Covid-19 has caused a fundamental disruption in various global economies and sectors across the globe. The novel virus has led to the depression of multiple markets while adversely affecting numerous real estate developments and projects with debt secured against them.
In the first instance, all parties should take a step back and look at the bigger picture. What is driving the distress and is it a short-term blip caused by the pandemic or something more long term? Can the flaw be quantified and remedied?
Does the project have strong underlying potential? Are there opportunistic players in the market looking to purchase the debt encumbering the project?
Financing considerations for the project owner
Where there is a breach by the project owner of the loan-to-value ratio of the debt (which would have been agreed upon by both parties within the financing documents), the bank (as lender) may give consideration to the margin of the breach and whether there is any altitude to revisit the covenant.
Alternatively, the project owner may seek to secure a temporary moratorium on the project in order to 'pause' some of the debt for a set period, or it may strive for a complete renegotiation of the security package terms.
If none of these options are viable for the bank, the project owner may look to sell the debt to an opportunistic investor in the market rather than seek to defend its rights before a court (if the bank decides to enforce its legal rights).
Depending on the circumstances, the sale of the project may be a faster option for the owner to exit from the project to limit their losses.
Issues for consideration by the incoming investor
As the incoming investor seeks to benefit and cash in on the opportunity to acquire the distressed project, an extensive due diligence exercise should be undertaken to assess the legal, financial and tax risks associated with the project.
Moreover, the reputation of the project, the timeframe for completion and the ability to relaunch the off-plan sales or the sales of the completed inventory should be serious considerations.
The asset class of the project will be an important concern too, particularly in light of the fact that some asset classes of the industry have been hit harder than others during the pandemic.
Hospitality assets may have short-term cash flow issues due to low rates and revenues that the hotels are able to achieve per available room (RevPAR), but investors should take a longer-term view when looking at such asset class.
Such hotel assets are typically encumbered by long-term management agreements with reputable hotel operator companies, which may provide attractive yields in a post-Covid world.
The investor may also try to use the restructuring as an opportunity to renegotiate more favourable terms in the hotel management agreement with the hotel operator and perhaps consider different models for the operation of the hotel, such as a franchise-type arrangement.
Similarly, mixed-use shopping mall assets may be subject to leases or pre-lets that will convert into leases upon completion of the construction of the project. These may offer attractive yields to an opportunistic player in due course.
Alternatively, the investor may consider reconfiguring the asset to a class in demand such as a datacentre or a retail warehouse (off the back of an increase in demand for online shopping by consumers).
Investors will need to consider the construction specific issues for completing the distressed project.
The majority of construction contracts will provide the contractor with an extension of time to complete the project due to the trigger of the force majeure clause.
The doctrine of force majeure derives from the French civil law system and is frequently incorporated into commercial contracts that are governed by common law systems. However, it is important to consider the governing law clause in the construction contract as this will ultimately have an impact on whether the pandemic can be classified as a force majeure event and, subsequently, whether the contractor will be granted an extension of time to complete the project.
Supply chain delays for raw construction materials and health directives in force by the government (such as a restriction in workforce numbers and social distancing requirements) are just a couple of additional issues that could slow down the construction process and may lead to additional costs for the incoming investor, which may be irrecoverable from the contractor.
For example, in Dubai the incoming investor will need to open an escrow account with a registered escrow agent and comply with the Real Estate Regulatory Authority (RERA) requirements in respect of the deposits previously received from third-party investors into the project and any new deposits received going forward.
As part of any restructuring negotiation, the incoming investor should ensure that it is suitably ring-fenced from any potential litigation against the defaulting developer or the project.
Friction may arise with the contractor over the force majeure provisions in the construction contracts and any previous delays in the funding of the project (and where workforce may have previously been reduced or laid off, for example).
Aggrieved third-party investors or contractors may issue claims against the investor as the active 'face' of the real estate project. In Dubai, for example, such aggrieved parties could issue claims before the real estate circuit of the Dubai Court and the investor must ensure that it is protected from any such litigation.
The risk and reward analysis for any incoming investor will be an important one when looking at a distressed real estate project.
However, if suitable legal diligence has taken place and appropriate contractual protections are in place, the savvy opportunistic player will most certainly reap the rewards.
About the authors
Keri Watkins is a senior lawyer in the Dubai office of Baker McKenzie Habib al-Mulla. Keri is a UK qualified real estate lawyer who has been working in the Middle East since November 2007. Keri advises on all aspects of the commercial real estate transaction from the initial due diligence and structuring of the deal to post completion and litigation aspects.
Amir al-Khaja is a senior lawyer and head of the commercial and banking dispute team. Amir is a licensed UAE lawyer with over 15 years of experience in the UAE and has rights of audience in the local and federal courts of the UAE (including the Cassation Courts and the Supreme Court).
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