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According to Wikipedia (here), President Trump’s hotel and casino businesses declared bankruptcy six times between 1991 and 2009. Many people seem to have been outraged by this use of the bankruptcy laws. While I don’t know the details of these specific bankruptcies, I do not have any objection, in principle, to the use of bankruptcy. I have a fair amount of professional experience litigating in the bankruptcy courts, though I am not a bankruptcy specialist.
The positive response to my post, earlier this week, of a real estate investment hypothetical (Trump’s Tax Figures Tell Us Little or Nothing) makes me interested in presenting a similar hypothetical, to illustrate how bankruptcy law works in the context of real estate investing.
I. The Scenario
My prior post illustrated real estate investing using a hypothetical 10-year investment in a $1 billion property ($100 million in land, $900 million building), with an $800 million, interest-only mortgage at 6% (a “loan-to-value,” or LTV, of 80%). The property generated rent of $78 million/year with operating expenses of $8 million/year, an EBITDA (earnings before interest, taxes, depreciation, and amortization) of $70 million. The “cap rate” was 7%. The “cap rate” is the implicit rate of return, which determines the ratio between the EBITDA generated by the property and the value of the property. The basic formula is: EBITDA / interest rate = property value.
For the bankruptcy hypothetical, I’m going to assume a greater LTV (loan-to-value) of 95%. So in this hypothetical, my investment is $50 million and the mortgage is $950 million. I assume an interest-only loan, but the rate is 7% — higher than in the first hypothetical, to compensate the lender for the additional risk.
You might think that this 1% interest rate increase would not be enough, but it probably would be. Here’s a calculation to understand how the interest rate differential worked. Consider the $950 million mortgage to have two components — an $800 million mortgage at 6% (the assumption of my prior post), and a second $150 million mortgage at 12.3%. This provides an overall rate of 7%. As you can see, the lender is quite well compensated for the additional risk inherent in extending an additional $150 million beyond the standard 80% LTV on the property.
Annual interest on the mortgage is $66.5 million, while the property is generating $70 million in EBITDA. So I’m making $3.5 million/year in cash flow (while showing a tax loss of $25 million/year due to depreciation expense).
Incidentally, here is how this hypothetical plays out if all goes well, compared to the hypothetical in my prior post (both assume that the property appreciates by 60% over 10 years):
80% LTV hypothetical: 10-year profit $820 million ($220 million cash flow from operations, $600 million appreciation); $65.7 million tax loss due to depreciation expense.
95% LTV hypothetical: 10-year profit $635 million ($35 million cash flow from operations, $600 million appreciation); $250.7 million tax loss due to depreciation expense.
Note two significant differences. First, in the 95% LTV hypothetical, my total profit is less, because I’m paying a higher interest rate on a larger loan — but this is a much higher percentage return, because my investment was only $50 million, compared to the $200 million in the 80% LTV hypothetical. Second, the tax loss is much higher, because my cash flow is lower (due to paying a higher interest rate on a larger loan).
The period for this hypothetical investment is the late 1980s. Little would be different today, except that there is a slightly longer depreciation period under current law (39 years on commercial buildings now; 31.5 years in the late 1980s).
Loans of this sort, incidentally, were the major cause of the S&L crisis in the late 1980s. At the time, many of the loans were “non-recourse,” which means that repayment was secured solely by the property itself. In a non-recourse loan, if the borrower fails to pay, the lender can take back the property, but cannot go after any other assets of the borrower.
This sounds unwise, but you need to understand that most investments of this type are made through legal entities such as corporations, LLPs (limited liability partnerships), and LLCs (limited liability companies). Such an entity need have little or no capital beyond the value of the real estate, and a wise investor uses a separate entity for each property.
As we will see from the bankruptcy hypothetical below, whether the loan is recourse or non-recourse ends up making little difference because a wise investor does not have any other significant assets held in the entity (LLP or LLC) that owns the real property and is obligated on the mortgage.
II. The Bankruptcy Hypothetical
Assume that things go well for two years, and then there is a serious economic downturn. My tenant, let’s assume just one, for ease of the hypothetical, can no longer pay the $78 million rent. Market rents are down 15% (which is what happens in an economic downturn). The tenant could declare bankruptcy, or could just walk (leaving me trying to find a new tenant in a renter’s market). So I agree to reduce the rent by 15%, to $66.3 million/year for the next two years.
This puts me in a bind. My operating expenses ($8 million/year) didn’t change, so my EBITDA is now $58.3 million/year, while I owe interest of $66.5 million/year; a shortfall of $8.2 million.
Moreover, the property value has declined. Cap rates are probably up, as investors are wary in the economic downturn. Say the new cap rate is 8% (the old cap rate was 7%). With the new EBITDA on my property of $58.3 million, the property value has plummeted to $728.75 million. We’ll round this to $730 million.
My $50 million investment is gone. I’m $8.2 million short per year in the cash flow that I need to pay the mortgage, and I owe $950 million on a property worth about $730 million. What do I do?
File a Chapter 11 bankruptcy, that’s what. Here’s how it works.
I’ve been saying “I,” but as a savvy investor, I hold the property through an LLP (today it would be an LLC). I’ve taken out $7 million in net cash flow over the first two years, but the lender can’t get that back, because the LLP was solvent when I took these distributions.
The lender is secured, but only to the extent of the value of the property. So the lender has a $730 million secured claim, and a $220 million unsecured claim. The unsecured claim can be discharged in bankruptcy, as my LLP has no other assets.
The result is commonly called a “cramdown.” The mortgage is reduced to the current value of the property, $730 million, at the original 7% interest rate.
This may seem unfair to the lender, but I disagree. This is the risk that the lender took. My other option was to simply stop paying and let the lender foreclose, which would give the lender a property worth $730 million, the same value as the “crammed down” loan. The lender would then have to operate the property in the short term (which is generally outside the lender’s expertise) and would have to sell the property to recover its investment (which takes time, and is a bad place to be in the seller’s market of an economic downturn).
The lender’s best course is to argue for a higher valuation. It has two grounds: (1) it could argue that the 15% rent reduction was too much, and that market rents were down only 10%; and (2) it could argue that the cap rate didn’t really go up from 7% to 8%. These changed assumptions would give a valuation of about $888 million.
We might litigate the issue before the bankruptcy judge. Alternatively, we might compromise, and agree to write down the loan to, say, $750-$800 million. Such a compromise might result in dismissal of the bankruptcy with an agreement to reduce the loan principal; or the compromise might be built into the bankruptcy plan and stated in an order of the bankruptcy court.
For purposes of this hypothetical, I assume that I compromise with the bank on a $750 million valuation. Annual interest is 7%, or $52.5 million. My cash flow is $58.3 million, so I have sufficient cash to cover this.
III. The Recovery
After two years of downturn, the economy recovers, and the property gets back on track. For years 5-10, my tenant is back to paying an annual rent of $78 million. This is great for me because I was able to write off $200 million in debt through the bankruptcy. My cash flow for years 5-10 is $17.5 million/year, much higher than the original $3.5 million/year.
My original hypothetical assumed that the property would appreciate to $1.6 billion over 10 years. Due to the downturn, I’ll reduce this to $1.4 billion. How does this investment work out for me?
95% LTV hypothetical with bankruptcy: 10-year profit $723 million ($123 million cash flow from operations, $400 million appreciation, $200 million debt write-off); $162 million tax loss due to depreciation expense.
95% LTV hypothetical without bankruptcy: 10-year profit $635 million ($35 million cash flow from operations, $600 million appreciation); $250.7 million tax loss due to depreciation expense.
Interestingly, in this hypothetical, I actually made more money than I would have if all had gone well because I was able to write down the debt and avoid paying interest. This was true even though, in the bankruptcy hypothetical, the ending property value was only $1.4 billion (compared to $1.6 billion in the non-bankruptcy hypothetical).
Even if the property value recovered only to the original purchase price of $1 billion, I would still have made a 10-year profit of $323 million.