Dealing with distressed real estate



FW moderates a discussion about distressed real estate between Jacqueline A. Weiss at Arent Fox, Keith M. Brandofino at Phillips Lytle LLP and John S. Mairo at Porzio, Bromberg & Newman, P.C.

FW: Broadly speaking, in what ways have you seen the real estate market change over the last few years? 

Mairo: In the commercial real estate arena, we’ve seen many tenants seek bankruptcy protection because of the down economy. As a result, landlords must decide whether to agree to reduced-rent terms and keep the tenant, or go out and find new tenants. My experience is that commercial landlords are willing to work things out: a paying tenant in the hand is worth two in the bush. In light of these realities, lenders to commercial landlords have been willing to work with their borrowers, for example to ‘extend and pretend’. However, since an economic recovery is not around the corner, there is a good chance that these restructurings or extensions will be resurfacing in the next few years. In the residential world, there seems to be some shifting. While previously banks were more willing to do workouts or hold off from foreclosing, there appears to be more focus now on pursuing foreclosures. Indeed recent reports showed that banks repossessed more than 1 million homes in 2010, with 2011 figures expected to be even greater. Although there is a rising tide of scrutiny on banks and their foreclosure procedures, this has only temporarily halted the number of foreclosures.

Brandofino: Property values in 2010 and 2011 have fallen far below the predictions relied upon at the height of the real estate market. Prior to 2007 there was a false belief in the real estate industry that no matter what the purchase price for the property was, the property would nevertheless increase in value. As a result, real estate investors often acquired property at prices well beyond the true worth of the property because they mistakenly relied on assumptions that proved to be grossly optimistic. In some instances, investors and lenders were operating under the assumption that the property had a capitalisation rate of less than 4 percent, allowing borrowers to obtain significant debt. However, such forecasts proved untrue and in many instances, the rental income generated by the property has been insufficient to support the debt service. Illustrative of this is the well-publicised acquisition of New York City’s Stuyvesant Town and Peter Cooper Village. In 2006, a group of investors purchased the 11000 apartment complex for $5.4bn. Based on an apparently overly optimistic forecast, the purchasers obtained $4.4bn in debt. In 2010, the investors were unable to meet their monthly debt service obligations and a foreclosure action was commenced. It is now widely believed that the buildings are worth a total of $2bn.

Weiss: The real estate market has gone from irrationally overheated, say, through 2007, to being perceived as the cause of many of the ills of the national economy in 2008, to a net neutral in the overall economy for much of 2009, and beginning in the final quarter of 2009 and continuing more strongly in the opening weeks of 2011, to a net positive. Based on the, admittedly small, sample of transactions we are seeing and that have been reported over the last three or four months, investors’ appetite for real estate – and therefore the pricing of real estate assets – is starting to increase.

FW: Has the uncertain economic climate led to a rise in contract and lease disputes?

Brandofino: While I am unable to say with any precision that there has been a rise in lease disputes because of the economic climate, I can confidently state that there has been a significant shift in the parties’ bargaining positions. During the height of the real estate market, a landlord had little reservation about taking a hard line in a dispute with a tenant, regardless of payment history. Landlords were emboldened with the belief that their space could be re-let with any of the myriad of businesses looking for space. Since 2008 landlords have no longer had the confidence that their space can be re-let easily. Quite the contrary, many landlords now find themselves fortunate to have a paying tenant. As a result landlords are more inclined to cooperate with the demands of a paying tenant.

Weiss: Although most real estate professionals expected that the number of contract and lease disputes would increase with the uncertain economy, this has not been the case as a general rule. While there have been some very notable defaults that have been reported, and certainly a fair number of deal terminations as a result of parties to agreement simply going out of business, there has not been the sort of wholesale contentious workout, renegotiation and litigation that everyone expected. Much of this has to do with the fact that lenders are reluctant to exercise remedies – and therefore are more willing to extend and forebear; that landlords have not until recently had multiple creditworthy choices to replace defaulting tenants and therefore have also been willing to work with tenants in financial trouble; and that many borrowers and tenants are not willing to simply walk away from properties unless forced to do so. It will be interesting to see if the improvement in the economy generally, and the uptick in the real estate market, will have the effect of actually increasing the velocity of real estate disputes.

Mairo: Without sufficient income, borrowers default on their contracts/leases and creditors come to collect. But the uncertainty in the economy has also led to intentional defaults, such as borrowers choosing not to make mortgage payments when their building or home is under water. Lenders and landlords have their contractual rights to repayment and interest. Even more stable borrowers, or tenants, have sought to take advantage of the ‘buyer’s market’ by seeking reductions of their payment, or rent, obligations.

FW: How are lenders responding to problems in the real estate market? Are they pursuing foreclosure and bankruptcy proceedings or leaning towards workout solutions wherever possible?

Weiss: Most lenders have opted for a workout solution if possible. Many of us have variously referred to this as ‘extend and pretend,’ ‘forget and forbear,’ or even ‘kick the can down the road’. This trend is based, in part, on the fact that few lenders wish to take real estate on their books and to deal with the regulatory and economic consequences of doing so. Another part of the issue centres around the fact that there has been no resale market and therefore no independent basis on which to value the real estate assets in question, which in turn makes it hard to take the real estate on the books.

Mairo: The answer here depends on many factors, including the financial status of the lender and pressures the lender is under. Other key factors are the quality of collateral at issue and the credibility of the borrower. If a responsible borrower with valuable collateral presents a feasible solution, then a reasonable lender is normally willing to avoid a foreclosure or push a borrower into bankruptcy. Banks are in the business of lending money and being paid back; typically they don’t want to take over the borrower’s business with its attendant risks and potential liabilities. While pushing the sale of the defaulting borrower’s business can be an option, in today’s market there is no assurance that there will be buyers; thus, workout solutions are often the chosen path.

Brandofino: In 2009 and 2010, I did not see the dramatic increase in commercial foreclosure filings that I expected given the economic downturn. It appears that many lenders and servicers of securitised debt were retaining the loans longer in order to attempt a workout solution. Each loan has its own peculiar set of factors, which determine the exit strategy. In some instances, it may be appropriate to enter into a forbearance agreement, whereby the borrower is provided with a fixed amount of time to cure a default. In other instances, it may be in the lender’s best interest to accept a discounted payoff of the debt because the income generated by the property cannot sustain the debt service for the foreseeable future and/or the property value has declined so significantly that the lender will not realise a recovery at or near the amount of the debt. Commencing a foreclosure proceeding is viewed by many lenders and servicers as an option of last resort. The reluctance to foreclose is due in large part to the expense and the length of time a foreclosure takes to complete. However the foreclosure process can provide a lender with very powerful tools when dealing with a recalcitrant borrower.

FW: In a distressed situation, at what point should interested parties consider taking control of property income by appointing receivers? What factors should be taken into account when selecting a receiver?

Weiss: The decision to cause a receiver to be appointed is a complicated one for most lenders. On one hand, the property is out of the hands of a defaulting borrower, and therefore the borrower’s natural leverage is decreased. On the other hand, the receiver is a fiduciary not of the lender, but of the property. As a general rule, receivers are not supposed to do the lender’s bidding and many times do not consult with the lender before acting. Moreover, as a fiduciary, a receiver may decide to take actions with respect to a property that will ‘protect’ the property, but will also actually reduce the cash available to repay the lender. As a result, a lender should seek to cause a receiver to be appointed in cases in which the borrower in question is committing waste or improperly siphoning off funds, or the imposition of a receiver is necessary to perfect the lender’s security interest in the rents or the property itself.

Brandofino: Once a lender has decided to foreclose, I typically recommend to my clients that they should seek the appointment of a receiver simultaneously with the commencement of the action. A well-drafted commercial mortgage will grant the mortgage holder the right to seek the appointment of a receiver on an ex parte basis. This allows a lender to submit an application without notice to the borrower and avoid a protracted fight on an absolute right granted to the lender. Once a receiver is in place, he or she removes control of the mortgaged property and the cash flow from the borrower. A receiver in place will surely get the attention of the borrower. In the past, the receiver appointed in a foreclosure action often had little or no real-property management experience. As a result, the receiver would seek permission to hire a property manager. Both the receiver and property manager would then draw fees from the rents, which often times left little or no cash flow to satisfy the debt, let alone maintain the property. New York State has established a set of rules aimed at ensuring the appointee has the necessary qualifications for the appointment. To this end, New York State maintains a database of qualified appointees, both lawyers and non-lawyers, from which a receiver is to be appointed.

Mairo: Receiverships are best used to protect a corporation’s assets for the benefit of creditors. Interested parties must be cognisant, however, that receivers are entitled to compensation, which is taken from money that could otherwise go to creditors. Thus, when considering the need and potential benefits of appointing a receiver, creditors must weigh the costs. In New York and New Jersey, receivers are appointed, but movants can propose suggestions to the court. In this regard, creditors should look for receivers with experience, integrity, thoroughness, and reasonable rates.

FW: Recently a US Court decided that a foreclosing party must establish that it has an assignment of mortgage. What implications could this decision have in the CMBS arena, where loans are transferred regularly, often without the correct documentation in place at the time of the foreclosure action?

Mairo: The biggest implication, I believe, involves more of what we’ve already seen: banks will have to slow down the rate at which they bring foreclosure actions. These banks will have to carefully ensure and verify that they actually own the mortgages and have standing to sue. Going forward, I’d imagine that entities selling loans in the CMBS arena will make sure that they have been properly assigned rights to the CMBS; however, trades that have already occurred must be thoroughly scrutinised before foreclosure actions are brought.

Brandofino: At the outset it must be understood that courts are loathsome of the foreclosure process, whether it be residential or commercial. This coupled with the efforts of borrowers’ counsel to find ways to prevent foreclosures has revealed what appears to be the Achilles heel of the CMBS market – evidence of the ownership of the loan being foreclosed. In what appears to be the latest assault on lenders, on 7 January 2011, Massachusetts Supreme Judicial Court in US Bank National Association v Ibanez, 10-005-11 upheld lower court decisions in that state vacating foreclosure judgments where the mortgage holders failed to demonstrate that they were the proper party in interest at the time of the foreclosure. This decision, as well as others throughout the US, provides a basis for borrowers to attack the foreclosure actions commenced against them, even where the default is indisputable.

FW: Would you say there has been an increase in acquisitions and disposals of distressed real estate over the last 12 months or so?

Weiss: Yes, there has been some increase in the number of acquisitions and dispositions of distressed real estate. The increase in activity may be due in large part to the general economic recovery. As more investors have confidence in the market – or at least perceive that we have hit bottom – more money is available to acquire assets and therefore distressed owners and borrowers, or their lenders, can finally find someone to acquire the asset at something other than a ‘bargain basement’ price. Interestingly, as the amount of available investment capital accumulates on the sidelines, the number of potential bidders increases, which in turn means that there is market competition and resulting mini-bidding wars over properties that do come to market. This in turn seems to be causing more properties to come to market in this way.

Mairo: Distressed situations can present opportunities for above-market returns for lenders and investors, and our current economy is no exception. As financial institutions try to clean-up their balance sheets, acquiring or divesting distressed real estate is surely a big help. Lenders not in the long-term game are likely interested in disposing of distressed property and related notes/loans, albeit at a discount, and letting another entity deal with the collection headaches. But others may be more optimistic in the market’s future and will hold onto these properties/debts. If they can weather the storm, then they’ll be in a better position when the sunshine returns, which may not be for a while.

FW: What valuation challenges are tied to determining the true value of a distressed property? What are some of the different valuation methods that can be applied?

Brandofino: Often when the borrower has defaulted, they go into hiding and do not respond to the lender’s inquiries, including requests for current financials. Without this information, the lender’s ability to accurately assess the current value of its collateral is hindered. As a result, a lender of a distressed property is often left relying on dated rent rolls and an inaccurate schedule of operating expenses. To avoid this, it is important that the lender be proactive during the performing periods to obtain regular financial information. In determining the value of the property, a lender can rely on the following types of valuations. First, the cost approach, which combines the value of the land and depreciated site improvements with the depreciated value of the building. Second, the sales comparison approach, which compares the property to others and adjusts accordingly for differences between the properties. Finally, the income approach, which looks at market rents, subtracts a vacancy allowance and expenses for the property, and then takes the resulting net income and applies a capitalisation rate to determine value.

Mairo: Among the various methods for determining value is the sales-comparison approach. In today’s thawing economy, however, challenges to this method do present themselves. For example, with many properties not selling or selling only via short sales, accurate comparables are often not available. Consequently, market value is difficult to determine because many sales are often conducted at forced-value. Concurrently, the so-called cost-approach method, which is reliable for newer structures, becomes challenging as fewer properties are being developed. In light of this, appraisers seem to have more discretion with their valuations, which in turn increases the likelihood of valuation contests.

Weiss: I am not certain anyone can measure the ‘true value’ of distressed property at the moment. Traditional valuation methods based on rent rolls, which are depressed or impaired due to lease forbearance arrangements, or comparative sales, of which there remain few so far, are not really accurate in the current environment. Increasingly, I am seeing parties put out feelers in the marketplace, and allowing market interest to inform the value. To say this differently, even if traditional valuation methods suggest that a property has a value of ‘X’, if willing buyers in the marketplace are only willing to pay ‘X minus 10’ then the value at that moment in time, if exigencies force a transfer, is X minus 10.

FW: To what extent is it possible to realise value in distressed real estate assets by adopting creative solutions and evaluating new opportunities?

Brandofino: One way that lenders can try to increase the realisation of a distressed property is to strategically market the foreclosure sale of the property. In New York State, foreclosing lenders are required to publish a notice of foreclosure sale once a week for four weeks (or twice a week for three weeks) in a newspaper of general circulation. The publication in which the notice of sale must appear is dictated by the court. For reasons that I will not go into here, there are a limited number of periodicals that the courts will utilise. Because of this, there is often a narrow audience that will learn of the foreclosure sale. This audience is often comprised of investors that regularly scour the foreclosure notices looking for property that can be purchased far below market value. In order to expand the pool of potential bidders, I recommend to my clients that they advertise the foreclosure sale in other periodicals with the intent of targeting different audiences. Also, depending on the nature of the property, the foreclosing lender may want to consider scheduling the sale at an optimal time. For example, if it is beach front property, consider noticing a sale during the summer months as opposed to the winter months when there is little or no interest in purchasing beach front property. Finally, there may be certain circumstances where it is advisable to engage a real estate broker to assist in the marketing of the property.

Weiss: Real estate has a very long and proven track record of producing superior returns on investments over the long term, even in weak economies. For buyers who do not require leverage to acquire real estate assets, now may be a particularly interesting time to ‘go shopping’. Uncertain markets result in depressed prices, which mean that high quality assets – at least based on traditional valuation methods – are available at attractive prices.

Mairo: One creative solution that we’ve seen are well organised and publicised real estate auctions, which might not generate the most lucrative results, but can be used as a way to move stagnant collateral, pay off the lenders and possibly get guarantors off their guaranties. For instance, take a developer of a multi-unit property that was only partially sold-out when the economy crashed and now there are debts to pay and seemingly few buyers for the remaining units. A Chapter 11 bankruptcy that implements a sale process for the remaining units can be the best solution. With a bankruptcy, the process will be open and provide certainty through a court sanctioned bidding process. Buyers are often attracted to an auction due to the sense of ‘getting a bargain’ and the benefit of obtaining an order from the bankruptcy court declaring them the owners ‘free and clear’ of all liens. Lenders can benefit from such a process because it can be the best way to liquidate their collateral in a controlled, expeditious manner, especially with the current backlog of foreclosures. Another practical opportunity that presents itself in this distressed environment is a rise in short-term leases. Landlords do not want good space to be tied-up for years at low rents, and tenants may be uncertain about their long-term business plans. By entering into short-term leases, both parties benefit – landlords aren’t locked in with low leases when the economy bounces back and tenants can meet their financial obligations and have the flexibility to accommodate a fluctuating market. Thus, even in these down times, a silver lining still presents itself.


Jacqueline A. Weiss is a partner at Arent Fox. She represents and counsels clients in all aspects of real estate law, including representation of institutional lenders and borrowers in single property and multistate financing transactions, securitised loans, construction loans, and mezzanine financing transactions; lenders, investors, and/or property owners in acquisitions, sales and development transactions; and secured and unsecured creditors and creditor groups in debt restructurings. She has extensive experience in intercreditor relationships and also heads the New York real estate practice group and co-heads the firm’s leasing practice. She can be contacted on + 1 212 457 5460 or by email:

Keith M. Brandofino is a partner at Phillips Lytle LLP. He concentrates his practice in the areas of banking and commercial litigation, including business disputes, restructuring of credit facilities and creditor’s rights. In addition, Mr Brandofino has specific experience in complex real estate litigation, including title claims, foreclosures and commercial leasing disputes. His expertise also includes representing parties in connection with franchise related conflicts. He can be contacted on +1 212 508 0457 or by email:

John S Mairo is a partner at Porzio, Bromberg & Newman, P.C. His practice concentrates on the areas of bankruptcy, workouts, financial reorganisations and creditors’ rights. He is admitted to practice in New Jersey and New York courts, and is certified in Business Bankruptcy Law by the American Board Of Certification. Mr Mairo has represented creditors’ committees, secured creditors, administrative agents for syndicates of lenders, debtors, landlords, equipment suppliers and other interests. He also has extensive experience in litigating preference and fraudulent conveyance actions. He can be contacted on +1 973 889 4107 or by email:

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Jacqueline A. Weiss

Arent Fox


Keith M. Brandofino

Phillips Lytle LLP


John S. Mairo

Porzio, Bromberg & Newman, P.C.

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