COVER STORY, NOVEMBER 2008

REAL ESTATE LAW ROUNDTABLE
Legal experts outline the opportunities and challenges facing commercial real estate pros in the Midwest.
Kevin Jeselnik and Ashley Ball

Recently Heartland Real Estate Business spoke with a collection of Midwest-based lawyers specializing in real estate to get their perspective on the state of the industry in the face of the current financial climate. The participants included Jay Gitles, partner in the real estate practice group at Chicago-based Seyfarth Shaw; David Frantze, a partner and leader of Kansas City-based Stinson Morrison Hecker’s real estate practice division; David Berzon, partner in the real estate group of Chicago-based Levenfeld Pearlstein; and Jerry Slusky, partner, and Dan Smith, partner, of Omaha, Nebraska-based Smith, Gardner, Slusky.

HREB: With the problems in the financial and economic sectors, what is the bulk of your real estate practice focused on now?

Jay Gitles: Corporate real estate transactions are increasing, which are sort of the bread and butter. Every business needs space because they have employees — that doesn’t change because of the liquidity problem. We haven’t really seen significant bump up yet in the way of loan workout transactions, but most of us expect that to be a significant growth phase coming up if we’re reading all the signs correctly.

David Frantze: A client group we are working with heavily now is the real estate user, those that are buying for their own operations, where their primary business enterprise is not real estate. Those folks are still out there; at least the solid companies are not having trouble getting reasonable amounts of credit.

Dan Smith: A lot of what I have been doing lately is refinancing. There are a lot of deals out there for construction loans, which would be essentially an interest-only loan for a period, or a construction mini-perm followed by a 2- or 3-year period where there are principal and interest payments. In any case, they are coming due and those developers, even if they have successful developments, have to go to permanent financing.

David Berzon: Clearly, we are in a very dynamic and volatile economic period right now, causing the nature of our practice to change almost every month. Throughout the year, we have maintained a decreased, but steady, flow of our typical transactions — sales, acquisitions, leasing, and debt and equity financings. The gap created by the decreased transaction volume has been filled with a significant increase in all forms of workouts, including a very large number involving homebuilders and condominium developers. These workouts involve significant restructurings, foreclosures, other litigation and bankruptcies. Given the immediate economic crisis that has enveloped the United States and other countries around the world over the past few weeks, we see a further erosion of transaction volume throughout the rest of the year, and a substantial increase in workouts. The buying and selling of distressed debt and other troubled assets will almost certainly increase, as a result of the Economic Emergency Stabilization Act and other factors.

HREB: Has there been a lot of activity in re-working/renegotiating leases or loans — marginal deals that may have closed during the boom before the current troubles?

Smith: What I’m seeing are some retail centers that are stressing, with occupancies that have not hit pro forma expectations; therefore, obviously cash flow and cash available for debt service have not hit expectations. What that is requiring is a meeting with the lender and the owner and trying to find a solution that would maybe reduce the amount going to principal or maybe going to interest or so, until we weather the storm.

Berzon: Many, maybe most, deals that did not close before the latest troubles began, have either been substantially restructured — in favor of buyers, tenants and their financing sources — or have simply not closed and won’t close in the near future.

HREB: How are the problems in the lending industry impacting real estate from your perspective?

Gitles: It can’t be good for anyone. My developer clients that had letters of intent or commitment letters for loans have had numerous instances where the lenders have backed away citing the material change of condition clauses of commitment letters, causing clients to scramble to find alternative sources of financing or lose earned money deposits and fail to close.

There is still a disconnect between sellers and buyers on pricing, which is probably driven by lending-related issues because of increased equity requirements, higher interest rates and so forth. And now you’re seeing examples of large public real estate investment trusts that are highly leveraged and facing major concerns about having to sell off into a down market because they can’t refinance. If the larger companies are doing that, you can imagine the issues some of the more entrepreneurial real estate developers are facing.

Frantze: The credit has tightened up substantially in the commercial market, and frankly I think one of the issues that is out there is that, right now, the markets on Wall Street are not discriminatory. They are afraid of the subprime mortgage crisis, but they are going out and treating a commercial lending conduit or REIT exactly the same as a home mortgage one. And the reality is that most of our commercial tenants are still paying their rent; they are still operating in their business. I think there is a difference between how the market is treating [commercial loans] versus what the reality is.

HREB: What opportunities are out there now for real estate companies?

Gitles: Once a pricing correction occurs, those companies with ample equity can presumably buy in at lower prices. Expected returns and pro formas are probably going to have a significant adjustment to what they were being penciled in at in prior years, but those with capital and strong lending relationships stand a chance of succeeding well in this environment.

Jerry Slusky: I think we are too soon on the distressed scale to get there. I don’t think we feel that that is not coming. We are probably several months away from that, but I think people are adjusting to sort of the shock of what’s going on with this bill in Congress and the changes going on in the banking world. Then, I think we are going to see some properties come back on the bank’s balance sheet, and there will be some opportunities.

Berzon: Whenever there is stress in a market and widespread sentiment in only one direction, an opportunity to capitalize exists. Between current depressed market conditions, the Troubled Asset Relief Program (TARP) under the Economic Emergency Stabilization Act, and the fact that most financial institutions will need to dump distressed debt and other assets regardless of their participation in TARP, there should be a lot of opportunities to acquire assets at favorable pricing. Of course, these assets will typically have a lot of problems to be addressed, and strong competition for these assets will exist, but good deals are sure to be available.

HREB: Have negotiations for lease transactions changed over the past 12 months, such as concessions given by landlords or clauses requested by tenants? Have purchase/sale agreements become more difficult?

Gitles: In some respects yes, in others no. Retail tenants in some instances are asking for rent concessions. Those are really business-related issues. As lawyers, when we’re representing landlords we try to be careful and do some creative things, such as asking for rights to recapture if we’re going to give a rent concession — because you don’t want to be caught if the market turns and get nothing in response. I’m seeing significantly more requests from tenants for non-disturbance agreements from the landlords and lenders. Tenants are being more careful regarding concerns about foreclosure scenarios, so that they can remain in the space if the landlord loses the property.

Berzon: Recently, we have seen a greater willingness by landlords to offer concessions for the most creditworthy tenants. As you would expect, landlords’ analyses of tenants’ credit have become more stringent. Landlords are motivated to grant concessions in order to lock up high-credit tenants to long-term deals. On the other hand, in today’s turbulent economic times, landlords are typically avoiding the granting of upfront concessions to tenants with lesser credit, unless they can obtain assurances against losing the value of the concessions if the tenant fails to perform.

With regard to buy-sell transactions, sellers have remained surprisingly rigid, on both price and the other terms of transactions. It appears many sellers would prefer to have it their way, or no way at all. This phenomenon is likely to change, however, as more sellers are forced to dispose of assets due of upcoming loan maturities and deteriorating economic conditions affecting their properties.

Slusky: The board is 100 percent tilted toward the tenant now. The tenant is demanding not only lower rents, but more concessions in the way of either free land or free land plus a contribution for their building. If a national retailer comes to a power center, 2 years ago you would have negotiated a rent and the you would have either built to suit or sold them the land to build their own building. Today, if it is a sale of the property, you will give that property to the retailer, and in the last 6 months, I have seen three deals where the developer has made a $2 million to $3 million contribution to the tenant’s construction cost in order to get the retailer to anchor the center.

Smith: In smaller tenant settings, concessions are quietly being given by many strip center owners. Twenty dollar rents are going to $15 per square foot; they are making deals everywhere. Again, that goes back to the consumer not spending as much and impacting the ability of these small tenants to pay rent.

HREB: How has the rise of green building development impacted real estate law? How can real estate firms contribute to the growth of this trend?

Berzon: There is clearly a trend toward more laws and regulations relating to the development of environmentally friendly projects. As these legal requirements expand, more projects will be impacted, requiring all developers and their consultants to become knowledgeable and to factor in these requirements to many projects. Real estate firms can get involved with ICSC, BOMA, and other local, regional and national real estate organizations to lobby elected officials for green development legislation that makes sense for business.

Gitles: I ask myself how each of the parties to a real estate project are benefited or burdened by a green development issue — the developer, the tenant, the lenders, the government and the public. The developer is looking for a benefit by improving how much material it consumes and building cost it incurs. If it can make a business case that a sustainable design, which developers generally view as increased cost, can recoup the increased upfront building cost through higher rents and/or some form of tax benefits, then it’s a win-win situation. Tenants are always looking to reduce operating cost and, given energy consumption and costs, if [sustainable buildings] are proven to have a material savings in operating costs, then you may see tenants gravitate towards them. But there hasn’t been a stampede yet for that.

Frantze: It is catching on. We are working on a significant lease right now where green building/LEED certification is an important component of the deal for the tenant, so much so that the tenant and the landlord are agreeing jointly to make investments in the property to meet the standards. What the legal role in that process is — that is something that is still in flux. It is something that the lawyers and the development and leasing community are still trying to figure out: what exactly our role is and how it works.

HREB: Are there any new laws that are helping or hindering green development in the Midwest?

Berzon: On the local level, the city of Chicago is offering an expedited building permit process for owners that are building or rehabbing green. Certain states, including Illinois, and the Federal government offer tax-related credits for the use of energy efficient systems in buildings.

HREB: What are the trends or challenges facing real estate lawyers currently?

Gitles: There are likely to be lots of new laws that will emerge and require the assistance of lawyers to advise, interpret and assist clients in navigating the new landscape. The challenge is going to be, frankly, just keeping busy because the number of deals is going to be reduced.

HREB: What do you foresee for commercial real estate during the coming year?

Smith: A lot of [developers/owners] holding 10-year permanent loans from conduits are going to come back to the market looking for new terms, and they’ll be coming to the life insurance companies and traditional banks. The market is certainly creative and energetic; I think something else will come up. There might be a different flavor of conduit, but it just hasn’t happened yet.

Frantze: Number 1, the connection between Wall Street capital, in the form of debt and equity, from a capitalistic standpoint, is a market model that makes too much sense. It is certainly more efficient in the market than the traditional lending systems we have had for real estate. That model, over time, is too logical of a system for it to go away. Now, right now, that system is functioning right, but it will get fixed.

We still feel like we have a wide pool in the commercial real estate industry, but it is a shallower pool than it was. It is harder to dive in when you are not quite sure about the depth of the pool. Frankly, I think we are hesitant to take on risk, to add overhead, to do those kinds of things because are just not quite sure how long it will last and how deep this is going to be.

Berzon: Clearly, the current state of the credit markets and the economy is what is on everyone’s mind, and will likely dominate the real estate market for at least the next few quarters, if not for a substantially longer period of time. On the positive side, the hope is that with more widespread recognition of the problems that exist throughout our credit markets and the economy, we will finally see real estate based assets being re-priced to a level that will allow buyers and financing sources to comfortably re-enter the market. Hopefully, the government bail-out plan will help expedite this process. Exactly how long that will take is the $700 billion dollar question.

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