Picking Up the Pieces (2/5)
Feb 5, 2009 10:45 AM, By Jennifer Popovec
Although Chicago-based REIT General Growth Properties and Australian limited property trust Centro Properties Group have been so far able to work out a series of loan extensions and temporary deals with lenders, there remain persistent fears that one or both companies may get pushed over the edge. The industry has never experienced the bankruptcy of a REIT the size of either General Growth, which has $29.7 billion in assets, according to its financial statements, or Centro, which has a true asset book value of $8.3 billion. But if credit conditions remain as they are and the recession plays out as badly as some economists fear, the likelihood only increases that one or more REITs may eventually need to file for Chapter 7 or Chapter 11 bankruptcy protection.
Corporate bankruptcies (both Chapter 7 liquidations and Chapter 11 reorganizations) have increased substantially over the past two years. In 2008, 42,000 businesses filed for bankruptcy, a 45 percent increase from the 28,000 filings in 2007, according to a recent report by Paris-based Euler Hermes, the world’s largest credit insurer. This year, Euler estimates that an additional 62,000 U.S. companies will be forced to file for bankruptcy protection. If Euler is right, those numbers would mark the largest increase in corporate bankruptcies in more than 16 years.
Among those ranks are a growing number of retailers. That’s creating even more pressure on retail REITs as centers lose tenants while the ones that remain push aggressively for rental reductions. The difficulties in refinancing debt add another pressure. Put it all together and it creates a series of pressures on retail REITs. The industry seems profoundly worried about these developments. Retail REIT stock valuations have languished at 52-week lows for months and are off 70 percent from apexes reached in early 2007.
All this is leading observers to consider it a matter of when, not if, the industry sees a major player file for bankruptcy protection.
And that has a lot of people nervous.
What would a REIT bankruptcy look like? How could a firm reemerge from such a reorganization while still living up to the stringent rules imposed on REITs? Is it possible that the current wave of difficulties will lead firms to de-list from public markets altogether, like what small retail REIT AmREIT is currently doing?
Bankruptcy experts, however, say that many of the worries may be unfounded. The sector may not have been tested by a big bankruptcy yet, but enough is known about how the companies are structured and how a bankruptcy proceeds that experts think the industry should emerge fine, even from a series of bankruptcies. Further, there is reason to believe that because REITs control a tangible base of assets through large portfolios of real estate, these firms may be more likely to survive bankruptcies than other companies that’s value is harder to pin down or could be subject to liquidation.
In any case, bankruptcy is a costly, lengthy process, and the final outcome is hard to predict.
Learning from history
One reason for nervousness about REITs and bankruptcy is that the era of large, publicly traded REITs is still relatively young. Although the structure has been around for decades, it really didn’t take off as a dominant model for commercial real estate ownership until the mid-1990s when changes in regulation made it much more attractive for owners to seek REIT status. Since then, there have been some ups and downs in commercial real estate—most notably the brief debt crisis triggered by the Russian default in 1998 and a brief downturn in property fundamentals in the early 2000s—but nothing on the scale of the current credit crunch and recession. During that time, no major equity REIT was forced to seek bankruptcy protection.
However, there is some precedent for bankruptcies among mortgage REITs. In fact, the most high-profile REIT to declare bankruptcy was Criimi Mae, a REIT specializing in non-investment grade commercial mortgage investments, in 1998. Criimi Mae had a portfolio of $2.7 billion at the time of its bankruptcy. Mortgage Realty Trust and Wedgestone Financial were two more mortgage REITs that filed for bankruptcy in the 1990s.
Similar to the conditions today, REITs then were highly leveraged and were pushed into bankruptcy by a credit crunch, says John Wilcox, senior vice president of Savills Granite, a New York City–based real estate investment banking firm. Wedgestone, for example, bought mortgages with money raised in the commercial paper market. When the commercial paper market froze in the early 1990s, the company filed for Chapter 11 reorganization in 1991 and emerged from bankruptcy in 1992. It had $100 million in assets at the time. However, it lost its REIT status and eventually got out of the mortgage business altogether.
Looking a bit further back, a number of mortgage REITs also filed for bankruptcy during the 10-year period from 1971 to 1981. Several traditional equity REITs, many sponsored by banks, also sought bankruptcy protection after seeing the value of their portfolios crater during the real estate bust of 1973 and 1974. For example, Chase Manhattan Mortgage and Realty Trust Co. ended up in Chapter 11 reorganization when the REIT began running out of operation funds and started to sell off assets to meet its subordinated debt obligations.
The REIT ran into real trouble when creditors holding a first debt position found out that subordinated debt holders were being paid before them, according to John Jerome, a partner with New York City-based law firm Saul Ewing LLC who worked on the REIT’s bankruptcy. Burdened by inter-creditor squabbles, Chase Manhattan’s REIT eventually bypassed Chapter 11 reorganization and ended up in Chapter 7 liquidation. It sold off all its assets, raising $1 billion, to pay its creditors and ceased to exist.
It’s hard to predict whether REIT bankruptcies will ratchet up over the next couple of years, but they’re certainly more likely to occur during recessions and credit shortages, Jerome says. “When a REIT’s cash flow is impacted because the properties themselves aren’t performing and that decreased cash flow makes it impossible to meet the obligations to its creditors, it may find itself resorting to bankruptcy,” he warns. “The same is true if a REIT cannot refinance its debt and defaults on its loans.”
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