounting rules would require a creditor to measure the impairment of a loan based on the present value of expected future cash flows instead of the nondiscounted approach in use today. That could apply even more pressure toward foreclosures.

The courts, however, are showing signs of decreasing tolerance of bankruptcy as a tool for troubled real estate borrowers. There is growing criticism in both judicial and legislative circles of the use of single-property Chapter 11 filings as a means of averting or fore stalling property foreclosures.

As a result of all these pressures, property owners and their advisors will continue to evolve new strategies, and to fine-tune the definition of the evermore-complex "workout." asset. In that case, that often prompts the borrower to file for bankruptcy protection.
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Title Annotation:non-judicial dispute resolutions
Author:Convissar, Michael
Publication:Real Estate Weekly
Date:Jul 22, 1992
Words:827
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