Navigating a New Era of Rising Costs, Rising Interest Rates and Other Unanticipated Economic Concerns
In today’s economic climate, many commercial property owners (“Property Owners”) and their general partners or managing members (“GPs”) have suddenly found themselves with underperforming properties and substantially lower property values. GPs must navigate a tense tapestry of considerations, balancing concerns over:
Rising interest rates
Rising property costs
Changes to rent laws
The upcoming debt ceiling crisis
Ramifications related to recent bank failures
Post-COVID effects
General geopolitical uncertainty and divisiveness
All of the foregoing concerns have now completely upended the GP’s business plan on projects that they closed on just a few years ago and created significant uncertainty amongst not only Property Owners and their GPs, but also their limited partners (“LPs”). Therefore, right now is the time for GPs to be proactive in protecting their properties and staying engaged with their LPs.
In light of the foregoing concerns, it is important for GPs to take a new hard look at these properties, re-think their business plans, and most importantly stay actively engaged with their LPs. GPs will most certainly have to address challenges from many of their LPs who will want to receive timely property reports and an honest assessment of their investments. In order to achieve these objectives, GPs should regularly communicate with their LPs by providing updates on their investments, the state of the market, and keep them informed of any potential risks that may arise. To that end, GPs should also take another look at their existing loan documents (especially loan covenants) which will reduce the Property Owner’s risk of breaching such loan documents. The foregoing will help keep the LPs informed and engaged, all of which will not go unnoticed by LPs. This engagement should pay off in the future when the market once again changes and the GP wants to go after that next deal with many of these same LPs.
Review LP Agreements
In today’s economic environment, there is an increased likelihood for LPs to be faced with capital calls, related to a refinancing or even in connection with a sale, given the reality of (x) higher interest rates, (y) lower valuations, and (z) tightening underwriting requirements from all the usual mortgage lenders. As a result of the foregoing, there are currently very few, if any, cash-out refinances taking place in commercial real estate and that trend is likely to continue for the foreseeable future. GPs who just a few years ago were hoping to benefit from earning their carried interest and promotes are coming to the realization that such a likelihood has been greatly reduced, and they are stuck with having to spend time and energy helping to manage a property while recognizing little or no economic. Meanwhile, LPs, who were expecting a relatively safe return on their investment, are now not only wondering if they will see a return of their initial investment, but will they now be subject to a capital call (and the impact of not meeting that capital call). GP and LP interests in the investment may start to diverge, creating tension between the parties. Imagine the negative feelings that could be brewing between the two if the GP is earning asset management fees and a potential disposition fee on the sale of the project while at the same time the LP is losing some, if not, all of its investment. It’s these types of scenarios that make it so important for the GP and LP to have an open dialogue with each other. In order to prepare for a likely higher volume of questions and requests from LPs, GPs should be familiar with the operating agreements the LPs have signed, focusing particular attention on the capital call and waterfall provisions. Therefore, GPs (and LPs for that matter) should take a fresh look at the following in the operating agreements:
Waterfall Provisions. The status of priority returns, carried interest, promotes, or other fees that may be due to the GP and the likelihood that any of the foregoing will be earned by the GP and LP.
Capital Call Provisions. The effects that may result in the GP making a capital call notice to the LPs. Will the LPs be subject to punitive dilution, default interest, or a loss of any of their consent rights if they fail to satisfy a capital call?
Transfer Provisions. The procedures that are in place under the transfer provisions of GP and LP interests (along with the respective provisions in loan documents). While any such transfers will likely need GP (and possibly lender) approval, certain LPs may insist on being allowed to sell their interests? How will the GP’s approval (or disapproval) of this request affect its relationship with such LP, and how will such a decision affect the GP’s relationship with other LPs?
By taking into consideration all of the above, GPs will be better positioned to have informed conversations with their LPs and thus be able to address any of their LP’s questions and demands, all while working to maintain a positive working relationship with their LPs.
Stay in Compliance with Loan Covenants
Property Owners and GPs may find themselves having trouble complying with certain loan covenants, especially as it pertains to loan to value and debt-service coverage ratio requirements. As such, they may want to seek to modify some loan terms or at least work through any such issues with their lender. Although this can be relatively easier to do with traditional bank lenders, the same cannot be said for non-traditional lenders and CMBS lenders. Even banks, who tend to be a little more forgiving when it comes to violations of such loan covenants, will lose such patience at some point which may result in a more aggressive approach or even a sale of its loan to a new lender, who also may not be as forgiving. Add to the foregoing, recent regional bank failures and the sale of their loan portfolios and all of a sudden the GP may find themselves speaking to a complete stranger who may not be as sympathetic to the Property Owner’s and GP’s situation. No Property Owner with a traditional bank loan wants to find themselves in a situation where they are now forced to deal with a new lender who may be more “opportunistic” with their loan portfolio and just waiting for a Property Owner to default on its loan. Accordingly, it is imperative that Property Owners and their GPs stay ahead of their lenders and be fully up to speed on their loan agreements, especially all of their obligations under various loan covenants and financial obligations. Experienced Property Owners should make sure they have a system in place that can properly track such covenants and provide timely quarterly and year-end financial statements.
By staying up to date on their operating agreements and loan agreements, GPs can stay ahead of their LPs and lenders and be well positioned to address the concerns of their LPs, while at the same time staying on top of their loan covenants. Effectively stewarding their LPs investments during such tumultuous times, while communicating with LPs in a clear and informed manner, should be something that their LPs remember when it comes time for the next deal.
If you have any questions about this article, please contact Mitchell Taras at (212) 573-8417 or mtaras@sadis.com and Jonathan Bernstein at (212) 573-8030 or jbernstein@sadis.com.
