Beyond the basics: How to deal with troubled loans on special purpose real estate assets with operating businesses.

"Rents vs. Accounts"--This issue here normally comes up when a hotel goes into bankruptcy. The Bankruptcy Code looks to state law for the characterization of the property and how a security interest is created and perfected. For example, you generally create and perfect an interest in real property with a mortgage or deed of trust and an assignment of rents which you record in the appropriate office, but you create and perfect an interest in personal property with a security agreement and a UCC-1 that is filed appropriately. And as lenders to operating businesses know, the filing of a bankruptcy petition cuts off even a perfected security interest in future earnings of a bankrupt business (though leaving it in place as to pre-petition receivables and inventory), but a perfected security interest in real property survives the bankruptcy petition filing. Thus it is critical to know whether your collateral is viewed as a real property interest or a personal property interest. This characterization will affect bo th how you create and perfect your security interest--or whether you have a perfected interest--and it will also determine whether your security interest terminates upon the filing of bankruptcy as to post-petition revenues.

As an example, say one has an office building and a hotel. Both structures and the underlying land are real property. And the security interest in the real estate is perfected by the recording of the mortgage or deed of trust and assignment of rents. But what is the revenue that is derived by the owner from each of these pieces of real estate? Rents?

It has not always been so, at least according to the courts, and even now it is not always so. Normally the revenue derived from an office building or an apartment house under leases will be treated as "rents." But one doesn't sign a lease on checking into a hotel, and, in addition to providing a room, the hotel may provide a number of services including food and beverage, telephone, parking, laundry, in-room movies, banquet facilities, golf or tennis, spa treatments, maid service, and so on. Are payments the hotel collects for the use of the room and these services really "rents" or something else?

At least one court in a case called Drake Hotel Associates5 said the payments were "rents." Realizing that it was one of the few courts to take that position, the judge said that he did not care about the overwhelming number of cases to the contrary. He felt that the common-sense meaning of "rents" should characterize revenues derived from use of a hotel and its facilities. Unfortunately, there were many more cases representing the other view generally characterized by the Northview case (6) that held revenues from hotel rooms and these other activities were not "rents." Instead, they were some form of intangible personal property in the nature of "accounts" or receivables.

What does that mean to a lender? If the loan is secured with a typical mortgage and assignment of rents, this would create a valid security interest in the real estate under either line of cases. But the lender also wants to control the income or cash flow from the property. That is what the cash collateral battles are all about while seeking relief from a bankruptcy stay or working on a plan for disposition of the hotel. And that is where the difference is.

Under the Northview approach, unless one had a security agreement with an appropriate description of the revenues from the hotel and a properly filed UCC-1, the security interest in the revenues would not be validly created and perfected. The typical assignment of rents in a mortgage would not be adequate. So when the hotel goes into bankruptcy, the security interest is not perfected in either the pre-petition or post-petition income from the hotel.

And if even if the lender did use a good security agreement and UCC-1, under the Northview approach, the security interest is cut off by the filing of the bankruptcy petition in post-petition revenues. Only under the Drake Associates approach does the security interest survive the filing of the bankruptcy petition as to post-petition revenues.

Although this appears to be a fairly grim scenario for lenders, things were improved a little when the Bankruptcy Code was amended in 1994. There was a specific provision added to treat room revenues like rents. The provision was amended to include "fees, charges, accounts, or other payments for the use or occupancy of rooms and other public facilities in hotels, motels, or other lodging properties ... except to any extent that the court, after notice and a hearing and based on the equities of the case, orders otherwise." (7)

Unfortunately, in a full-service hotel or resort, revenues from other sources--banquet, food and beverage, telephones, and the like--can easily constitute more than 60 percent of the total income from the hotel. Those items of income do not come from room revenues and would appear to still be subject to the old "rents vs. accounts" or "Drake vs. Northview" dichotomy. Undoubtedly, there will be a great deal of litigation in the bankruptcy courts in the next industry downturn to determine what the amendment to the Bankruptcy Code means.

Evaluating the Options

From the lender's perspective there are several options or alternative courses of action on a troubled asset. It can do nothing of course, or it can pursue a strategy that is directed toward one or more of the following:

* Workout

* Receiver

* Deed-in-lieu of foreclosure

* Foreclosure

* Bankruptcy

The workout typically leaves the borrower in possession or physical control of the asset, and the other alternatives all seek to move that control to someone else---a receiver, the lender, a buyer of the property, or a bankruptcy trustee.

KEY TO EVALUATING ALTERNATIVES: "BUTLER'S MATRIX"

The situation analysis should have considered all the relevant factors concerning the borrower, the hotel and their related considerations. Now it is time to consider these in light of the lender's goals and the available alternatives. Given the complexities of the typical special asset, it is sometimes helpful to boil it down to a summary form that may over-simplify, but at least provides a grid or framework for analysis.

One of this article's authors, Jim Butler, developed an analytical tool in the last great real estate and hotel downturn in the late 1980s that has come to be known as "Butler's Matrix" (see Table 1).

In applying Butler's Matrix, no single factor or group of factors is necessarily determinative, although a single factor could be. The lack of a critical mass of motivations on one side or the other will normally suggest that the lender will want to take possession by foreclosure or deed-in-lieu of foreclosure or at least displace the borrower from possession through use of a receiver.

For example, in the absence of other controlling considerations, inadequate collateral value for the debt, defective documentation, a good borrower, a strong management company, and a weak market would all suggest a workout instead of the possessory alternatives. However, if the property is severely damaged by a hurricane or other disaster, that factor alone might outweigh all the others and swing the evaluation in favor of one of the other "possessory" alternatives.

SAG -- PROFIT CENTER FOR THE 21ST CENTURY

How the SAG is run can make a critical difference. Utilizing the SAG as a profit center can make a difference in amounts recovered and how the bank is protected from lender liability claims. The bank can position itself to make a bigger impact on its profitability, more so than the commercial loan originations. In recognition of that, senior management should be given prompt access to decision-makers and other resources, including hotel lawyers and consultants.

NOTES

(1.) The terms of a hotel management agreement can easily add or subtract 25 percent or more to or from the value of a hotel.

(2.) James R. Butler, Jr., Co-Author, Chapter 14 "Special Legal Considerations for Hotel Investors," Hotel Investments Issues & Perspectives (2nd Ed. 1999), Educational Institute, American Hotel & Motel Association.

(3.) Baltin's Law was formulated by Bruce Baltin, Senior Vice President of PKF Consulting in Los Angeles, California. Mr. Baltin has more than 30 years of hotel experience.

(4.) The SNDA is the acronym for Subordination, Non-Disturbance and Attornment agreement, which is usually a three party agreement involving the owner, the operator and the lender of the hotel. Such agreements typically provide comfort to lenders that upon a foreclosure, deed-in-lieu or sale in bankruptcy that the lender or its successor in interest will continue to enjoy the benefits of the management agreement. This may be of great value in some circumstances. However, many such agreements also limit the lender's or successors' options in purporting to bind them to the terms of the agreement whether they want it or not. This poses many interesting issues where the lender or a successor want to remove or terminate a brand or operator.

(5.) In re S.F. Drake Hotel Associates, 131 B.R. 156 (Bankr. N.D.Cal. 1991) (minority view holding that hotel room revenues are "rents").

(6.) In re Northview Corporation, 130 B.R. 543 (9th Cir. BAP 1991) (majority view that room revenues are "accounts" and not "rents"). See also, In re Ashkenazy Enterprises, Inc., 94 B.R. 645 (Bankr. C.D. Cal 1986) and In re Mid-City Hotel Associates, 114 B.R. 634 (Bankr. D.Minn. 1990).

(7.) Bankruptcy Code Section 552(b).

RELATED ARTICLE: Appendix 1

Basic Do's-and-Don'ts of Working with Troubled Loans

1. Prevention. Prevention is the first step in a well-planned approach to troubled loans. Proper underwriting, documentation, and provisions for access to information may help a lender facing a troubled loan. in the event the loan does get into trouble, the lender will be in a stronger position to protect its interests. Prevention includes careful underwriting of the collateral and the borrower. In underwriting the borrower, the lender should obviously look to the usual credit report and financial statements, but should often go beyond them to get a better feel for the borrower's reputation, character, fortitude, expertise, consistency and creativity. The lender should ask: Has this borrower built or managed this kind of project before? Are the market and feasibility studies realistic? Are the projections consistent with these factors and do they provide adequately for a worst case scenario?

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