There are several broad categories to restructure and manage existing debt.
By Michael Criscito | February 20, 2024 at 04:42 PM
In the dynamic landscape of real estate, commercial real estate owners often find themselves facing financial challenges that necessitate a strategic approach to debt management. In such cases, exploring debt restructuring options becomes a crucial consideration. Property owners looking to navigate their way through financial uncertainties and emerge with a strengthened financial position have numerous options available.
Common reasons for debt restructuring
Prevailing market conditions have created an environment ripe for more potential defaults in commercial real estate and an increased number of distressed assets. While the post-pandemic slow return to the office has led to reduced demand for office space and decreased valuations of those properties, other challenges are motivating owners to restructure their debt as well. These include rising interest rates and tighter liquidity, the decline in brick-and-mortar retail that is plaguing malls, and the more complex financing scenarios for distressed properties.
Debt Restructuring Options for Owners
Several broad categories encompass ways to restructure and manage existing debt, to create a healthier balance between debt service and business results, and to strengthen the borrower’s financial position. Restructuring the loan with a lower interest rate or modified loan terms or refinancing existing debt with a new loan with more favorable terms can shore up cash flow. Other traditional options include:
Debt moratorium, consolidation, settlement, or debt-equity swap. These measures enable owners to temporarily reduce or suspend payments, combine multiple debts into a single, larger loan with a potentially lower effective interest rate, negotiate for a reduced debt amount, or convert a portion of the debt into equity for the lender.
Equity infusion from existing owners or external investors to enhance the borrower’s financial position and provide the necessary funds to repay or restructure debt.
Sale-related transactions to generate cash for debt repayment, such as sale-leasebacks or the sale of non-core assets.
Chapter 11 bankruptcy filing to effectuate debt reorganization while continuing operations under court supervision. This strategy may be limited depending on full recourse/bad boy carve-out guarantees.
In today’s environment where liquidity is scarce for certain asset classes, lending requirements have significantly tightened, and asset values have declined to a point where owners do not see a return on putting in new money under the current capital structure, the options may not be viable. More creative solutions are needed for owners to retain control of their assets. Some innovative ways to prioritize debt load, generate cash up front, or provide lender/investor equity as means toward stability are described below:
Rent Restructuring and Lease Modifications
Owners may want to work closely with tenants to explore rent restructuring options. Offering flexible lease terms or renegotiating rental rates can improve cash flow, making it easier to meet debt obligations. Owners may also consider creative lease structures, such as revenue-sharing agreements providing a win-win scenario for both parties.
Creating A/B structures
This more nuanced, strategic approach refers to a dual-class or dual-tranche structure that segregates and prioritizes different classes of debt or claims. It provides flexibility in treating different classes of creditors or stakeholders based on their contractual rights and priorities within the capital structure. This structure is typically implemented when the owner injects new capital into the property. The “A” piece represents the existing senior debt at some negotiated reduced principal balance, and the “B” piece represents the new capital injection. The new capital will support the project in multiple ways, including funding capital improvements and supporting revenue generation such as new leases, covering shortfalls, etc. The owner can negotiate for a certain return on their new money and agree to a sharing of net proceeds with the lender upon the eventual sale so that both parties ultimately maximize their respective recoveries.
Other solutions depending on the specific situation could include:
Revenue-sharing agreements link debt repayment to a percentage of future revenues rather than fixed payments, aligning the interests of both parties and providing flexibility during uncertain periods.
Licensing agreements for intellectual property or brand assets to generate new revenue streams.
Convertible debt instruments that give creditors the option to convert their debt into equity under specified conditions, which potentially improves the borrower’s capital structure.
Profit-sharing debt instruments enabling owners to structure debt agreements with profit-sharing components to creditors in addition to interest payments.
Social impact bonds are an option for a business with a socially impactful mission where investors provide capital and returns are based on the achievement of predefined social or environmental goals.
For property owners facing financial challenges, proactively exploring debt restructuring options is a prudent approach to safeguarding investments and ensuring long-term financial stability. By engaging in open communication with lenders, seeking professional advice, and strategically leveraging available options, owners can navigate the complexities of debt restructuring and emerge with a strengthened financial foundation in the ever-evolving real estate landscape.
Michael Criscito is a Senior Managing Director and Co-Leader of Real Estate Restructuring Advisory at FTI Consulting, Inc. Contact him at michael.criscito@fticonsulting.com.