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MARKET MUSINGS | Volume 9, Issue 2 Summer 2015

1Post Office 468 ▪ Portsmouth ▪ New Hampshire 03802-0468 [email protected] (603) 502-2174

CONTENTS

Commercial Real Estate Crowdfunding Find out how it really works. Pg. 1

Cap Rate VariationsEveryone in real estate knows how to calculate a cap rate — or do they? Pg. 3

Real Estate Asset Protection Pg. 7

Seeking BalanceConstruction loans present unique circumstances for lenders. Pg. 8

Creating ValueUse real estate leases effectively in Chapter 11 situations. Pg. 9

Upcoming Events Pg. 10

Commercial Market Forecast Pg. 11

Industry Definitions Pg. 12

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Commercial Real Estate Crowdfunding

Find out how it really works.

by Sara Drummond

Crowdfunding is probably the biggest buzzword to hit the commercial real estate industry in the last couple of years. But what’s the reality behind the hype? As hundreds of crowdfunding portals appear online, is this really the disruptive technology that some experts claim or just another option for funding and investing in commercial real estate?

To find out how it all works, Commercial Investment Real Estate talked to three CCIM members who are active in the crowdfunding arena: Elizabeth Braman, CCIM, chief production officer, Realty Mogul Co.; Adam Hooper, CCIM, CEO/founder, RealCrowd; and Darren Powderly, CCIM, co-founder, vice president of real estate, CrowdStreet.

CIRE: What’s a typical size and type of deal your company targets for equity crowdfunding?

Elizabeth Braman, CCIM: We make investments in the range of $1 million to $5 million per deal. We will invest alongside other investors as well as taking a minority interest.

Adam Hooper, CCIM: At the beginning of 2014, average deal size was around $19 million; in the last quarter of 2014 the average deal size was $24 million. We anticipate to grow substantially in 2015 as we are currently looking at several $100 million-plus projects. We’ve seen projects in office, retail, industrial, and multifamily. The bulk of the opportunities have been property acquisitions, though we have also featured several funds that perform very well.

Darren Powderly, CCIM: CrowdStreet posts institutional-quality commercial real estate investments in a single asset or fund offering structured either as debt or equity. We’re comfortable helping our sponsors raise $500,000 to $2 million from our accredited investor membership base. The property values range from $2 million to $200 million, yet are typically under $20 million.

Where do you find the deals?

Braman: Generally speaking, qualified sponsors find us through our marketing efforts and press. Sponsors and borrowers come to our site and complete a form to see if they have a qualified project. We

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immediately schedule a call with one of our acquisition professionals to determine if we want to invest in, or lend on, a transaction.

Hooper: We source our deals from a mix of our experience and relationships in the industry. Combined, our real estate team and founders have more than 65 years of real estate experience and more than $5 billion of transaction experience. We also receive referrals from groups we’ve done business with and from inbound interest.

Powderly: Sponsors are finding us online. We have an excellent online presence, which we extend to our sponsor clients to help them build their online brands. Today we are fielding eight to 10 inquiries per week from real estate sponsors. We’re also communicating with institutional-quality sponsors on a regular basis to help them understand how to raise capital online via our marketplace. There are a lot of moving parts from a regulatory, technology, marketing, real estate, finance, partner, and investor relations points of view, so we go to great lengths to make sure our sponsors are prepared prior to posting an investment on our marketplace.

What are your company’s parameters for putting a property or deal up for crowdfunding?

Braman: Realty Mogul has internal guidelines that we use, but really it comes down to sponsorship and the risk/return of the investment. We look for sponsors and borrowers who have already shown that they have the ability to execute on a plan and have expertise in their asset class. From there we look at the property, the market, and the plan for reaching the return in the estimated hold period. If we feel like it is a deal we can support, we discuss it at a credit committee and collectively decide whether to proceed with finalizing a full underwriting and making the offering available to our investors.

Hooper: Our focus is on the real estate operating companies and their track records, experience, and what they have done to show that they put their investors first. In contrast to most real estate crowdfunding companies, we are not building a real estate investment company. Rather, our focus is providing best-in-class real estate operating companies with a technology platform that

gives them the tools to raise capital in this new environment. As such, we do not provide investment advice or recommendations on which assets to invest in, but we do provide investors with direct access to partners with the best real estate companies in the U.S.

Powderly: CrowdStreet posts institutional-quality commercial real estate with defined business plans from reputable and proven sponsors. As a CCIM-founded company with deep expertise in the investment real estate market, we know how to evaluate sponsors and deals prior to posting them on the marketplace. CrowdStreet introduces individual investors to high-quality sponsors in a transparent, secure online setting where they can access all the information they need to make an informed investment decision. If they have a question, they are welcome to contact us via chat, email, or phone, and we will help them get the answers they need prior to investing.

What’s the average timeframe for crowdfunding real estate deals?

Braman: It really depends upon the crowd. We have more than 15,000 investors, so things go more quickly on the Realty Mogul platform. We close our loans in 10 to 15 days on average. For equity, if it is a strong deal, we have raised funds in a week or less, although we set reasonable expectations of 30 days from start to finish. Usually we are waiting on the sponsor’s conventional loan to be underwritten and finalized to close.

Hooper: We’ve seen deals literally fund in a few days and we’ve had funds that have raised $3-plus million over the course of a month and a half.

Powderly: We’re experiencing an average funding time of 30 to 45 days from online property posting to closing of the transaction. The biggest surge of investor interest comes in the first three weeks and the remaining time is used for transaction management leading up to the deal closing. We’re solving the problem of aggregating a high volume of investors with the use of our technology. It’s certainly possible for an attractive deal to be fully funded within a few days. That’s the power of our online marketplace.



see the development of a secondary market emerge as a natural extension of these platforms.

Powderly: Investor exit strategies vary from deal to deal. The exit strategy on a particular deal should be clearly presented in the sponsor offering materials. These are private offerings, so unlike investing in a publicly traded real estate investment trust, there is no secondary market (yet) to create immediate liquidity. Investors should plan on having their money invested for the entire term of the investment or longer.

Anything else investors/service providers should know?

Braman: There are many different structures in how the crowdfunding platforms can invest. We have chosen to take on the capital raising responsibility for our sponsors by becoming their single point of contact; we create an LLC for our investors to be limited partners, and then invest as one limited partner into the ownership structure so that the sponsor has one Schedule K-1, one distribution, and one quarterly report. We can come in alongside other investors, and/or provide up to 90 percent of the required equity in a deal. We also offer debt on transactions, so we can be a true one-stop shop for the entire capital stack. One final thing of note is that we are selling securities, so sponsors should be careful to only work with companies on the equity side that either are a broker deal or are affiliated with one.

Hooper: Investors should double or triple check to make sure they know what they’re actually investing in. Look at the pedigree and background of the founders and team on these crowdfunding companies, and do your diligence as an investor as you would with any other investment product. Overall, if done correctly, this is a great vehicle to get direct access into real estate investments.

Powderly: As a CCIM-founded company with deep expertise in the investment real estate market, CrowdStreet knows how to evaluate sponsors and deals prior to posting them on the marketplace. Once an investment is made, investors receive regular updates via an online investor room where they track all of their active investments. Investors, for the first time ever, are empowered to build a diversified commercial real estate portfolio without high middlemen fees or the management responsibilities of direct ownership.

The future of commercial real estate capital raising is online. I’m proud to have applied my CCIM knowledge and network in the creation of CrowdStreet.

What are the due diligence requirements for investors on crowdfunding deals?

Braman: At Realty Mogul we underwrite very similarly to how a conventional lender underwrites a deal. We look at the strength of the sponsor and its track record in the same asset class and market. We look at the market to see if the fundamentals are there and the trends are positive. We look at the asset and how it has performed historically in the past and add stressors to future performance. And finally, we look at the deal structure proposed by the sponsor to see if it is favorable to our investors and something that will sell on our platform.

Hooper: Of utmost importance — and this is an area that I fear many investors don’t spend enough time and attention on — is doing their diligence on what the collateral of their investment is. What are they actually investing in: the real estate or a synthetic investment product that’s been structured by the crowdfunding company? If the crowdfunding company fails, what happens to their money? A lot of the crowdfunding companies are now offering “property dependent notes,” which, for investors, provides no security to the underlying asset. At RealCrowd, we believe that 100 percent of investor dollars should be invested in the actual real estate, not invested into a crowdfunding entity that bleeds fees and doesn’t provide direct ownership of real estate to the investors. Beyond that, it’s customary due diligence: who is the sponsor, what’s its track record, are its projections reasonable, and what has it done during the last downturn.

Powderly: Since our sponsors are best in class, they are professionals at due diligence and underwriting. Therefore, when we request due diligence documents, we often receive a full set of documents that are then uploaded to a property posting for investors to view. CrowdStreet follows a professional due diligence process based on industry best practices. If necessary, we will hire third party consultants to help us complete due diligence on a sponsor’s project. We’ve had success partnering with CCIMs in secondary and tertiary markets where they are the local experts.

When it comes to the investors, we build relationships with our investor members. It’s important to us to understand their investment goals, so we survey their investment preferences and maintain regular contact with them. The success of our individual investors and the health of our overall investor community are of paramount importance to CrowdStreet.

What are the investor exit strategies on crowdfunding deals?

Braman: The beauty of a platform like Realty Mogul, as opposed to a fund, is that we don’t have required end terms. With a fund, you might have to sell even if the market is not positioned for that to be the best investment decision. For us, we ask for the sponsors to give us an estimated hold period of three, five, or 10 years. We underwrite to the estimated hold period, but if it is not in the investors’ best interest to sell, we will allow our sponsors to hold longer. Alternatively, if the sponsor gets an amazing offer to sell one year into the hold they have the flexibility to do that as well.

Hooper: Right now, most exits are determined by the real estate sponsor according to the business plan for the asset. On some of the funds that have raised capital through our platform the investors enjoy quarterly redemptions (meaning they can request their initial capital to be repaid quarterly). Eventually we will



Marketplace Misuse?

Common reasons for cap rate variations often come from the income stream and operating expenses used in the rate’s extraction. Failure to consider the likely future income of the property (year one pro forma) does not follow the principal of anticipation. The historical and current operating data is useful when developing a projection of year one data, but should not be used in the extraction of a cap rate when applying it to year one projections. Extracting a cap rate from market data using historical income and applying it to the year one projection of the property being valued will result in an incorrect value opinion.

Real estate is often considered a hedge against inflation due to the ability to increase rents at or above the rate of inflation. In an upward trending market the buyer of a property is expecting next year’s income (year one) to be greater than the trailing year to account for appreciation. Extracting a cap rate from the in-place income (less risk) and applying it to the future income projection (more risk) will overvalue the property.

In addition, the same method of income and expense projections used to extract a cap rate from the market should be used to value a property. Using a different income stream from a comparable property (not stabilized, no third-party management, no replacement reserves, under market operating expenses, and such) will result in a different risk profile of the income stream and corresponding cap rate.

Many market participants do not include replacement reserves as an above-the-line (net income) expense when developing cash flow projections. Replacement reserves

Cap Rate Variations Everyone in real estate knows how to calculate a cap rate — or do they?by Daniel Kann

Commercial real estate professionals live and breathe capitalization rates. Every trade publication, market participant, and third-party report relating to real estate quotes cap rates for various markets and properties. But ask a group of real estate professionals to calculate a specific property’s cap rate and you are likely to get a variety of answers — despite the simplicity of the formula. If cap rates are widely used and easily calculated, then why does everyone come up with a different answer?

This article looks at the underlying reasons for cap rates variations, ranging from different uses by market participants to different methods of cap rate extraction. While CCIMs are trained to extract cap rates in a certain way, not all market professionals use the same criteria. Understanding how such variables can affect the cap rate and the value of a property is just as important as developing — and using — a consistent method of cap rate extraction.

Cap Rate Overview

A cap rate in its simplest form is a return on an investment based on the principle of anticipation. Value is the present worth of future benefits. A cap rate attempts to quantify the risk profile of the future benefits. It is calculated by using a non-complex formula, R=I/V, where I is the net operating income and V is the value of the property. In more complex terms, a cap rate measures a single-period, unleveraged rate of return on a real estate investment. By converting income into value, a cap rate expresses the relationship of one year’s income and value.

A cap rate’s three main components are net income, property value, and the rate of return. If two of the three variables are known, the unknown variable can be extracted through a simple calculation.

Granted, different types of cap rates exist — overall, terminal, equity, mortgage, building, and land — which may cause some confusion among market participants. The overall rate, or OAR, is the cap rate applied to both the land and building and is the most commonly used rate by real estate professionals. A cap rate is essentially a dividend rate, so one could call the mortgage constant a “lender” cap rate and a cash-on-cash an “equity” cap rate. However, in commercial real estate transactions, brokers and investors tend to focus on two cap rates: acquisition and disposition.



for future capital expenditures are market specific. Including or excluding replacement reserves will have an impact on the cap rate extracted from the sales transaction, but not the value of the property. Neither method is incorrect as long as the same method is applied to the property being valued and the sale comparable. If the sale comparable does not include replacement reserves in its pro forma projection, and the subject does include replacement reserves in its year one projection, the market extracted cap rate must be adjusted downward to reflect a riskier income profile of the sales transaction comp when compared to the asset being valued. If no adjustment to the cap rate is made, then the subject will be undervalued due to differing risk profiles. Properties that do not include replacement reserves have increased risk due to the lack of a sinking fund for future capital expenditures.

In other words, the NOI needs to be “clean”: One cannot compare an NOI with deducted reserves above the line with one deducted below the line.

Owner-Managed Properties

Another common misconception concerns third-party management fees. Small properties or ownership entities that have a built-in management company often do not include third-party management fees in their pro forma. Having a third-party management company manage an asset may reduce the operational risk of the property and can result in a lower risk profile of the future income stream. A lower risk profile results in a lower cap rate. Table 1 shows how excluding third-party management fees impact the year one return and risk profile.

As Table 1 reveals, a 7.5 percent cap rate is appropriate if the property pro forma includes expenses for third-party management fees. Based on the projected NOI and market extracted cap rate, a value of $1,666,667 is indicated. If the same property does not include management fees in the pro forma projection, the value of the property is unchanged, with the risk adjusted cap rate increasing to 8.1 percent.



quoted by brokers in third-party surveys for marketing purposes, to 6.48 percent, based on using year one projections. All of the extracted cap rates are correctly calculated. However, the difference in rates is attributed to varying risk profiles of the income stream. Based on the provided example, adjusting just one variable can result in a 13.68 percent difference in value. If additional variables are included, the spread between the cap rates can widen and further magnify the miscalculation.

While there is a simple formula for finding the cap rate, there is no standard method for cap rate extraction. Various markets and market participants apply different income and expenses projections when calculating NOI. However, a standard method for extracting a cap rate from market data is critical to properly value a property. Not all NOIs have the same risk profile. A property that includes third-party management and replacement reserves will have less net income, a lower risk profile due to adequate third-party management, and appropriate funds for future capital expenditures — and result in a lower cap rate. Regardless of the variables included or excluded in the cap rate extraction, if applied consistently to the property being valued, a reliable estimate of value will result.

The Cash Flow Analysis Worksheet used in CCIM classes shows reserves below the NOI line, so CCIMs need to pay careful attention to the components of NOI and make sure that the NOIs of comparable properties are calculated in a consistent manner. A thoughtful CCIM will re-construct NOI to be consistent and will know enough about cap rates in the marketplace and expense ratios, vacancy, and market rents to sense if adjustments are necessary to an advertised NOI.

This is why it is necessary for potential buyers to reconstruct NOI to include such items as property management. The increase in the cap rate is to account for increased risk due to the lack of professional third-party management. Additionally, real estate is considered to be a passive investment with the opportunity cost of the owner’s time requiring compensation through a management fee or higher rate of return.

Expense Comparison in Sale Comparables

Comparing the operating expenses used in a sale comparable to extract a cap rate is a good indicator if the cap rate is market driven. A sale comparable that is owner managed and does not include reserves will have below-market expenses on a per unit comparison (percentage of effective gross income, per square foot, per unit, and such). A comparison of the expenses from the sale comparables to industry standards used in the local market will allow the analyst to adjust the extracted cap rate accordingly and then apply the revised cap rate to the property being valued. If a data set of comparable sales indicates a wide range of cap rates, then it is likely that one or more of the sales is not based on market derived income and expenses.

Impact on Property Valuation

Table 2 shows how various income and expense projections can impact the extracted cap rate and the asset’s value indication. For purposes of this analysis, only one variable has been adjusted. In actuality, a sale comparable will often have multiple variables that need to be adjusted in order to accurately extract a cap rate.

The Table 2 example reports a market extracted cap rate that ranges from 5.70 percent, based on the asking price commonly



Structuring Assets

The second step involves the proper structure in which to hold real estate. For investment properties, it is highly unusual to hold them in an owner’s personal name. Holding property in one’s personal name or jointly with a spouse places personal assets and other investment properties at risk if a lawsuit results in damages being awarded. Thus, investment real estate is typically held in a corporation, a limited partnership, or a limited liability company. Transferring title to one of these entities will provide some insulation from lawsuits.

Since the early 1990s when legislation providing for the formation of LLCs was enacted in all states, the LLC has become the structure of choice for many real estate holdings. The key features of a LLC are that owners are called members and no member is personally liable for the obligations of the LLC. The LLC can elect to be taxed as a partnership with items of income or loss flowing through to the members’ personal tax returns. If it is structured as a single-member LLC, the LLC can be disregarded completely for tax purposes. The income is included on an individual’s personal return.

Another benefit is that an LLC is not required to maintain records such as minutes, bylaws, or shares as is required of a corporation, so there is no chance of piercing the corporate veil for failure to follow prescribed formalities. Each state’s legislation is specific on the required steps to create and use an LLC, so local legal assistance is necessary.

When a property is owned by an LLC, only the assets of that LLC can be used to satisfy a claim. Other assets are protected. This is important as it allows individuals to hold real estate without exposing other assets to risk. When multiple properties are involved, although more costly, it may be worthwhile to hold each property within its own LLC in order to isolate each property from the liability of other properties. In some states it also is possible to establish a series LLC that is designed to protect each property within a single LLC.

Other strategies can be enacted with legal help. For example, property may be titled in a land trust with an LLC, corporation, or limited partnership plus corporation as the beneficiary of the land trust. Thereafter, a living trust may receive the property upon the owner’s death. Use of multiple layers requires the use of an attorney who is an expert in asset protection planning.

Finally, domestic asset protection trusts are currently permitted under the laws of a number of states. These are typically established by wealthy individuals and those in high risk occupations, such as doctors and real estate developers, due to their net worth.

In all cases, investors should consult a personal legal adviser for guidance on asset protection strategies. These strategies should be tailored to their personal situation and needs.

Real Estate Asset Protectionby Mary Stark-Hood, JD, CFP

Ownership of real estate has many benefits from an investment and tax standpoint. There is downside risk, however, since the value of real estate holdings may be significant and can be used to cover damages awarded in a lawsuit. Therefore, it’s important to consider asset protection strategies relating to real estate holdings in order to minimize such risk.

Insurance

Asset protection planning is a way to reduce exposure to future lawsuit risk. It encompasses insurance and how real estate is titled to make it and other assets less vulnerable to the claims of individuals who may sue in the future. It is about pre-emptive planning.

The first place to start is with the property itself. Whether it is a single-family home, a portfolio of apartment buildings, shopping centers, office buildings, an industrial complex, or undeveloped land, make sure the property is adequately insured for its type and its use. Occurrences associated with the property, such as injury to a tenant or delivery person, employees, fires in the building, or breaking and entering, may cause an owner to be sued. Therefore, consult with an insurance professional on possible areas of exposure and insurance needs based on the type of property owned and its current use. Also discuss coverage, costs, and limits for business liability insurance and umbrella business liability insurance. Since real estate investors are easy to identify, easy to sue, and appear to have deep pockets, being adequately insured is a necessity.



Seeking BalanceConstruction loans present unique circumstances for lenders.by Joel C. Solomon

As the economy recovers from the Great Recession, construction lending is slowly resuming its place as an important component of real estate lending. For example, in Chicago, there has been a flurry of multifamily developments, and currently two major office projects are under way. And in secondary markets such as Cleveland and Kansas City, entrepreneurial developers are undertaking challenging adaptive reuses by converting vintage office buildings into hotels and condominiums. Clearly construction has returned and with it, the construction loan.

Apart from the many nuances of the different product types, a construction loan is unique because the loan is for something that does not yet exist. The developer must create a cogent business plan that will withstand a lender’s underwriting. The lender must negotiate big-picture loan terms with the borrower and underwrite the feasibility of the ultimate project and its economic value.

By the time a loan closes, the lender and the developer have typically finalized many critical-path items including an agreed-upon budget. The loan agreement will require post-closing lender approvals for anything not final at closing. Therefore, if the basic plans of the project are in place but key items such as finish standards are not finalized, lender approval must be required as a funding condition. Other funding hurdles, such as orderly draw requests with lien waivers and architect’s sign-offs, help the lender control the process.

Notwithstanding its approval rights, a lender is contractually obligated to fund the loan provided the borrower is in compliance with the loan agreement conditions. Recently, a California jury reached a $39 million verdict against East West Bank, finding the bank breached its construction loan agreement. That action forced the family-owned developer to default on the loan, which eventually led to foreclosure.

Change Orders

Change orders are part of the construction process, and they occur for a number of reasons, including overly aggressive contractor bids, inefficiencies in design/build projects, material cost increases, cost estimates that prove to be wrong, and developer or end-user requested changes.

Change orders usually mean increased costs and the risk that the project could go over budget. Change orders may also reduce the costs of the project through value engineering with either seen — the lobby or pool build-out — or unseen — the heating and air conditioning system — changes.

Loan-in-Balance Provisions

The ultimate protection for a lender is the requirement that the loan remain “in balance,” meaning that the unfunded loan is sufficient to complete the project.

The budget expresses the project’s cost. It accounts for everything required to transition from concept to finished project, including leasing costs and operating deficits for multifamily projects; marketing costs for condominium projects; tenant improvement costs and leasing commissions for office projects; and furniture, fixtures, and equipment costs for hotel developments.

To the extent that change orders increase the overall cost, reallocating savings from other line items or contingencies provides the borrower flexibility. Soft cost contingencies are for overruns from expenses such as fees for architects and engineers, building permits, and utility access; real estate taxes; leasing commissions; and sales and marketing costs.

Even with reallocations of line item savings and contingencies, it is always possible that change orders or erroneous budget assumptions create concern that the undisbursed loan proceeds will not be sufficient to complete the project and pay off the borrower’s obligations. If that occurs, a lender relies on the right to declare a loan “out of balance.” Effectively, the lender can declare a default based on its conclusion that the undisbursed loan will not be sufficient to complete the project.

An ideal loan-in-balance provision provides that the loan shall be in balance only when the available source of funds equals or exceeds the lender’s estimate of remaining costs (a global budget analysis) and each budget line item is sufficient to pay the costs of the line item (a line item analysis).

Because the lender needs to rely on firm, defensible criteria before asserting that a loan is out of balance, the available source of funds should incorporate the remaining unfunded loan, the unfunded contingencies — to the extent available — upgrade deposits, tax deposits, and any other sources of funds for the borrower. The definition of “lender’s estimate of remaining costs” should contain objective criteria that a reasonable lender may rely on to determine what remains unpaid. Suggested factors include pending and expected change orders, contractor or supplier claims for additional amounts, and the effect of anticipated or actual delays.

A declaration of out-of-balance default allows a lender to institute default rate interest and stop funding. Such remedies clearly create a make-or-break situation for a borrower/developer. The lender must be in a fully defensible position by having objective evidence if it seeks to declare an out-of-balance default.

Developers and lenders are aligned in the goal of a successful project delivered on time and within budget. Reasonable approval rights account for the evolving nature of a construction loan. A well-developed budget and objective criteria governing its use provide for the possibility that a complex plan does not proceed exactly as the original budget anticipated.



auction, 14 qualified bidders were at the table. After 13 hours of spirited and contentious bidding, the properties sold for more than $30 million. Proceeds from the real estate sale along with the sale of the operating business yielded nearly $66 million, which enabled the estate’s secured creditor to be paid in full.

A Sale Scenario

The degree of interest in acquiring a bankrupt company, either by a strategic buyer such as a competitor or a financial buyer such as a private equity firm, is often influenced by real estate. In many cases, the potential acquirer plans to maintain operations in the buildings, but does not want to be in the real estate business or simply does not want to use additional capital to buy the buildings.

By structuring new leases based on go-forward tenancy in the building, a valuable asset for the estate is created, which enables the debtor or the acquirer to offer a fully leased building to the investment marketplace.

Based in suburban Chicago, Qualteq was a market leader in manufacturing plastic credit and gift cards for companies such as American Express, Visa, and MasterCard. The owner’s personal financial difficulties forced Qualteq into Chapter 11 in 2013. The bankruptcy trustee and his financial advisers first stabilized the company, then sold the business to Brazil-based Valid S.A. through a Bankruptcy Code Section 363 bankruptcy sale. However, Valid had no interest in purchasing the four buildings Qualteq occupied.

Working in tandem with the bankruptcy trustee and advisers, Hilco structured new, five-year leases on each of the four buildings with Valid as the tenant, based on the strong balance sheet that was created with Valid’s purchase, enabling Qualteq to continue operations in their current facilities.

Prior to the finalization of the new leases and with no certain commitment from Valid to remain as a tenant, there was no immediate interest from the real estate investment community for four potentially vacant industrial buildings. Once the new leases were finalized, the leased buildings were then put through a sale process by Hilco, which garnered significant interest from third-party investors. Stalking horse bidders were obtained for each property, followed by an auction. Hilco estimated the four buildings, on an empty basis, were valued at approximately $10.5 to $12.5 million. When the gavel came down, the auction resulted in total sales of almost $19 million for the four fully occupied buildings.

Utilizing the real estate as a vehicle to enhance value further ensured that the estate achieved maximum value of the Qualteq business/assets and helped to secure a successful transaction with Valid. Furthermore, the added value created by selling buildings occupied by a quality credit tenant resulted in sufficient proceeds to fully pay all mortgage holders.

Whether a company in Chapter 11 reorganizes and exits from bankruptcy on its own or is acquired by a strategic or financial buyer, the real estate occupied by the business can be transformed into a value enhancer. By recasting leases with a strong tenant and aggressively marketing the properties, a significant amount of incremental cash can be generated to benefit the bankruptcy estate in a reorganization and/or a going-concern sale. In bankruptcy, debtors and creditors should regard companies’ real estate as a value-creation tool, not an illiquid liability.

Creating Value Use real estate leases effectively in Chapter 11 situations. by Joel H. Schneider

Owner-occupied real estate can be an untapped source of balance-sheet value for bankrupt companies. Such real estate assets provide a potential catalyst for exiting bankruptcy successfully or a financial carrot to motivate prospective strategic or financial buyers.

Currently, real estate investors are clamoring for stabilized properties occupied by creditworthy tenants. The competition for income-producing real estate assets has caused capitalization rates to nosedive in recent years. Today, properties in many real estate categories, such as industrial, are priced at cap rates below the 2007 peak.

This article reviews two cases where bankrupt companies enhanced the value of their owner-occupied real estate. Through new lease agreements that included higher rents, reimbursement of expenses, and multiyear lease terms, substantial cash flow streams were created. The properties were then marketed via auctions to maximize recoveries, and sale proceeds were used to expedite the reorganization process, satisfy creditors, and/or hasten the successful sale of the go-forward enterprise.

A Reorganization

Giordano’s, the Chicago-based deep dish pizza retail chain, filed Chapter 11 bankruptcy in 2011 after defaulting on approximately $45.5 million in loans.

As part of the filing, the company listed 20 parcels of owned real estate associated with corporate and franchised restaurants. Of the 20 parcels, 10 were considered operationally significant to the go-forward business, including a high profile 139,000-square-foot mixed-use property that served as the company’s corporate headquarters and flagship restaurant location. One of the keys to this situation was to position the Giordano’s real estate to take advantage of a re-capitalized corporate balance sheet to encourage buyer interest in buildings occupied by a ”reconstituted” Giordano’s.

Hilco Real Estate worked with the debtor to restructure the company’s leases to make them more attractive and marketable, while concurrently crafting a plan to market the properties to the largest possible real estate investment market. Prior to the lease restructurings, initial bids for the real estate had yielded offers around $20 million. When the newly leased properties went to



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Katherine Williams Kane at: 603-502-2174

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