Given the state of commercial real estate, the prospect for defaults by commercial borrowers has greatly increased. The last time there was a significant downturn in the commercial real estate sector in the early 1990s, owners of buildings and other real estate often turned to Chapter 11 bankruptcy as a method of buying time and, in some cases, lowering or at least restructuring the amount of secured debt against the real property through a plan of reorganization. This raises the question — will the same story play out again in this downturn?

Major Bankruptcy Law Changes In 2005. As many readers of this blog know, major amendments were made to the Bankruptcy Code in 2005 — formally known as the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”) — including ones that affect real estate. One of the better-known changes was the addition of strict limitations on the time bankrupt tenants could have to assume or reject commercial real estate leases.

However, there was another amendment that may have a significant impact on some owners of real estate in Chapter 11, and could complicate the prospects for using bankruptcy to restructure debt on certain distressed projects. This change was the elimination of a valuation cap that had previously limited the number of real estate debtors subject to the Bankruptcy Code’s single asset real estate (“SARE”) rules, most notably provisions that impose special requirements on single asset real estate debtors to keep in place the benefits of bankruptcy’s automatic stay. 

The Bankruptcy Code’s SARE Definition. Prior to BAPCPA, there were relatively few SARE cases because the definition was limited to debtors with less than $4 million of secured debt against the real property. This meant that only smaller real estate cases were covered by the more restrictive SARE rules. BAPCPA, however, removed the $4 million secured debt ceiling. As a result, a real estate entity owing hundreds of millions of dollars in secured debt may be subject to the SARE rules. Consequently, the number of real estate cases potentially subject to the SARE provisions has increased dramatically.

The Bankruptcy Code’s current definition of SARE provides:

The term ‘single asset real estate’ means real property constituting a single property or project, other than residential real property with fewer than 4 residential units, which generates substantially all of the gross income of a debtor who is not a family farmer and on which no substantial business is being conducted by a debtor other than the business of operating the real property and activities incidental.

11 U.S.C. §101 (51B).

Impact Of A SARE Designation. A SARE designation can have a big effect on the debtor. When a debtor states on its petition that it is a SARE, or a secured creditor files a motion and the Court rules that the debtor is in fact a SARE, the dynamics of the Chapter 11 case will change. As discussed below, a SARE debtor must either file a plan of reorganization with a reasonable chance of being confirmed within the later of (i) 90 days after the order for relief is entered in the case (in a voluntary bankruptcy case this is when the case is filed) or (ii) 30 days after the date the court determines that the debtor is subject to the provisions of SARE, or must start making monthly payments to the secured creditor at the loan’s non-default interest rate. If a SARE debtor fails to satisfy these requirements, the court is likely to grant a secured creditor relief from stay to commence or continue with a foreclosure of the real property.

Who’s A SARE? Not every owner of commercial real estate in bankruptcy will be a SARE debtor. To determine what types of commercial properties and developments qualify as a SARE case, courts focus on interpreting the meaning of “a single property or project.” In cases in which one debtor owns one piece of real property, this issue will likely be straightforward. In other cases, however, the question may be more difficult to determine. For example, a real estate business owning many interrelated projects through separate, multiple limited liability companies ("LLCs") or partnerships may be able to avoid a SARE ruling. On the other hand, an entity owning more than one property, if considered a single project, may be deemed to be a SARE. To read one court’s analysis of these issues in a series of related bankruptcy cases involving multiple entities and properties, click here, here, and here.

If a single property or project is involved, courts then analyze whether the single real estate asset is used in the operation of a business or whether it is simply held for income. A SARE case usually involves passive rent collection without other active business activities that generate revenue for the debtor. The SARE standard is factually driven and generally looks to “whether [the debtors] conduct substantial business other than operating the real property.” In the Matter of Scotia Pacific Company, LLC, 508 F.3d 214, 221 (5th Cir. 2007) (debtor’s substantial entrepreneurial business operations went beyond mere passive collection of money). As the Scotia Pacific court held:

In order to be single asset real estate, the revenues received by the owner must be passive in nature; the owner must not be conducting any active business, other than merely operating the real property and activities incidental thereto. Under the prior jurisprudence, those passive types of activities are the mere receipt of rent and truly incidental activities such as arranging for maintenance or perhaps some marketing activity, or … mowing the grass and waiting for the market to turn.

A business would not be a SARE if a reasonable and prudent business person would expect to generate substantial revenues from the operation activities–separate and apart from the sale or lease of the underlying real estate.

For example, a golf club where the owners are actively engaged in activities such as employing third party workers, selling club memberships and merchandise, and charging green fees, has been held not to be a SARE. Likewise, a debtor in the hotel or marina business also may not be held to be a SARE.

Limited Automatic Stay Benefits For SAREs. A SARE debtor cannot count on the automatic stay remaining in force for an extended period of time. Instead, to maintain the benefit of the automatic stay, Section 362(d)(3) of the Bankruptcy Code requires a SARE debtor, within 90 days after filing bankruptcy, to file a plan that has a reasonable possibility of being confirmed or commence regular payments to the secured creditor at the non-default interest rate.

• A SARE debtor that is not in a position to file a plan will, in effect, have to pay for the continuation of the automatic stay. This can prove difficult for projects that are not producing significant cash flow.
• If a plan is filed instead, the debtor does not have to establish that the proposed plan will in fact be confirmed but must show that the assumptions that underpin the plan are reasonable. What constitutes a reasonable time to confirm a plan will vary from case to case.
• If the debtor fails to satisfy either of these requirements, the secured creditor will likely be able to obtain relief from the automatic stay to foreclose on the property.
• These rules do not preclude a secured creditor from seeking relief from stay on other grounds, such as a lack of adequate protection or other cause.

Overall Impact On Commercial Real Estate. Owners of distressed commercial real estate projects that are SAREs may find Chapter 11 to be less useful than in past down cycles.

• With careful planning, some SARE debtors will be able to restructure through bankruptcy. Yet as an interesting study shows, many SARE (and non-SARE) real estate cases in the past few years have ended with the secured creditor obtaining relief from the automatic stay to foreclose. Faced with this prospect, some owners have simply decided to turn over distressed real property to the lender, often through a deed in lieu of foreclosure before bankruptcy.
• In today’s environment, some lenders are willing to work with real property owners to extend loans and avoid foreclosure or taking back the property. However, if the SARE rules would apply in a potential bankruptcy, this fact may give the secured lender more leverage in those negotiations. 

What’s likely to be the end result of the SARE rules and the 2005 removal of the valuation cap? As single asset real estate projects face default, although some will certainly be able to restructure their debts, many may end up in the hands of lenders as real estate owned ("REO") properties. With distressed borrowers working through hundreds of billions of dollars in commercial real estate loan problems across the country, the negative impact defaulting commercial real estate loans and resulting REO may have on banks and other lenders could end up being the bigger part of this SARE story.