July 22, 2014 | Valuations
In re Civic Partners Sioux City, LLC, 2013 Bankr. LEXIS 4225 (Oct. 7, 2013)
After declaring Chapter 11 bankruptcy, the debtor, a developer, asked the Bankruptcy Court to confirm the latest version of its reorganization plan in a “cram down” proceeding. Two key creditors objected, arguing that the plan rested on an improperly low valuation of the building complex that represented most of the collateral securing the claim. To resolve the issue, the court considered expert testimony on the value of the property.
Road to bankruptcy. In the early 2000s, Sioux City, one of the creditors involved in the case, invited proposals to revitalize a historic district. The debtor, a California real estate developer and his company, won the contract. The plan included building a movie theater complex with related retail spaces, including restaurants, bars, and similar services, as well as a hotel complex on an adjacent property. As part of the development agreement, the city offered cheap land and significant tax increment financing. The debtor received construction financing from a major bank, the other key creditor. The bank took a first mortgage and assignment of rents on the property in the amount of its loan whose principal sum was $5,625,000. Under the loan agreement, the city guaranteed the debtor’s payments up to $300,000 per year to the bank. In addition, the debtor borrowed almost $2 million from the city. All parties agreed that the arrangement between the debtor and the city were subordinate to the debtor’s obligations to the bank. The city had a second mortgage on the property.
The debtor only built the theater complex. It settled the city’s claim that it had failed to perform on the hotel development. In 2004, it leased the theater space to a regional movie theater operator under an agreement that the tenant would pay “several categories of payments totaling $1.2 million in annual rent” and the debtor would fill up the vacant retail spaces with complementary tenants. Essentially, the theater operator was financing the debtor’s whole project; its annual rental payment covered the debtor’s debt service payments to the bank and the city. But construction on the site continued after the theater opened, and it had difficulty attracting moviegoers. Ultimately, its operator was unable to make even one full rent payment.
Relations between the debtor and the tenant deteriorated. The debtor never whipped the vacant retail space into ready-to-rent condition, and by 2009 it had decided not to put any more money into the project. Subsequently, an expert from the city testified about significant water and structural problems plaguing the building and requiring prompt fixing. Eventually, the debtor fell behind on its own payments to the bank, the city, and other lenders. Attempts among all the parties to restructure the entangled financial arrangements in mediation failed when the city decided not to support a proposed new arrangement because of the prior agreed-upon tax assessment and loan guarantees.
Among other things, the parties had contemplated an amended lease that lowered the annual rent payment to $900,000 to address the tenant’s complaints, with one immediate $200,000 payment to make the new lease effective. Before it knew about the city’s decision, the bank had taken steps to effect the loan modification for the debtor, and the debtor and the tenant had executed the amended lease. Once apprised of the city’s decision, the bank cancelled its agreement and filed for foreclosure. The debtor initially adhered to the amended lease and collected on the $900,000 annual rent. But 12 days before declaring Chapter 11 bankruptcy, in April 2011, it reinstated the original lease, without obtaining the required consent from the bank. It never offered to pay the movie house operator back the $200,000 upfront payment or any of the $900,000 rent. For its part, the city sued the debtor for breach of contract based on its failure to pay on the city’s additional loan. The debtor countersued and transferred all the actions to the Bankruptcy Court (N.D. Iowa).
Three reorganization plans. The debtor’s first plan was based on reinstatement of the original lease. The debtor claimed that the tenant owed $3.2 million in back rent and it wanted equitable subordination of the creditors’ claims. The bank called the plan “impossible to confirm,” as it wrongly assumed that the tenant could afford to pay back rent or even was responsible for it and that the creditors did anything to justify equitable subordination.
Eventually, the debtor filed an amended plan that generated the same resistance from the creditors and the movie house operator. It contained a “new value” contribution from the debtor for $150,000, which the creditors found “woefully inadequate” to move the development ahead. In addition, it required reinstatement of the original lease, recovery of back rent, and equitable subordination.
When the lease issue took on urgency, the court ruled that the amended lease governed the case. Subsequently, the debtor filed a second amended plan—the subject of this case—under which it would continue to use the property that served as the bank’s collateral. The latest plan sought to reduce the bank’s secured claim and leave the city unsecured. At the same time, it contemplated full satisfaction of any smaller debt the debtor company’s owner had guaranteed personally. Further, by way of a “new value” contribution in the amount of $150,000, the owner would keep an ownership interest in the reorganized business.
Not surprisingly, the bank and the city requested denial of the confirmation and dismissal of the case. Meanwhile, the movie house operator, satisfied about the lease ruling, backed off on most of its objections. In fact, at the time of the confirmation proceeding, its business was profitable. It was able to pay rent under the amended lease and wanted to stay in the space.
In response to the objections, the debtor asked for confirmation under the Bankruptcy Code’s § 1129(b)(2) “cram down provisions.”
Valuation of property. The bank and city’s objection ultimately boiled down to one argument: that the plan was not feasible under the code’s § 1129(a)(11). Specifically, it significantly undervalued the bank’s secured claim. Proper valuation would leave the debtor unable to pay the secured claim in full as the applicable law required. (The bank submitted a total claim of over $6.2 million.) Also, the creditors argued, the plan was based on unreliable and unrealistic cash flow projections, and the debtor proposed to continue the same futile course with the same ineffectual management.
Because the bank had a first mortgage on the property and the property made up a large part of the total value of its security interest, valuation of the building was pivotal in determining the total value of the bank’s secured claim. Both sides retained experts, who agreed that the discounted cash flow (DCF) method was the appropriate valuation technique but disagreed about variables that figured into the computation, including the length of time appropriate to measure cash flow and inputs for future cash flow.
1. Debtor’s expert. Both experts used the seven years of annual rent that remained under the amended lease to project future cash flow. The debtor’s expert used a 10-year holding period with a projected sale after 10 years. He said he believed the amended lease was substantially “above market” because it was paying off back rent from the original lease.
Fair market value rents would drop “precipitously,” in years eight through 10. This decline in rent, in turn, would drive the property’s resale value down sharply.
As comparables, he used an older movie theater project, as well as other commercial rent properties that did not function as movie houses.
He valued the property at $4.2 million, excluding repair-related deductions. As he saw it, no buyer would take the property without the requisite structural and drainage repairs, which amounted to $290,000, lowering the property’s value to $3.91 million. He subsequently raised the repair costs by an additional $400,000 and decreased the property’s value to $3.51 million.
2. City’s expert. In contrast, the city’s expert used a seven-year holding period with a projected sale after seven years. As he saw it, a prospective buyer would be more interested in the cash flow for the known and definite seven-year period than in adding three years of estimates. This was the most accurate forecast of how a buyer would determine value, he said. But he did give an estimate of Year 8 rent, which helped provide the proper reversion value for his calculation. For that value, he assumed the annual lease payment would be similar to the projections for the seven-year existing lease. But he applied a “generous discount” to account for the possibility—small, he believed—that the amount could drop after the seven-year period.
For comparables, he looked to one similar movie theater complex in Sioux Falls, S.D. This theater was geographically close to the one at issue; also both movie houses were similar in age and were part of economic development areas in their locations. They became the leading movie theaters in cities “that function as regional population centers.” Moreover, he noted that, if the building’s vacant spaces were improved to vanilla shell quality and the rent was lowered to $10 per square foot, the entire space could see full occupancy in three to four years. Avoiding a delay in building out the space, he believed, would improve the project’s financial situation significantly. “[N]ewer dollars are worth more than future dollars.”
He concluded the property was worth $5.54 million, including a downward deduction of $290,000 for the necessary repairs to the building. His valuation exceeded the debtor’s appraisal by over $2 million.
3. Court. The court found several aspects of the debtor’s valuation “entirely unpersuasive.” For example, in assessing rent under the amended lease, the debtor’s expert did not use a similarly situated movie theater. Even though he had more comparables than the competing expert, his selected properties were “less ‘comparable.’” Moreover, he and the debtor strained to explain away the contradiction in the debtor’s position as to the amended lease. On the one hand, the debtor had spent most of the case claiming that it had a right to reinstatement of the original lease, which provided for $1.2 million annual rent, and to $3.2 million in back rent under the original lease. On the other hand, its valuation expert testified that the amended lease was significantly above market value. “The Court finds those arguments hard to square.”
All the evidence supported the city expert’s central assumption that the current rents would continue. To show that the amended lease was near fair market value, he properly relied on a theater that was “a good comparable and good indicator of market value.” Also, the theater operator had experienced an increase in revenue and had been able to pay the rent under the amended lease. If anything, the city expert’s generous discount to account for a possible drop in lease payments may have produced too low an estimate. For these reasons, the court adopted the city expert’s valuation.
However, it agreed with the debtor that the downward deduction for repairs should have been $600,000, not $290,000 as the city expert assumed. This modification resulted in a $5.23 million valuation for the property.
Effect of post-petition payments on secured claim. The bank received post-petition payments from the debtor because of its secured position. The parties reasoned these were appropriate because the case qualified as a “single asset real estate case” under the Bankruptcy Code, § 362(d)(3). In essence, the provision seeks to compensate secured creditors for the use of their collateral. (The court noted that none of the parties had ever asked it for a determination of whether the case indeed qualified as such.)
The valuation-related issue was how the payments affected the bank’s secured claim. As the court noted, if the payments reduced the bank’s secured portion of its claim, the amount the debtor had to pay in full to the bank would decrease, which would make the debtor’s plan more feasible. Conversely, if the payments did not reduce the bank’s secured portion but only the overall claim value, there would be no reduction in the amount the debtor had to pay, and the plan would be even less feasible. Courts have divided over the treatment of such payments: Some have added the post-petition rents to the secured portion and reduced the creditor’s claim from the unsecured portion first; others have subtracted the payments from the secured portion and reduced it before affecting the unsecured portion.
Here the court concluded that the “addition approach” was more appropriate. In applying the approach, it found that the bank’s post-petition security interest in rents increased its collateral, bringing the total value to over $5.5 million. This claim did not include any value the bank claimed for its security interest in “general intangibles,” the court added.
The court’s finding added yet another layer of support to its overall conclusion that the debtor’s reorganization plan did not provide enough funds to fulfill its obligations. Under the plan, the debtor would likely “wind up in a future reorganization or liquidation,” the court said.
Problematic cash flow projections. The court also agreed with the creditors’ claim that there was no way that the debtor could pay off all its obligations over the life of the plan through its cash flow projections. For one, the projections were based on the undervaluation of the bank’s secured claim. But other aspects of the projections were equally questionable.
Even though it was clear that the debtor needed to spend significant amounts of money immediately to turn the project around, until now, it had failed to put that value into it. Testimony showed that repair costs amounted to a minimum of $600,000 and certain defects demanded immediate attention. But the projections deferred most of the maintenance and repairs, without factoring in the greater future costs that would result from the delay. The projections also did not “realistically” address costs related to building out the vacant retail space. By the bank’s “most persuasive” estimate, these exceeded $500,000. “That money simply does not appear in the near-term projections,” the court found.
Repair and build-out costs were likely to rise above $1 million, said the court. But the debtor’s plan only provided for a new value contribution of $150,000 augmented by $148,000 in the tenant improvement account. Even assuming all of these funds were available now, the debtor would still be short. The projections “simply reflect a hope that what did not work in the past will work in the future—without any new ideas or concepts for how that will happen,” the court concluded, finding the debtor’s reorganization plan not feasible and declining to confirm it.