There are economists who say the recession is over and the economy is poised to stabilize quickly and begin to rebound. But for some asset classes and submarkets, there are enough signs pointing to a downturn that could prove deep and long-lasting.
Currently, sponsors owning hospitality and retail are dealing with major asset-performance problems. Cooperation among lenders and owners and deferring current obligations is helpful. But if current conditions persist, stakeholders will need to undertake a review of their restructuring options. And though other asset-class owners such as multifamily and office have enjoyed decent—or “better-than-feared”—rent collections over the past few pandemic months, it is reasonable to consider whether this is sustainable. If collections have been assisted by federal stimulus programs, this current state of play may not last long enough to sustain some owners until the economy begins an upward turn.
Commercial real estate sponsors who start working now on contingency plans for their future capital needs will be better-positioned to weather a recession than those who allow a sluggish economy to overtake them with a “wait-and-see” approach.
The prudent path for sponsors, even those with assets that are currently performing, is to plan now. The likelihood of a better outcome increases with thoughtful and advanced planning, should fortunes turn.
At the outset, sponsors should review and audit their current and future capital needs. A broader economic downturn means higher vacancies, revenue declines and proportionately higher operating expenses. Capital for most asset classes has already tightened and will pull back further in response to a negative economic trend line. Even flat rents for just a couple of years and a lack of investment to maintain an asset, coupled with just a modest pullback in lending, can result in a refinance shortfall.
Downturns also create a more competitive environment among sponsors, as they compete for a smaller and more conservative capital pool. Whether it’s capital to repair or “right-size” a balance sheet, or to address more immediate needs brought on by an economic downturn, sponsors face the same challenge. A good restructuring plan, at its essence, is the sponsor’s road map, charting a course to accessing the necessary capital. The plan positions the sponsor with its lenders in order to pursue capital in an extremely competitive and demanding environment.
Here are five actions to take now that will provide the elements of a restructuring plan:
Assess company strengths and weaknesses
Weak markets expose vulnerabilities. Objective, critical self-assessment—evaluating strengths and taking stock of shortcomings—and understanding how the sponsor’s capabilities are viewed through the lens of a third party are necessary. The sponsor should be benchmarked against its peer set, which may also be its competition for capital. In addition to its operating capabilities, the sponsor’s understanding of its submarket, its asset class and its competition, and the ability to draw on meaningful insights into these aspects of the sponsor’s business are important foundations.
Take a fresh approach to the numbers
Revisit existing forecasts of revenue and occupancy assumptions, time frames, financing terms, contingent liabilities and equity terms. Sponsors should also review foreseeable capital needs and sources, such as property cash flows, unfunded debt, untapped business lines of credit and equity relationships.
Undertake scenario planning
Stress test the revised forecast to reflect a range of financial scenarios. In addition to revenue and expenses, more conservative debt assumptions should be applied. If a restructuring plan is needed, the sponsor will need the support of the key stakeholders, especially the lenders. To that end, the sponsor will likely need to demonstrate that its plan is anchored in an approach that has considered a range of scenarios.
Determine what’s needed to execute the plan
A downturn’s impact on property performance is obvious. The need to restructure, financially and operationally, may also be apparent. Less obvious are the challenges that this presents to the sponsor. This includes the need to change internal functions, shift responsibilities, and implement new systems, goals and practices.
In addition, renovation plans may need to be suspended if revenue growth needs to give way to revenue maintenance. And high turnover to attract new, higher paying tenants may need to be suspended to maintain occupancy and stabilize the property through the cycle. These operational and business strategy shifts are hard, require planning and are not usually executed overnight. Sponsors should be thinking about the aspects of their business that will need to make changes, in the event of a deteriorating environment.
Secure buy-in from all parties
Successful restructuring plans require the support of lenders, partners, employees, consultants and any other party that stands to be impacted by the restructuring. Achieving this buy-in requires the sponsor to articulate their operating strengths, demonstrate an insight into their respective markets, and instill confidence in their ability to execute a plan.
Often, a sponsor’s capital needs arise due to a refinancing shortfall, deferred capital improvements, or tenant improvement or leasing commissions. These can be significant, but not enough to threaten a sponsor’s ownership. What the sponsor needs most—absent an immediate source of funds—is time. Time for the crisis to dissipate, the sponsor to work the asset and to execute a plan. With planning, forethought and communication, the sponsor is best-positioned to secure the buy-in, maintain reasonable goodwill throughout the process, and get the time to execute the plan for the capital they need.
In the end, lenders just want to get repaid. Faced with a challenging market and a potentially impacted loan, lenders are looking for assurances that their sponsors are solid, transparent, and able to adjust their operations and their approach to reflect a challenging environment. Sponsors who build on their relationship with their lenders and instill confidence in their ability to manage through the cycle ultimately position their project to obtain the best available capital. Those who fumble or give little attention to what they are communicating risk losing their stakeholders’ support and the basic trust that is required when a restructuring plan is necessary.
Paul M. Fried is the executive managing director & head of equity capital markets at Greystone. Fried leads Greystone’s equity capital placement services. He and his team provide advice on structuring creative equity solutions and source institutional equity capital on behalf of real estate owners and developers across all commercial property types.