#320 - Real Estate Real Talk: Personal Guarantees, Foreclosures, Bankruptcy, and Bouncing Back with Andrew Kirsh and Zack Streit

Chris Powers: This episode is dedicated to my friend, Artem Tepler. Artem was a huge part of the real estate community and the real estate Twitter community and left a huge impression on many. One of the nicest, most genuine, kind guys I've met along the way. And to hear of his passing was tragic. On this episode, I have Andrew Kirsch, an attorney based out of LA who knew Artem and knows the real estate industry and anybody I've come across.

Zach Streit is a capital markets advisor who understands the debt and equity sides well. We had a great conversation today about navigating tough situations in real estate. We have been on a bull run for a long time, and we're now entering a period where a lot of our peers and a lot of folks in the industry will have situations they'll have to navigate and work through.

The good news is that we end on a very positive note. There are solutions to all of these things, and a lot of it has to do with your character going into them and how you handle yourself. But the good news is there are solutions to tough situations. So, today is a huge learning experience for me on all the different components of a deal gone sideways and things that you can do.

In the show notes, there is a link, a GoFundMe link for Artem's daughter. The real estate community has already come together to raise over 200,000. And we're continuing to grow for that. And so, if you would like to check that link out, please see it in the show notes. And as always, enjoy today's episode; we will start with personal guarantees.

The market's been great for a long time. When you talk to people that have been in this for cycles, you'll hear older folks say, I would hesitate to sign personal guarantees, but I think over, you know, multi decades of up into the right, people tend to forget what they mean, and so maybe we could start there from a legal perspective, perhaps a lending perspective, like what is a personal guarantee and are there different types of guarantees?

Andrew Kirsh: So, there are two different types of loans. There's a non-recourse loan and a recourse loan. And even with a non-recourse loan, there's still a recourse component. So, take a step back when somebody talks about a non-recourse loan.

It means that if, you know, the project doesn't go well, the lender needs to enforce its remedies and foreclose on the property and ends up owning the property, regardless of what the value of that property is. The borrower and guarantor are off the hook. The lender has taken the property, and they're now the owner of the property with one key exception, and that's called non-recourse carve-out guarantee, which is a list of what we typically call the bad boys, where if you generally lie, cheat, steal, or also have an environmental issue, then the lender can come after you in addition to owning the property.

So that's one bucket of loans, a non-recourse loan with a non-recourse carve-out guarantee. The other bucket of loans is a recourse loan. It could be partial recourse; it could be full recourse. And that's where, if there's a deficiency after a lender forecloses on the property, the lender has the right to pursue The guarantor for that deficiency.

If it's a partial recourse, it's up to the maximum stated in the guarantee. And if it's full recourse, then the lender can be fully made whole on the loan balance on debt service that may not have been paid on legal fees and other expenses.

Chris Powers: How often are they enforced on a personal guarantee?

That was a common question that came up. We sign lenders. At what point do they start enforcing them, and are they generally implemented, or are there a lot of steps of a workout that tend to happen before they try and enforce the personal guarantee?

Zach Streit: It's more a legal question, but I can step in and take a first crack at that.

It depends on where we are in the cycle. Is the answer over the last ten years, maybe before the last few months, you hadn't seen a lot of enforcements of deficiencies or personal guarantees because you haven't had to, because when foreclosures occurred, generally the loan was at a lesser amount than the value of the property.

So, there was no reason there would be no trigger for deficiency. There would be no trigger for a bank to say, Hey, I sold your property, and I sold it at a 10 million loss to my loan amount. I will come after you, Mr. Personal Recourse Guarantor, individually, and you owe me a 10 million deficiency or liability.

In the aftermath of the GFC, you did see recourse guarantees getting perfected, so you did see banks and other lenders coming after guarantors individually when there was this deficiency. Hence, the answer depends on where we are in the cycle. I am still waiting to see it so far in this downturn; Andrew may be in a better place to discuss it, but it's probably coming in the next year, with higher for longer.

So it is something to watch out for. It doesn't happen immediately. Also, to your point, Chris, it takes time. You have to go through the foreclosure process. The property has to go, or what we call real estate owned, which means that the lender, either a bank or a debt fund, takes it back and holds it.

They then have to conduct their auction or their sale, sell it. And then a loss has to occur after all of those things happen. If there is a deficiency, so if the project is, or property is sold for less than a loan amount, and there is a personal guarantee, there is a full recourse obligation. As Andrew mentioned, the bank can go after the borrower, but many things must occur before that happens.

Andrew Kirsh: The conversation is really, and Zach, curious of your thoughts, and also Chris, your thoughts as the type of borrowers. Who is signing full recourse guarantees versus the type that isn't? In our practice, 90 percent of our transactions are not recourse loans. You know, they'll have a, they'll have a non-recourse carve-out guarantee standard.

And if there's a construction component, there will be a completion guarantee, which is the third guarantee, which essentially requires the guarantor to deliver a completed project. Some borrowers will ask me, what's the difference between a completion guarantee and a full recourse guarantee?

Because if I still have to spend the money to deliver a completed project, isn't that the same as a recourse? Yes and no. As Zach and I described, the recourse guarantee wouldn't create more liability if the property's value is less than the completed project.

While the completion guarantee stops your exposure to construction costs, it generally took a complete generalization in our practice. Syndicate getting outside investor money through syndication or a fund joint venture will usually be a non-recourse loan product versus a high net worth individual just betting on themselves. Let's say it has balls of steel. It doesn't matter to them how you know they're not answering to any other investors. They would prefer the cheaper cost of capital, the cheaper debt, and sign recourse.

Zach Streit: There's a really important point, Andrew; you made a great point. And there's a really important point that flows from this. The reason for what Andrew said is that if you are in a typical joint venture structure. You are doing a 90-10 deal or an 80-20 deal where you, the sponsor who is expected to sign on the guarantees, are only 10 percent of the equity or 20 percent of the equity, and your joint venture partner is 90 percent of the equity or 80 percent of the equity, you're not incentivized.

Signing a repayment guarantee is a lot of risk to you, the sponsor, and you are a small amount of the equity. The upside is that personally guaranteed or recourse loans usually carry a significantly lower rate than non-recourse loans as they should. They are less risky to the lender, but sponsors and borrowers usually aren't incentivized to do that because the deficiency, Should it ever occur, is their liability.

It wouldn't be the liability of the partnership in the absence of some legal drafting that, you know, somehow would make it the partnership's liability, but that is different from what happens. And so when you're doing a large transaction, let's say it's a hundred million dollar deal. Let's say you're getting a 60 million loan using easy numbers.

And you have 40 million of equity, and then 90 percent of that 40 million or 36 million is raised from a single large institutional partner or multiple. And the sponsor only has 4 million of his own GP capital in the deal, which is mostly syndicated to some degree. Also, you're asking that the sponsor sign a full repayment guarantee when he only has a fraction of the equity in the deal; that usually needs to be clarified. Most sponsors won't do that. And so that's why most contracts in the middle market and upper middle market typically don't involve recourse obligations. Where they do is where it's one person writing that entire 40 million check.

Chris Powers: Okay. I'm going to drill deep on just a few nuances with how we get to personal and non-recourse, but quick; you said personals are usually cheaper than non-recourse in a traditional market; how much more affordable? I know it's nuanced, but how much cheaper is a personal recourse loan than a non-recourse loan, by basis points, or how do you want to answer it?

Zach Streit: Yeah, I'll take it. And then Andrew, you see this a lot on the finance side. So, 200 to 300 basis points, depending on the type of loan, construction might be a little wider, and the bridge might be a bit narrower, but that's what a normal market looks like. That is different in today's market because you need a functioning regional bank system, and regional banks were the dominant purveyors of recourse financing. And they are largely on the sidelines and the absence of, you know, big, big deposits, and even then, they need to do more deals. It's almost academic today, but Chris, it's 200 to 300 basis points. So it's significant.

Chris Powers: So, one, can everybody get a non-recourse loan?

Or does it have to be like you have to have a track record? Your LTV has to be at a certain amount. So it's easy to say, like Andrew, you said 90 percent of my clients use non-recourse loans. I remember when I first got into the industry. There was only a non-recourse loan on the planet if I was at 30 percent LTV or something where it needed to make more sense.

So, at what point can somebody get a non-recourse loan? And are there ways to get a non-recourse loan earlier in your career than you should have besides sacrificing LTV?

Andrew Kirsh: Let me jump in. It's an interesting, it's a great question, Chris. And yeah, we're here. You know, because unfortunately, you know, Artem Tepler, you know, committed suicide and, and we all knew him and Shon Tepler, his partner is Paul Shon, you know, a client of ours.

I think they also did business with Zach, and he was on my podcast, or they were on my podcast, and, you know, they spoke, and Artem is the one who did talk about it when they were starting; no one would give them a non-recourse loan. They had to bet on themselves. They had to sign recourse. The only lending options for them and the type of deals they were doing started with small home flips and then smaller apartment buildings. And then, it grew to larger apartment buildings or the regional banks. And as Zach mentioned, most regional banks are going to require recourse. That's just how they're set up. Zach, we do a lot of business with debt funds and private, you know, debt funds are primarily non-recourse lenders.

But do you have to graduate to get there?

Zach Streit: Yeah, it's a really good question. And this is a problem for new sponsors that are starting. So, generally speaking, yes, you do. There are higher-octane non-recourse lenders out there that might back a sponsor on their first deal, but the rate will be extremely high.

So there is a cost to that, but your garden variety debt funds are usually out there when we talk about it. The deals we traffic in Andrew, which you and I believe are similar, are in the 30 million to the 150 million total capitalization range.

Getting a non-recourse loan in that range on your 1st deal can be challenging. It takes a lot of work to get a recourse loan if it is your first deal in that range for various reasons, but starting with, you need a track record to do so. And so, the primary way we help quote first-time sponsors, and first-time in quotes, is it might be someone's first project.

Really, but rarely, or it could be somebody's first project as part of a new platform where they worked for a large institution, and they spun out, right? We represent entrepreneurial sponsors doing institutional-level deals and help them arrange financing. And so for guys that don't have their own track record or balance sheet, we recommend, and we can put this, that a co-GP come into their deal, which can enhance their deal.

And that is the simplest. It isn't simple, but that is the primary way. Let's say we help younger, newer sponsors or sponsors with a limited track record get financing. And 95 percent of the time when we do that, to Andrew's point, and most loans that we do also are non-recourse, there is the rare time somebody will want to sign recourse for the cost savings we mentioned, but that's the way to do it.

The way to do it is to bring somebody with a large balance sheet. You have to pay them for the pleasure of doing so, and they will afford your deal credit enhancement. And that will allow you to get a non-recourse loan.

Chris Powers: Okay. Before we move into what happens when a deal starts going sideways, is there anything that comes to mind when I asked the question, while you're originating your loan docs or while you're originating your legal docs, are there things that maybe somebody less experienced never asked for that come to mind of like, Hey, make sure you're checking on this before you sign on something.

Zach Streit: Hire an attorney; I suggest you hire Andrew. It is the first thing I tell people, seriously, hire a good attorney who knows what they're doing. Do not hire somebody who has never worked on transactions before, or frankly, many of them. I said the same thing if you were hiring a capital advisor, but in this instance, you know, in the wake of what occurred, hire Andrew.

It would be an enormous mistake not to go ahead. Andrew, you have the more detailed stuff.

Andrew Kirsh: Now I have to buy lunch the next time we see each other. So great look, Chris; there are so many different ways a borrower can protect themselves in loan docs. You know, you'd be surprised how many borrowers feel that.

Loan docs are to be negotiated and for some lenders. That is true. You won't deal with a bank; they will have their pre-printed form in California. We call them these laser pro form docs. I don't know in Texas if regional banks have a typical. It is a standard set of loan docs, but it is hard to get negotiations from a bank.

Debt funds, these private lenders, and the smaller balance load amounts are sometimes harder to negotiate. But when talking about loan amounts north of 10 north of 20 million, they serve up a 100-page loan agreement and 14 different ancillaries. You can do a lot, from noticing cure periods to giving yourself latitudes and concerning certain covenants and conditions, extensions, and things of that nature.

But ultimately, a set of loan docs is going to be lender-friendly. They just are, but around the margins, you can try to rebalance them to make them. These debt funds provide loans to get their capital out and want to be seen as cooperating lenders. And so you'd be surprised how much you can negotiate with these sophisticated debt funds.

Zach Streit: And the negotiation isn't just at the loan doc stage, and you'll know, you know all these answers, Chris, because you guys do a ton of business, but the negotiation starts with us and with your counsel or anyone's counsel at the term sheet stage, because there's going to be a lot of things in that term sheet that pertains to some of what we're talking about.

The term sheet Will and should outline the type of guarantees that are required, you know, generally, if there's a construction component, there will be completion. They're almost always carve out, or the bad act guarantees. But is there a carry guarantee? Right? Will somebody be on the hook for debt service property taxes and insurance?

And if so, for how long does that extinguish upon foreclosure? What networks and liquidity covenants will be required? Is this a recourse or a non-recourse loan? So, you know, on a kind of at a high level, there's that there's also, is there an equity pledge, which we didn't discuss, but that's a fast track way for a lender to foreclose or take control of the asset and, you know, do the notice and cure periods for that mirror, the notice and cure periods for a typical mortgage foreclosure or not.

Some pretty threshold items can be negotiated upfront. Thus, the understanding of the transaction is from the perspective of what lenders' remedies might be. Certainly, the meat is in the loan doc phase, but it starts much earlier. It starts when we begin to source term sheets and put them side by side.

And we, you know, we wonder who might be the friendliest to us.

Chris Powers: And this is like where we currently are. When things are up to the right for many years, there may be covenants in your loan docs that banks may overlook or are a little lighter on. Are you seeing banks right now?

Say it's in the document. We're enforcing it. It might have gone unnoticed two or three years ago, or they would have been a little friendlier. What are you seeing now with lenders and how they treat their covenants?

Andrew Kirsh: I have a real-life example: single-tenant, commercial quasi-office a year before the loan matures, and the tenant had an extension. And the tenant exercises their right or refuses to exercise the extension. The lender was aware of it for months. Almost a year went by, and nothing happened. The maturity was October 3rd, this past month, and right before loan maturity; because loan maturity was coterminous with lease maturity, the lender informed the borrower that all the cash flow they received during the last 12 months of the lease should have gone to the lender.

It was an event of default or a breach of a covenant because the tenant, the sole tenant, did not extend the lease, and we're in the middle of battling with the lender on so many different grounds and waiver issues. Still, they need to be more accurate with the loan docs. It is purely a money grab because they know the value of this asset is far less than the loan principle. And so anyway, they can recapture some dollars, they are, and this is a gigantic stretch. And this is one example.

Zach Streit: I can add to that, Chris; we started seeing that Andrew can speak much more about what happens once a loan closes. Cause our focus is really on arranging the financing and getting it completed.

But about a year ago, we began to see a real tightening. Even amongst the debt funds on what they would and wouldn't allow regarding loan doc negotiation. So, Andrew's point is correct. There's a lot you can negotiate in debt fund loan documents. They are robust again and get great counsel, but we saw it tightening.

We had one deal that we worked on in the hotel space for a prolific sponsor. I'll leave their name out of it. And an equity partner that was a giant. And it was a relatively small loan. It was a 25 million loan. I think we spent two months, and the lender was a big investment bank, but through their sort of debt fund silo, I think we spent two months and an enormous amount of legal dollars negotiating.

Replacement guarantor and transfer provisions relate somewhat to our conversation, but not a hundred percent; in two months, the legal fees on that deal on a 25 million loan ended up being 600,000. And I think that's wild. They were not scorecards. They were not sparkers. They needed to be more smart.

Chris Powers: Congrats, Andrew.

Zach Streit: No, but I bring that up because that was the beginning of a tightening in our minds. That was a sponsor and a very large equity partner that were, rightfully, upset and frustrated. And the lender said, "Look, we normally give on items. We're not going to give up on this.

Okay. Pause for a week. But you, you got to give here now, or we're going to pause two weeks now. It was a game of chicken, and begrudgingly, the sponsors and the equity partner had to close because they had a maturing loan with another big bank that would not extend either this off their books.

And so we had to close it, and you know, the legal fee was three times what we charge. And it's very unusual to see that on a deal of this size, but it related to a tightening since then, you know, we've seen this occur on other deals, but sponsors have had to give more because it's become a lender market that's out there.

And so we haven't seen a situation, maybe that egregious sort of sins, but that was the beginning of when I saw like, okay, the tides have shifted. You do need to be very careful and read what you are signing up for, but the ability to negotiate may be more limited than it was because of market conditions.

Chris Powers: Is there a look back? So anybody that's listening right now says I blew through some covenants, but we're good now. And it's going off what you have just said. And I won't go into a story we're dealing with even in our portfolio, but Is there a look-back period that once you've cured the covenant and you're far enough down the road, that busted covenant is no longer good?

Because I think the message here and anybody listening is it would be prudent to at least look at your last 12 months of history and see if you've blown through any covenants, even if you're in good standing right now, because what I'm starting to hear are lenders calling up their sponsors going, Hey, remember back in February when that tenant blew out here, we are, because what.

You have a 3. 9 fixed loan. We're losing money on your loan. And our bank board wants every dollar back that we can get. What's the look-back period, and what should people be doing right now to go? Look, I want to make sure I am in good standing. Yeah.

Andrew Kirsh: We have a legal theory called go after yourself.

If that were to occur on the, you know, these covenants. Let me even take a step back. What you're finding here is especially lenders that may, if they're having issues or there's a slowdown in originating new loans, originators are now playing the role of asset manager. They're scouring through their loan docs and figuring out ways to protect themselves and add additional revenue or get back as much money as possible because of the concern that the principal is less than the value. So that's what's going on here. Typically, these low dock covenants on cashflow, you know, if you blow, A-D-S-C-R, usually these loans are set up where you go into cash management. Lenders can then sweep the cash flow, and then only until you're satisfied.

Usually, an elevated DSCR test is performed for multiple quarters in a row. Do you get out of the penalty box? Can a lender retroactively put you in a penalty box when you blew a DSCR covenant but now are in good standing? I would take that on. The lender will not be able to, even though there are nonwaiver provisions.

You know, your standard provisions that'll say, even if a lender doesn't enforce its remedies, they can subsequently, but to the extent you've cured it. Then I don't think there's much the lender can do, but I, Chris, I would imagine that the covenants are not fixed for most borrowers out there, especially because the way, and this is at the term sheet stage, Zach, I think we should get into it of how these DSCR tests are defined.

It is extremely punitive to the borrower, so much so that it doesn't reflect reality. And it's almost impossible to get out of once you're in. Because they'll amortize the loans, even if it's an interest-only loan, they'll have heavy amortization at 25 years instead of 30.

And it's like, I'm in the penalty box. How do I get out of it? It's not a two-minute minor for holding. It is just that this is a long-term deal. Zach, what do you think?

Zach Streit: I agree with your point very much. And we're seeing a lot more scrutiny on the cash management triggers.

You know, what could cause it, what could go wrong with my business plan to, you know, get me into cash management, you know, can we negotiate the triggers to be a little bit more borrower-friendly, and then we're paying a lot of attention to how you get out of it because, you know, there usually isn't necessarily.

Reciprocity on the two to your point, Andrew, like we'll typically say, Oh, you know, I can put you in cash management for anything that's occurred on a T1 or a T3 basis, but you're not getting out for an unless it's a T6 or T9 basis. That's not reciprocal. That's not fair. It shouldn't be done that way.

Certainly, if I'm a lender and drafting a term sheet, I will do that because it strengthens my position, makes me look better with my credit committee, and makes me look better with my line lender. And so that's why that's in there. But we spend a lot of time making sure that there is parity that, you know, whenever the trigger is for getting in for a debt yield or DCR, or the period of look back on the operating history, that it should be sort of similar towards getting out.

So again, a lot of this negotiation needs to and should start at the term sheet phase. The other spin on this that I would add is to the earlier point, Chris; I haven't seen anyone get defaulted because of something. Initially, it was tripped up, but then it was cured. But what I'm hearing a lot of, and I had a phone conversation with the bridge lender that we're very close with, and he had told me, Andrew, you've done a lot of deals together with us, with him, and he said to me that he sent out.

Five notices of defaults in the last week, I'm like, my God, that's a lot. And he's like, this is the first time we've done that in one week. And then I said, well, what was precipitating it? Why'd you do it? And he said all the things that we could anticipate. He said, you know, I had borrowers that had, you know, CapEx busts.

And so I had to re-margin their loan, depleted interest rates, and springing rate cap obligations. They weren't fulfilled, and I said, is this out of the blue? Are you just defaulting them because, you know, or did you give notice? They're like, man, we shared so much notice, but we gave notice.

We reserve our rights. Then we gave notice, and we booked our rights again. And then, we gave notice and reserved our rights a third time. And now I've just decided that market conditions have deteriorated to the point where we're done. We're tired of giving notice and reserving our rights.

We're, we're escalating this. So that's the first time I heard about that many NODs. Being issued in a week, assuming it's true in 15 years,

Chris Powers: What's a CapEx bust?

Zach Streit: What is a CapEx bust? So when I say CapEx, I refer to capital expenditures just for the backing up. So in a lot of, in a lot of deals and just backing up.

You see bus more on the construction side than you do on the value-added side. But, we're all familiar over the last few years, given inflation and escalation and costs, that there have been many cost overruns or buses in large construction projects. And that means that the cost of materials and labor or both exceeded, you know, what the sponsor pro forma or exceeded what we often see.

That was envisioned in their GMP and their contract with their general contractor. And that can happen for a variety of reasons. I don't think we have to go into all of them, but what fewer people knew about, I think, was that many value-added deals, particularly in the multi-family space, but Chris, probably in the industrial space too, that required some repositioning of the asset.

So you were, you know, going to increase rents because you were repurposing industrial property, you know, adding devising walls, maybe you're adding a cold storage component, whatever it may be, or an apartment deal, you were turning units, and you know, you were adding new appliances and new flooring and new pipes, new MVP, whatever it was, you know, sponsors proforma X.

And the cost became Y very common, you know, bust outside. And that, so that's a CapEx bus.

Chris Powers: A lender would say we need to resize your loan because that happened. Cause you're out of whack.

Zach Streit: A hundred percent they will say that. And now more than ever, lenders want to ensure their position is secure.

Lenders want to ensure they have a fully funded holdback, which means that if you hand back the keys to the project, they have enough money in their loan to complete your business plan. So, folks must understand this. A lender never, ever, ever wants to be exposed where if they took back a property, they need more funds in their CapEx reserve, construction hold back reserve to complete your business plan.

Now, do they do that if they take the property back? Maybe, maybe not, but it doesn't matter. They never want to be in a perceived position of weakness where they need more money to complete the project.

Chris Powers: Okay. We will move into what I will call a deal that starts going bad.

What do we do? But I want to tee it up with this because many people who have not done this for a long time all think, Oh, my banker is my best friend. I play golf with him all the time. My debt fund guy took me to play golf in Cabo, where we're boys. We're good if things don't work out, especially at the bank level.

Can you give a blurb on it? It's not up to the banker at that point. There are way more forces at play. So, I always joke that all banks are a front for the government. They take you to play golf. They act like they're private institutions, but they are government-controlled entities. That's why there are auditors every 90 days.

It's why, I mean, it's a government entity. So, from your perspective, is the banker my best friend? What is that? What does that mean to you?

Andrew Kirsh: Yeah. So we're having these challenging conversations exactly to the point you're talking about, Chris, who is the originator of loans with enormous business development and closing budgets. They're going to abandon dunes, and they're going to Cabo with the borrower.

And sometimes, the lender or the lawyer gets invited. I know Zach always gets asked, but the lawyer sometimes gets invited.

Zach Streit: And they only invited me because my golf game stinks.

Andrew Kirsh: Everything's hunky dory. Everything's great. And now we're in a situation like we're in now, low maturities or rate cap ups are due, and where's Mr, you know, fun-loving, golf inviting, boondoggle invitation?

He's not there. He even throws his hands up and says, Hey, Mr. Ms. Borrower, I'm helping. I'm trying to help. I need help to do something. It is now in the asset management department. It is now in the servicing department, and it's up to them, and there's no relationship. And those people aren't invited on the boondoggles.

They're not playing golf. They're not at pebble. And so it's very frustrating for borrowers who got sold on a relationship lending structure or idea. And that relationship is only as good as when the market is good. And when the market isn't good, that relationship doesn't matter anymore because the bank needs to protect themselves, and everyone's in it for themselves.

So, the biggest example we see is as loans are coming due. This quarter, next quarter, in the couple quarters into 24, how are lenders dealing with the fact that they are, that they've got an issue in how do they get paid back? Because they know there's a very small chance of an outside lender taking them out.

And so, extending the loan, what will it cost the borrower to develop a loan when they're not meeting their covenants? And it's usually how much the borrower has to pay down this loan, has to re-margin the loan, and has to make a decision: am I going to spend seven figures, multiple seven figures, in re-margining this loan for six months, twelve months, eighteen-month extension?

Am I going to be out of the woods in that period? And if the answer is no, it's a much more difficult conversation.

Chris Powers: Right. So I call you guys and say, I'm starting to, I got a bad deal. I've got a variable-rate loan. We can call it on; the asset type doesn't matter, but I need help.

I don't see any end in getting out of this deal alive, and candidly, I've already gone to my investors, who're not putting any more money in. And look, I still got to put food on the table. Every payment I make to the bank now is just cash out of my pocket that I know I'll never see again. What do I start to do?

Zach Streit: Yeah. So it's a great question, and it's a timely one. And we just signed up our second, what I'd call recap transaction of the year, where we had exactly the scenario you mentioned, Chris; we had a sponsor who owns four properties for multi-family value properties down in Phoenix.

He knows and is open about the fact that his equity is wiped. He has talked to the equity extensively, and they're not interested in contributing any more capital. He's got some busts. He may even have a NOD. I'm unsure yet, but I'm finding out in real-time. And he came to us, and he said, you know, Hey, like, what can I do here?

And we said we can help you. And we can help you in a few different ways. The first way is a classic post-GFC transaction, which many folks probably last saw 15 years ago. We spoke to his existing equity partner and confirmed everything he said, and we said, okay, you know, would you be okay?

Let's recap this on a debt basis to start bringing a new equity partner. Either pay down the loans with that money or take them out with new lenders completely and allow the new equity to make a 20 on its money. And then you, Mr. Existing equity partner, can get, you know, 50, 50 on the ups after a 20.

And it was a challenging conversation. And we knew the existing equity partner well. And he, you know, at the end of it, he said, you know, yes, that's much better. Then, I'm returning the keys and being extinguished because when the market rebounds, I can get something. So the first thing we did in this situation was say, Hey, we can help.

And here's our thought on how this could go. You're going to be at the forefront of this. But that's a good thing because there's a lot of appetite for these transactions in the market. People have been discussing them for the last 12 months and have not seen them. And when they have seen them, they've been on busted construction projects or in tertiary markets where people don't want to touch them.

But now we're seeing it in a really good market that got overheated from an asset value perspective. So that's the first thing that we can do in that situation. The second thing is to look once we go out and field offers. If we can find someone to recap this deal on a debt basis, you know, great a transaction occurs.

If we can't, we will arm the lenders with a lot of data on where the market is. So if nobody gets to 110 million in total recap cost on this deal, and the mark comes in at 95 or a hundred, lenders will know that, and they'll see that we went out to 200 or 250 equity sources.

Those are the same equity groups that will probably back a note buyer or a note sale if the lender were to sell its notes. So we're going to the same guys, and the same guys are giving you that feedback. So you now know where the market is, which could help inform decisions. And it doesn't mean it's over for the borrower if that happens.

Some lenders will tranche their notes into an A and a B, take a hope note, and bring new capital and wedge in between, so there are things you can do. The most important takeaway for me and the sponsor in this situation was right: he is trying to do everything he can to preserve any value for the existing equity.

And if there's one thing I would convey to the audience here if you are a sponsor in this situation, and many are, you're not alone, right? Some people are here for you on a friendly and professional basis but also do everything you can to try and preserve value for your existing equity because they will remember that you did this.

They will care that you did this. You will also build up the right reputation in the investment community. If you want to continue doing more deals, don't try to do everything and say, I'm out, handed back the keys, see you later, good luck. You are rebuilding your track record. Good luck going to your existing or new sources of capital.

Even with our help, when we have to talk about how you acted, how you comport yourself when things are tough.

Andrew Kirsh: Yeah. You know, what's interesting is that, you know, the market started changing. What would you say, guys, May, June of 22, and for 12 to what 16 months, you know, people would ask me, wow, Andrew, you must be so busy.

It was loan workouts and loan modifications. And I said, actually not, I'm not, it's a frozen market. Many folks have their heads in the sand, and we're not doing these transactions that we did every day from 2008 to 2011; all of a sudden, in the last 45 to 60 days, it is like GFC days, all over again.

And so it's inbound calls on strategy, whether representing a borrower or a lender navigating through the situation. And so whether it's these recap deals, which are difficult because the equity has not transacted for the last 12 to 18 months for them to return.

They want blood, a high cap rate, and a low basis. It's hard for that to pencil out preferred equities. We've done more preferred equity deals in the last few months than in several years. The cost of that capital is getting more and more expensive. And it takes more work to even recap a deal.

Zach, you could talk about this and be on the equity side when they can get equity-type returns—being on the senior or being in a preferred equity position. So it's just a challenging market, and you have to be creative, and the lenders that recognize that they must be entrepreneurial must be innovative.

Will the ones that will end up being okay with their portfolio and the lenders that are just going to have their heads in the sand and not think creatively and take back assets, they're going to end up with the same problem? And so the bet these lenders are having, and the discussion they're having is, you know, is it an operational problem and the borrowers the issue, or is it a capital markets problem? We're all in it together, and we need to restructure the capital stack so that in 24 months, we all will benefit, but we'll take some lumps now.

And we're going to do things that we don't like doing in maybe reducing loan principle, reducing or going from an advertising loan to an interest-only loan, or allowing people to leapfrog us in priority and, you know, subordinating our position to a more junior position. Still, it will give us a better exit and outcome 24 months from now.

Chris Powers: Everything I'm hearing, and this is just nailing this point home, acting in good faith matters. It's more than just paying the lender is all they care about. It's preserving reputation. It's exhausting every resource, and that's free to do. It does. It's free to work hard. That can't be understated enough.

Cause a lot of people think no matter how I act, if the bank isn't getting their payment, I'm toast. And what I'm hearing from you all is a lot of this is how you act, treat people, and the work you're willing to put in to make it right.

Zach Streit: 1 000%; you must let your lender know at every turn what you are doing and what you are faced with because there are no surprises anymore. People know it's tough.

Chris Powers: So, in most situations, I imagine that if we're like today, the lender will not be surprised to hear that you're in a tough spot. As you said, there'd be very few lenders; this started in May of 2022. People who aren't in real estate don't realize that we've been feeling this now going on 18 months, and it's accelerating now.

You call your lender, and they're probably like, yeah, we knew this was coming. My question to you all is, and maybe this is for you, Zach, when you know it's toast, you have some cash left, but you know that every dollar that you now give out is never coming back. What do you do? Because a lot of people are looking at their balances and checking accounts.

I need to, even though I owe it to the bank; like every time I make this payment, I'm toast to what begins to happen from the bank side. So then you call your bank and say, I'm in trouble. I have a bit of cash left, and I've again, equity isn't coming in. And I may still need to find a rescue loan.

Like I'm tapped out of resources. Now, what's starting to happen?

Zach Streit: Yeah. So, great question. We've seen that the lender will be the one in that situation to initiate the dialogue because something will happen, right? A loan needs to be rebalanced from a capex perspective. A loan requires an interest reserve that has now been depleted because of the run-up in rates or is taking you longer to refinance or execute your business plan, and you have to replenish it.

There's a spring rate cap obligation, which is a big one in debt fund land where guys either didn't take out rate caps at all and something happened, and they had to, or maybe they took out a one-year rate cap, and they had a three-year loan, and they had to do another one. So some sponsors will proactively reach out, realizing this will happen, and say, Hey, we don't have the money for this.

Others will wait until it occurs, which I wouldn't do. And then they'll get a notice and cure letter from their lender saying, Hey bud, you know, you've got to buy a rate cap, and that's called tough. Looking at the volatility in the ten years, you know there was a positive story in recaps for a long time.

End of last year, it was about two points on a rate cap. Then I went down to one, then to 50 bits, and now it's probably back up around a point again. It can be significant what you'll have to pay. So over communicate upfront, but when that notice comes, you've got to call your lender, and you've got to explain the situation, and you've got to work it through with them.

You have to say like. We need the capital to do this. My investors are not going to pay here. We're concerned that your LTV might be at 100%. That's the reality that most folks are facing. The lender is not going to be surprised by it. Come up with a solution. And maybe that solution is to hire us.

That solution is to hire Andrew or anyone. It doesn't have to be us per se but in this situation. Work with a capital advisor that understands how to work out transactions. Find a lender, find service providers that can help you work through the transactions on a workout basis, and that know what to do, and they can help you script strategies to deal with this.

We're doing a lot of this. There are a lot of deals now where we're getting hired to do two things. We're getting engaged to negotiate with a lender over here, and we're getting engaged to run a new process over here. And sometimes, the two are overlapping. We have a deal today where the new operation will require some concessions from the lender, assuming the lender doesn't want to foreclose.

And most lenders, not all, most lenders do not. But it would help if you came promptly. It is important to communicate up front, say, Hey, all right. I know I have a problem. I don't have the million or two million dollars for this spring rate cap coming up, or they send you that notice and cure.

All right, here's what I'm doing. Bring us into the deal, or bring somebody into the deal or a workout specialist out there who can help you flip a script. There may be deals that are so upside down that, at some point, there's nothing to do. We're marketing a preferred equity note on a big busted construction deal in Irvine.

Most of our feedback is that the preferred equity is toast. The bond, the sponsor is toast, and even the senior lender might be impaired; at that point, it may be hard to do anything because there's been so much value degradation, but I don't think that's most deals today. Most deals today are on the margin; the value is somewhere on a spot cap rate basis where the loan amount is.

So there's room there. That's a partial wipeout. That's not the lender saying, Oh my God, my loan is worth half.

Andrew Kirsh: So you asked Chris, you know, why are lenders not foreclosing? Some will, but lenders must be set up to own and operate real estate. They're set up to lend, charge an interest rate, receive that money again, and put it out again and do that repeatedly.

And when you're in a one-off situation, when the borrower didn't execute their business plan, they'll foreclose. Because there will be someone else who will step in, and the lender will either take it asset management for a while and then sell it. But when you're a lender, you see a tidal wave of foreclosures or Dean and loss, which we could talk about or short sales.

They're not set up for this. They need the infrastructure to operate and asset manage, especially construction projects or challenging real estate that require a lot of leasing and tenant improvements, such as an office or multi-tenant industrial. It is daunting for them. And so they want to work and have no choice but to work with the borrowers.

Borrowers know that, and on the borrower side, we're seeing borrowers.

Get approached by lenders who have made offers to their borrowers or demand to extend loans for 12 to 24 months by re-margining and paying down some principal, and borrowers say, no, I'm not. Just take my property. Here are the keys. And now it puts the lenders back on their heels, saying, do we want this asset?

Chris Powers: Real quick. So I know what happens when I'm in trouble, and I call Zach, but Andrew, I also, I'm going to contact my attorney and be like, I need you to engage. What will you probably tell me in those early, maybe that first couple of phone calls or advise me to do as a pure attorney in this deal so that I can start thinking of how to protect my company, my entity, myself, whatever it may be?

Andrew Kirsh: The first thing goes back to what we discussed: reviewing the loan docs and ensuring what guarantee exposure you have. That is critical if it is a non-recourse loan; sometimes lenders get creative. They can seep in recourse-like provisions if they don't have sophisticated borrowers or counsel.

And so that's number one. Do you have any recourse exposure? And the answer is no, you don't have recourse exposure. We're discussing whether you are willing to return the keys. Do you want to fight? Do you want to save this property? Do you want to continue to own it?

Do you want to work with your equity providers and investors to save it? And I'll tell you what, Chris, plenty of clients of mine have talked to their tax advisors, who have given them the advice and have said, that's all specific. It's all case by case, but they have said that if you get a foreclosure and just let this thing go to foreclosure and have a deed in lieu, You will be better off financially from a tax perspective.

Take a tax loss and give the property back. Let's live it, let's fight another day with other properties, then try to make it work with an asset that has no light at the end of the tunnel, which will take 2, 3, 4 years plus to get to a cash neutral position and hopefully, cap rates have come back down.

Prices have come back up, the market has adjusted real, interest rates have come down, and we'll sell it then. And the decision is to take a tax loss in some cases. Now, then, the follow-up question: I don't want to be the moderator here off your show, but the follow-up question is, well, what does that mean?

If I'm taking a foreclosure on my record, a deed in lieu, a short sale, and Zach, that's, you know, I would love to hear your thoughts because I get that question a lot. A lot of that impact is based on what lender foreclosed. Is it an agency, Fannie Freddie lender, that will put you in the penalty box for an extended period, if that happens, versus a debt fund where they seem to have short memories? And so, how does that affect your ability to obtain debt and equity when you have this on your record?

And that's usually at the load application stage, where you're more involved act than I am.

Zach Streit: Yeah, it is a good and timely question, and it has been a big problem just now, and it will become one quickly. Your point is a good one, Andrew. It depends on who your lender is, and it also depends on how you act.

So, for sure, every lender is going to ask these days and is asking, do you have defaults in your current portfolio? Do you have any foreclosures? And if you do, what are you doing to work them out? We're seeing this now in the early screen on deals we had. And it's a new thing over two or three months.

And I expect that to continue into next year. It would be best if you had a sponsor; we will coach you as a sponsor to have a letter of explanation. You have to talk about what's going on in your existing portfolio if there are issues and get ahead of them. The worst thing you can do being in the run-up of trying to obtain financing is hide it, and then it comes out because credit checks flags, or they read about something worse on like real deal or curbed, and now they know that you're in trouble.

Or they're, you know, all these lenders talk, they all have buddies at different shops, and going out and having drinks, and they're like, oh my God, did you hear about this guy? I mean, he was; he was just awful to us. And he wasn't communicative, and he, you know, basically was stonewalling.

You don't want that. I don't think that for most debt funds, if you have one of these, it necessarily puts you to your point, Andrew; in the penalty box, there's much more flexibility than Fannie and Freddie government lenders. There's also a lot more flexibility than banks. Banks are going to see this very myopically.

If you have NODs and foreclosures, you're probably not getting a recourse loan for a while. And that's something to think about. So letters of explanation are something you need, and you need to bring in a co-GP, and that line is not exactly known because a lot of time has passed since the line was more known in the GFC days.

And I am curious to know how different lenders react to different situations. But it would help if you were communicative about your actions; they need to make sense. And to Chris's point earlier. It would help if you did the right thing. Okay, and you don't do the right thing. You're in the penalty box for sure, and you're out.

Chris Powers: Okay. I want to take this back. So we're now at a point where I will foreclose. I've exhausted all my resources. And even though we've talked about most lenders don't want to, we're just at no other option, and I have a personal guarantee, and now I'm starting to feel the pressure.

What is happening? So it's like the events of, okay, we tried, we're still acting in good faith. The property is worth less. I'm in a bind. I have a personal guarantee, a family to feed, and other things. Now, what starts to happen?

Andrew Kirsh: So, and if that's an uncomfortable situation and you don't know your full exposure until the lender has exercised its first remedy of foreclosure, sold the property, and now you've marked how much of a deficiency is there, that's when a guarantor knows their true exposure.

And if they're getting hit on several frauds on several lenders and have recourse. And this is, you know, an example of what we've seen by certain borrowers, then the ultimate decision they need to make is whether they file bankruptcy, and that option is there for them. And the government has set up this structure.

To allow borrowers to restructure debt across a portfolio. It's not there for a single-asset deal. It's there because creditors across a portfolio are jockeying and positioning themselves of who will get what piece of you. And a bankruptcy reorganization will do that in a structured way.

There will be consequences, but do you know what Chris and Zach know, folks? Plenty of established real estate professionals have filed for bankruptcy and come out of it 10 to 20 times stronger and wealthier than before the bankruptcy. And it's how do you do it? What's your communication style?

How forthcoming were you? Were you trying to screw people over, or were you trying to say, guys, I'm trying to make the best thing out of the tough situation, and they rose again.

Chris Powers: If I was going to file for bankruptcy, can you say it's not a single asset? I have many creditors coming after me; I've done my best.

At what point do I make it? Is it an attorney telling you it's time to file bankruptcy? Is somebody telling that to me? Because if I've never filed for bankruptcy, I don't know when to. There may be a different time, or there is the right time. Is there a certain thing that once I've crossed this line, it's time to think about?

And maybe the other question is so I don't regret it; man, I wish I had filed it earlier or something to that degree. Because if you've never filed for it, you don't necessarily know when.

Andrew Kirsh: Yeah. And there are things called preference actions and, you know, things of that nature where if you are, if you are making payments to certain creditors and then within a certain period file bankruptcy, will all those payments can be clawed back, because of a fraudulent conveyance and preference. Look, that decision is a personal decision made by the client, the borrower, an attorney, or a financial advisor.

And when you see that your liabilities far exceed your net worth. And there's no end, and there's no recapitalization that Zach or other arrangers of capital have exhausted all avenues. And that's what the bankruptcy system is there for.

Chris Powers: And what assets are protected? If I say I'm filing for bankruptcy, I have nothing left, but I must buy a meal tomorrow.

And I know, maybe your is a protector, what situation? What assets can I keep and which ones, and what is leaving?

Andrew Kirsh: Yeah. I look first. I play a bankruptcy attorney on TV, and we have bankruptcy attorneys at our firm, but there are, as you said, there are assets that will be protected, and the state also states it in terms of homestead protection; there are protections of retirement accounts and pension accounts and things of that nature. The bankruptcy court, along with the trustee and lawyers or creditors committee or certain creditors, will determine the fate of the debtor and the assets that will be split among the first; the secure creditors go first, and then the unsecured creditors go next.

And, if you're filing a Chapter 11 reorganization, the goal is to reorganize to recast the debt amounts to reduce the debt amounts so that you can continue as a going concern when you come out of bankruptcy and operate.

Chris Powers: To be clear, if you go into chapter 11, which may be real quick, there are multiple types of chapters.

There's chapter 7, chapter 11. What is the difference between the two?  

Andrew Kirsh: 11 is a reorganization with the expectation that you will come out of this, reorganize the debt, and still operate as a business; 7 isn't just a pure liquidation. That's when they're just selling all your assets, and you aren't going to have that company exist anymore.

Now, as an individual, you are aware. You reconstitute yourself and re-establish yourself under a new company, start all over fresh, clean, with no debts, no assets other than the assets you are allowed to keep under bankruptcy laws, and start over, partner with GPs, and partner with groups who feel that.

It wasn't you personally. You could have been a better operator but got caught with bad timing and capital markets.

Zach Streit: I would add that Andrew knows this better than me. When you do an 11, there's a repayment path. There's a repayment concept that your creditors are going to get repaid in whole or in part.

When you do a seven, that repayment concept extinguishes. There is no more repayment like you are starting fresh, so there are options.

Chris Powers: And it should be said, call a bankruptcy attorney if this is the route that you're headed. I know you know enough at a high level. Who decides to file Chapter 7 or Chapter 11?

Or do you make that decision once you realize where you stand?

Andrew Kirsh: A combination of a bankruptcy attorney and a financial advisor. In looking at the financials and looking at the amount of debt, who the lenders are, the type of debt secured, unsecured, is there a prospect of, is the company a solid company that has a bad capital stack and needs to reorganize itself, that is what chapter 11 is for.

Suppose there's just no end in sight. And it just needs to be liquidated; that's chapter seven.

Chris Powers: Okay. And just quick. So, in this scenario, we had discussed where I own a property, the equities are wiped out, and nobody wants to put money into it. It's worth less than the loan. I filed for bankruptcy. We're talking about a single property, but we could be talking about a portfolio.

And I go into chapter 11. Am I going to the lender because the lender's going to foreclose, right? They're going to take back the asset already. Am I then going to them and saying, Hey, I know I owe, there was, maybe I'm calling it, a $2 million delta on what I owe you and what you could sell it for?

I'm renegotiating with that bank; let's make it a million, or let's make it half a million that I owe you instead of 2 million. They're agreeing. And then, as I emerge from bankruptcy, I have some plan to pay them back whatever I owe. Or is it just you owe me 2 million, no matter come hell or high water, but I might create a plan that gives you much longer to pay me off?

Andrew Kirsh: Yeah. Single-asset bankruptcies are rare and inappropriate, and a judge will kick you out of bankruptcy because of the proper remedy. It is a foreclosure; that's what the deed of trust or mortgage is for. They're secured, and the borrower uses bankruptcy as a stall tactic.

The lender will file a motion to get out of bankruptcy. It will likely be granted three or four months, and then they will foreclose. The bankruptcy process is there because there's recourse debt. It's across the portfolio. The borrower wants to avoid choosing and is not legally entitled to choose which creditors they will pay and at what percentage amounts.

And so the bankruptcy system is almost like a board of judges who has to confirm it. The creditors committee, the debtor, and the trustee will all come together and figure out a plan of who's getting knocked down on their loan amounts, who's getting paid, and what's the capital stack, and that plan is then put in place because there is a belief by all these players that this borrower, this debtor.

If reorganized properly, it will be able to be a going concern in the future and operate. And so that's what it's there for.

Chris Powers: And then we've talked about many success stories. There are people everywhere who have filed for bankruptcy and come out, and they are much stronger today. They have lessons that they've learned; they've built back wealth. Are there any lingering effects besides telling lenders or people, Hey, I've been in bankruptcy before? Are there things that pass off to your estate or other nonobvious things that happen when you file bankruptcy?

Andrew Kirsh: Well, the bankruptcy is your restart, right?

That's what gives you a completely fresh start. What lingers with you is that for every loan application or every equity application, you're going to check a box that you filed for bankruptcy. But like I said before, I've got plenty of clients whose success stories post-bankruptcy would shock you because of how they did it.

Chris Powers: All right. I know we've talked about tough things, and, you know, these are not fun things to discuss, but you know, business has real implications. Taking on debt has real importance. The positive I've taken from today is that this isn't.

If you're in a bad situation, it's not game over. How you act is the most important thing. And if you have people that you could reach out to and talk to, lenders and lawyers and advisors, start calling them early. There's no shame in telling people I'm in a bad spot. The quicker you admit it, the more you can solve it.

And so I'm ending on a high note that there is a process to get through this that could end with great outcomes. And Andrew, if there are any parting thoughts that you have for the audience on, you know, today's conversation, we'd love to pass it off to you.

Andrew Kirsh: Yeah, I know. First of all, Chris, I appreciate you having me on, and Zach, these are challenging times.

And for a lot of people who got into the business, you know, a decade or 15 years ago, they've only seen up, up, up, up, and up. And you and I have seen a couple of cycles there; our mentors have seen more. What was abnormal is that we hadn't seen a down cycle in 15 years, and usually, the cycles are seven to eight years.

There will always be tough times with how you communicate, conduct yourself, understand your rights, and understand that, yes, a lender is not your friend, but they also don't want your property for the most part. They are not predatory lenders. There's very few of them, right? These lenders want to lend money, get paid back, and do it over and over and over again. If you can think creatively with them, that should produce a win-win scenario. And if there is no light at the end of the tunnel, and you feel just from an intellectual standpoint, a dollars and cents standpoint, that it just does not make financial sense to spend good money after bad, then don't.

The last thing you should do is chase and invest more money in an asset that doesn't have a good outcome. Give the keys back to the lender. Do a deed instead of foreclosure. Be cooperative and even offer to asset manage the asset for the lender. That seems shocking to some people, but a borrower will become an asset manager for the same property they own.

And it just helps the lender, and it helps your reputation.

Chris Powers: Andrew, thank you so much for today. It was impactful. I appreciate it. Thank you.

Andrew Kirsh: Chris. I appreciate you having me on.