Editor: You were instrumental in dissecting the debt structure of major properties, one of which was the John Hancock Tower and Garage, one of the most prestigious office buildings in New England. By what method did you succeed in getting control of that property for your clients?
Mittman: Carolyn is a finance lawyer; I am a bankruptcy lawyer. We have worked together in bankruptcies and workouts over the last 13 years, but our work intensified with the current downturn. One needs to closely review the documents from a real estate perspective but also understand possible outcomes in the context of an Article 9 UCC sale, a foreclosure or a Chapter 11 bankruptcy.
Sullivan : On the Hancock transaction, our client, Five Mile Capital Partners, teamed up with another venturer, Normandy Real Estate Partners. The venture bought a participation in a mezzanine loan which was initially secured by pledges of the equity interests in not only Hancock Tower but also other properties that were owned by Broadway. So each of the underlying properties had a mortgage loan while the ownership interest in each of the fee owners was pledged as collateral for the mezzanine loan.
Mittman: Once the market became frothy, Five Mile Capital asked us to look at the capital structure of certain of these properties. We parsed their documents, identifying which tranche of mezzanine debt would likely be given control upon an appraisal event.
Editor: What did you learn that ultimately led your clients to gain control of that and other valuable properties?
Mittman: We learned that we could buy debt that was likely to go into default, and by choosing the mezzanine piece that would make us the control party to obtain a consent right in connection with the exercise of remedies when the debt went into default. Because the collateral for the mezzanine loan was the pledges of interest in the fee owner, the special servicer held a UCC foreclosure sale; our client and their venture partner bid at the sale and took title as owner of the property. The beauty of the transaction was that the venture was able to assume the mortgage so that no new senior financing was needed.
Editor: What was the rationale behind the use of mezzanine debt, and how did the market downturn ultimately make the Hancock - and similarly leveraged properties - vulnerable?Mittman: Coming out of the late '80s and early '90s downturn, mortgage lenders realized that they had overleveraged properties and consequently limited their lending to somewhere between 60 to 65 percent of the appraised value of properties. The mezzanine business grew up starting in about 1993 to provide more debt below senior loans which were encumbered by the real estate. Mezzanine financing is generally secured only by a pledge of the owners' interest in the entity that owns the property - it's really a stock pledge or an LLC pledge.
Sullivan : Prior to mezzanine financing lenders would take "second" or subordinate mortgages on properties. Mezzanine financing (which is secured by a pledge of the equity interests in the fee owner) grew in popularity when lenders began pooling and securitizing mortgage loans. The senior lenders did not want to have a subordinate mortgage loan secured by the same collateral because of certain bankruptcy concerns, so borrowers looked to mezzanine financing to obtain additional leverage.
Editor: Did you have different tranches of mezzanine debt?
Sullivan: On certain transactions there are multiple levels of mezzanine loans, and in others there is one mezzanine note, which is participated into multiple participation interests or tranches which are sold to different lenders. In a senior-subordinate participation structure, interest and principal is paid to the participants in order of priority, making the most subordinate participation interest the riskiest position, the most subordinate being what we usually refer to as the first loss position. Typically, because it is the first loss piece, the holder of the most subordinate interest initially has the "control" or approval rights. Once the loan goes into default, there is typically an appraisal mechanism to determine the value of the debt vis-à-vis the collateral. Often this results in a shift as to the "control" position.
Editor: By some predictions, nearly $1 trillion in acquisitions concluded between 2005 and 2007, mostly with short-term debt, will have to be refinanced. Do you see similarly great opportunities for smart real estate investors to take control of valuable properties?
Mittman: In my view what made this one really unusual is that it was a trophy building with a mortgage that was not maturing at the same time as the mezzanine debt. You need to have discerning business people who can really look through a lot of dross and come up with a gem, and smart lawyers who can analyze these complex structures and understand how they get played out in the real world.
Editor: What are some of the creative ways to gain control and take advantage of mezzanine positions?
Mittman: Investors need to focus on opportunistic purchases of distressed debt irrespective of where it is in the capital structure. In this market it is not uncommon for the holders of a junior position to try to team up with the owners in order to do a cram-down of the more senior portion of the debt under the Bankruptcy Code to extend the senior debt. The key is to have flexibility and to understand the process. The business people have to have a check for the initial investment. Then they should use whatever time they can muster to have the senior mortgage debt extended as many times as possible, depending on the real estate market at the time.
Sullivan : A clear understanding of the governing documents is required in these situations. For example, there may be non-recourse carveout guaranties given by parent companies or individuals that will come into play if there is a bankruptcy filing involving the borrower. The intent of these guaranties is to deter the borrower from filing for bankruptcy. In addition, intercreditor agreements among the lenders typically contain restrictions on actions that a junior lender can take in a bankruptcy context.
Editor: You have said that when examining the way the loan documents and instruments were crafted, it is evident they did not consider the possibility that values might fall. What legal problems could that present for current owners?Mittman: We were involved with a transaction involving a mortgage loan and multiple levels of mezzanine debt. When we first got involved, based on initial values, the most senior positions were covered. Ultimately the way it played out over several months not even the top tranche of the mezzanine debt was covered. It is difficult to figure out whether values on a particular property are going to drop or, alternatively, hold stable or rise. The lack of available financing has also impacted the market causing potential buyers to sit on the sidelines.
Editor: I understand that you also work with litigators.
Mittman: Yes, oftentimes the documents are not clear. There are intercreditor provisions that govern the rights between the junior mezzanine holders and those in the mortgage constituency. There are times when litigators are needed to nudge the owners of a property. This is not an area for the faint-hearted, and so frequently we have been involved in the context of litigation.
Editor: It has been said that in real estate, we have ten-year cycles and five-year memories. How do you envision real estate acquisitions will be financed once the market recovers? In other words, will the lessons of the Hancock foreclosure and others similar produce any lasting changes in large financings?
Mittman: Creative lawyering will not substitute for conservative financial underwriting. Investors have hopefully learned that they should no longer rely entirely on legal structures solely for their protection.
Sullivan : We will see structure changes and changes to the documentation as a result of some of the issues being litigated in the current round of bankruptcies and restructurings.
Editor: What are your thoughts about creating a hybrid model composed of fixed rate debt, participating debt and equity as the "new normal" for financing commercial real estate?
Mittman: It's hard to talk about what the "new normal" will be because we are far from being normal, so it's hard to predict. Structures that give you a blended rate are a good thing, but one needs to be careful about being on both the debt and equity sides owing to the real concern for equitable subordination of the debt.
Editor: Any other thoughts about the future way to structure deals?
Mittman: The John Hancock example is a real paradigm on how deals will get done in the next two years. Potential investors are looking at existing work-outs, saying that in somebody else's wreckage there are glimmers of opportunity for those who are prepared to toil through the legal process.