Maximising value in enforcement of development finance
January 2017 | EXPERT BRIEFING | BANKING & FINANCE
The current economic climate of low but potentially rising interest rates, increasing inflation, weak sterling, falling overseas investment and solvency concerns in the construction industry, poses multi-faceted risks to the real estate market, and in particular to those financing development projects.
The restructuring of a development site is significantly more complicated than a straight investment property. A number of stakeholders – the borrower, developer, building contractor, professional team, subcontractors, suppliers, potential tenants, local authority, second charge holder or unsecured lender – all have the ability to affect the successful outcome of the development following an enforcement action.
Does the lender have faith in the borrower’s ability to deliver the project? If the answer to this fundamental question is ‘no’, it is difficult to see any alternative to enforcement. If the answer is ‘yes’ then a consensual solution may be pursued alongside an enforcement option. Consensus may require some form of incentivisation of the borrower which could be linked to the value of the debt that is ultimately repaid. Weighing up the costs of this, rather than taking control through an enforcement action, will be an important preliminary consideration.
While the developer is responsible for delivering the finished development, the building contractor physically constructs it. Keeping the building contractor in place is often critical in terms of both the delay caused if it becomes necessary to appoint a replacement and the impact on subcontractors. The primary concern of the building contractor will be to ensure that they receive payment. The funding of these payments is an important element of contingency planning for enforcement.
There is little point in delivering the completed development if the tenants have used the opportunity to walk away. The terms of any agreements for lease should be examined to determine on what basis the tenants might be entitled to liquidated damages or to terminate the agreement.
Mezzanine and junior lenders
Mezzanine and junior lenders’ interests need to be established as a matter of priority. This will typically come down to the valuation of the incomplete property ‘as is’ and its gross development value at completion. A mezzanine lender who perceives significant upside on completion of the project may be a willing funder of the balance of any works, and equally will be incentivised not to crystallise its position through an immediate enforcement. This may put it at loggerheads with a senior lender who desires to, and can through enforcement action, get out in full now. Any hold out, for example, through consent to granting of leases, must be identified in advance and a workaround found or consent obtained.
If a lender decides to proceed with enforcement, there are really only two potential routes: administration or fixed-charge receivership. Both of these procedures have their advantages and disadvantages. Fixed charge receivership is a relatively straightforward procedure and therefore tends to be less expensive. It also avoids many of the complications that can arise when planning an administration appointment if the debtor is offshore. However, receivership can be of limited use in a development situation. Administration is a more powerful procedure. The administrator takes control of the company, as opposed to just the real estate asset, and has significantly wider powers.
In addition to stakeholder considerations, there are a number of issues which are particular to a development scenario that must be considered prior to any enforcement decision. The stage of the development, for example, is a key consideration in the decision to appoint. Any delays will have an impact on value.
Lender step-in rights
On loan origination, much emphasis is placed on the lender’s ability to step into the shoes of the developer with regard to the building contractor and sometimes certain key agreements for the lease as well. The difficulty that arises is that the lender will rarely, if ever, take over the development literally, due to the risk of becoming a mortgagee in possession or incurring a direct liability to the counterparties. A mortgagee in possession is liable for the burden of the freehold or leasehold covenants, is liable to account for rents and profits as well as to repair and maintain the property. They are liable for deliberate and negligent damage to the property and, potentially, for rates – the act of taking possession may constitute a change in the rateable occupier for rating purposes.
Well-drafted step-in rights enable the lender to provide a nominee to take over the obligations. This may work well where it is the developer that has become insolvent and not the land owner, since it is merely a case of novating the development agreement and other contracts to the new nominee developer. However, where the developer and the landowner are the same person (as is often the case), it becomes necessary to transfer the ownership of the land. Transferring the property at its full value is a difficult goal to achieve. Valuing a development mid-build with the myriad interrelated contractual arrangements and risks is not an easy task, even for a seasoned valuer. Further, the need to consider, in depth, the interests of second charge holders and unsecured creditors complicates the decision-making process. The most attractive route in dealing with this scenario is the hive-down.
Meeting existing obligations
As already highlighted, the first step in achieving a let development is to keep hold of all tenants already committed to the development. There are three aspects to this. First is ensuring that all required deadlines are met so that tenants cannot terminate for delay. Second is dealing with scenarios where tenants are entitled to terminate their agreements on the developer’s insolvency. Third is the ability to comply with obligations regarding the actual grant of the lease on completion of the development and any agreement becoming unconditional. This can be challenging. The agreement, in addition to financial obligations regarding contributions to tenant fit-out works, will often require certain legal requirements be met, in particular the obligation to grant any lease with full-title guarantee. Administrators will not be prepared to grant any lease or enter into any contract with full or even limited title guarantee.
Achieving further disposals
Unless a development is fully let or forward sold, the ability to let it further can add significant value to the property and increase realisations for the lender – perhaps even returning value to other stakeholders. However, there are two issues to overcome here. Firstly, an insolvent property owner does not present a particularly attractive landlord. Secondly, the protections that an administrator will require before entering into a lease can leave holes in the future management of the completed development, thus itself impacting on value.
When taking enforcement action, it is important to consider the ultimate exit strategy. This will affect both the initial enforcement route and further decisions along the way. In the case of a fully-let development, the strategy will be a sale of the asset as a whole and minimal asset management may be necessary. In the development context, and especially in a mixed-use development, a sale of the whole may not produce the best returns once complete, even assuming that a buyer can be found. Due to the complexity of the investor market, marketing a fully completed mixed-use development which is un-let in significant parts could limit the market considerably. Therefore, seeking to complete the letting of the development will help to increase the exit value and the lender’s recovery. However, achieving this is not straightforward as tenants will be wary of the insolvency background.
Every development scenario is different and we have sought to identify some themes common to many mixed-use developments. The aim must always be to analyse carefully and prepare in detail prior to actually enforcing. Identifying the key contractual relationships and issues that will need to be dealt with on enforcement will help avoid unpredicted value destruction. However, to truly maximise value, it is important to map out the process from enforcement right through to the ultimate final disposal. This way, it is possible to structure steps that will help to ensure that despite having to take the unattractive step of stepping in on a partially completed development, the ultimate outcome will be as positive as possible – not only for the secured lender, but for the other stakeholders as well.
Ben Jones and Barry Gross are partners at Berwin Leighton Paisner LLP. Mr Jones can be contacted on +44 (0)20 3400 4717 or by email: firstname.lastname@example.org. Mr Gross can be contacted on +44 (0)20 3400 4038 or by email:email@example.com.
© Financier Worldwide
Ben Jones and Barry Gross
Berwin Leighton Paisner LLP