Contributed by Jordan Bryk
Two recent decisions from the bankruptcy courts in Delaware and New York demonstrate the uncertainty surrounding distressed real estate valuation disputes. The range of valuation approaches available, as well as the discretion of bankruptcy judges throughout the process, make the results highly unpredictable. Although valuation disputes often play a pivotal role in the battle for control of distressed property, debtors and creditors, after advocating zealously for their respective valuations, must ultimately “let the chips fall where they may.”
In re Huntington Development, LLC
In August 2010, Huntington Development LLC filed for chapter 11 in the U.S. Bankruptcy Court for the District of Delaware to prevent RBS Citizens, N.A. from foreclosing on its property in Clayton, Delaware consisting of 32 improved building lots for single-family residential units. In In re Huntington Dev., LLC, No. 10-12461 (KJC), 2012 Bankr. LEXIS 1034 (Bankr. D. Del. Mar. 9, 2012), Huntington and Citizens presented expert testimony on the value of the property before Judge Carey. Both experts appraised the property using a “sales comparison approach” as well as a “development approach.”
The “sales comparison approach” estimates value based on the prices at which similar property can be purchased on the open market. The key drivers of this valuation are the comparable properties selected and the adjustments made to improve the accuracy of the comparables. The “development approach” projects the discounted cash flows from selling each of the 32 individual lots over time. The key drivers of this valuation are the assumed sale price per lot, expenses, and absorption rate, which forecasts the speed at which the lots are sold. For both the “sales comparison approach” and the “development approach,” the experts’ calculations differed as a result of the judgments that each expert made with regard to the key drivers of the valuation.
As in most valuation disputes, the competing parties had conflicting incentives for the size of the valuation number they presented before the judge. Here, Citizens, the secured creditor, advocated for a lower number to demonstrate that it is undersecured (i.e., the value of its collateral is less than the value of its secured debt) and, therefore, is entitled to foreclose on Huntington’s property. In contrast, Huntington, the debtor, advocated for a higher number to demonstrate that Citizens is oversecured (i.e., the value of its collateral is greater than the value of its secured debt) and, therefore, is not entitled to foreclose on Huntington’s property.
In the end, Judge Carey found Citizens’ conservative valuation of $1.68 million under the “development approach” to be the most persuasive. Judge Carey, therefore, ruled that, because the property was worth $1.68 million and Citizens’ secured claim against Huntington was, at a minimum, $2.1 million, Huntington had no equity in the property. Huntington’s less conservative valuation under the same “development approach” was $2.4 million, which could have created a small equity cushion for the company. With no equity cushion and dwindling prospects for an effective reorganization, Judge Carey granted Citizens’ request to lift the automatic stay under section 362(d)(2) of the Bankruptcy Code and foreclose on the property. It should be noted that, outside of the real estate context, Judge Carey is grappling with substantial valuation disputes in the Tribune Co. chapter 11 cases.
In re 785 Partners, LLC
In August 2011, 785 Partners LLC filed for chapter 11 in the U.S. Bankruptcy Court for the Southern District of New York to prevent First Manhattan Developments REIT from foreclosing on its vacant 43-story glass tower at 785 Eighth Avenue in Manhattan’s Hell’s Kitchen district. In In re 785 Partners, LLC, No. 11-13702 (SMB), 2012 Bankr. LEXIS 1182 (Bankr. S.D.N.Y. Mar. 20, 2012), 785 Partners and First Manhattan presented expert testimony on the value of the property before Judge Bernstein. Both experts appraised the property as a condominium building using a “net sellout approach” and as a rental building using an “income capitalization approach.”
The “net sellout approach” projects the discounted cash flows from buying the entire building at a wholesale price and selling the building’s 122 individual apartment units and retail space over time. The key drivers of this valuation are the assumed selling prices of the apartments and retail space, expenses, and absorption rate. The “income capitalization approach” projects a single year’s net operating rental income and divides that amount by a market-based capitalization rate. The key drivers of this valuation are the assumed rental value per square foot, operating and lease up expenses, absorption rate, and capitalization rate.
Unlike Judge Carey, who, in In re Huntington Development LLC, simply selected the most compelling expert valuation, Judge Bernstein took matters into his own hands and did the arithmetic himself. He evaluated each driver of the experts’ valuations, often averaging the experts’ values when both appeared plausible. After computing his results, he arrived at valuations of $81.6 million as a condominium building under the “net sellout approach” and $91.7 million as a rental building under the “income capitalization approach.” He concluded that the value of the building is $91.7 million, which represents its “highest and best use.” Subject to the court’s future determination on the amount of First Manhattan’s secured loan, 785 Partners may still have equity in the building.
Judge Bernstein’s proactive style follows in the footsteps of Judge Lynn, who oversaw the valuation process of the Mirant Group in the U.S. Bankruptcy Court for the Northern District of Texas. In In re Mirant Corp., Judge Lynn seized control of the experts’ valuations and demanded adjustments to their data, discount rates, and multiples. Much to the chagrin of the secured creditors, Judge Lynn revised the valuation upward and determined that value existed for the company’s subordinated debt holders and existing shareholders.
The valuation of distressed real estate determines the amount of the debtor’s equity in the property, if any. As a result, the process is often highly contentious. These recent cases demonstrate the divergent paths valuation disputes can take as well as the critical role played by bankruptcy judges. It is extremely difficult to predict not only which valuation methodology the judge will favor, but also the level of judicial involvement in the calculation. Each interested party would be well-advised to research earlier valuation decisions within a particular district to get a sense of how the court and its judges view valuation disputes. Yet, ultimately, one might find a bankruptcy valuation dispute to be like a high-stakes game of roulette – you place your bet, say a prayer, and hope that your number comes up.