The commercial real estate market has experienced sharp decline in recent months and foreclosures and bankruptcies are on the rise. Local bankruptcy and insolvency attorney James C. Bastian Jr. says that the problem is only going to get worse.
Many owners of commercial real estate are struggling as businesses close and tenants depart, leaving those owners short on cash flow and unable to pay on their loans to the bank.
“What happens when you have a commercial property that’s in distress is the natural friction between the lender’s rights and the idea of preserving the perceived equity in the property,” says Bastian, a partner at Shulman Hodges & Bastian LLP. “Those forces come into conflict, and you’ve got the lender on one hand trying to collect on its debt and you’ve got the owner trying to stay in control and stave off the lender.”
Smart Business spoke with Bastian about how to survive in a down market by taking a hard look at your tenant mix and by reaching out to your banker.
When your commercial property falls into distress, what are your options?
If you have a property that was fully leased, but then a couple of tenants go out of business or go bankrupt, you’re stuck with a property that’s not fully occupied. Your cash flow suffers and you’re going to fall behind on your debt. You need to sit down with your lender, explain the situation and adjust your cash flow models. Be realistic with the lenders and say, ‘This is what we can do.’
It is not uncommon when a piece of commercial property falls into distress to see the lender seek the appointment of a receiver to take control. That’s something that’s involuntary, keeps the owner out of control and really is for the benefit of the lender.
You need to attempt to work out a negotiation with the lender and say, ‘We understand we’re in default, we know it’s bad, but we don’t want a receivership, we don’t want a bankruptcy. We want to enter into a settlement with you and have you forebear, or modify, the terms of the loan to allow us to stay in control.’
In exchange, you have to offer a great deal of financial disclosure and reporting, and you probably will have to agree that the rents get put into a lockbox that will be controlled by the bank and used to operate on a tight budget and also to pay the debt down.
How important is an open relationship with your bank?
If the relationship between borrower and lender is broken down, it creates a lot of problems. You have to have dialogue. But from the borrower’s perspective, that dialogue is often one-sided, where the lender is making demands and restrictions that are not palatable. To level the playing field, bankruptcy lurks as an arrow in the quiver of the borrower. The foreclosure remedy, the receivership remedy, those are the big hammers for lenders.
Both sides know what they have at their disposal and, ideally, that leads to some constructive settlements and saves money and preserves the project. If you don’t have dialogue with the lender and ignore or deny their requests, they’ll lower the boom. But if you are upfront and you engage them right away, a deal can often be worked out.
How can working with your banker keep you out of foreclosure or bankruptcy?
You meet in the middle, and you try to come up with a deal that’s better and cheaper for everybody. Depending on how flexible the lender is willing to be will drive how this plays out. If the lender flexes its muscle and tries to pursue its remedies, the only real option for the company with the real estate is to file bankruptcy. If you provide good information and maintain an open dialogue, and both sides are realistic, a deal should be feasible.
What steps can you take to avoid getting into trouble?
You have to be very careful in watching your tenant mix. You don’t want to be concentrated in industries that are potentially going to fail. The retail sector is going to be tough. They lose money, they close the store and they vacate.
You’ve got to stay ahead of that, make sure you’re not too heavily concentrated in one area and find tenants who have long-term staying power, who aren’t dependent on cyclical areas of the market. If it’s something that’s the new hot thing, you have to be very careful.
Make sure those who rent from you are capable of paying the terms of the lease, even if their business fails. You often have to get personal guaranties and standby letters of credit — especially with businesses that are new or not very well capitalized.
By having so many onerous demands, you can scare people away. But if you don’t have high standards for your tenants, you can get left holding the bag.
You have to be flexible and offer concessions. It’s far better to keep a tenant at a lower rate than to cling to that higher rate. Landlords could go to their tenants and say, ‘Will you extend for five years if I lower your rent by 20 percent?’ Then they have a longer-term commitment, they’ve got a cash flow projection they can count on, and they stabilize their property for a longer term.
JAMES C. BASTIAN JR. is a partner at Shulman Hodges & Bastian LLP. Reach him at (949) 340-3400 or email@example.com.