Updated with correction
A pending U.S. Supreme Court ruling could make life more expensive for money managers that invest in distressed real estate debt.
If the court overrules a lower court decision, it would effectively end the practice of credit bidding in bankruptcy auctions, raising the costs for investors in real estate debt.
In the case of River Road Hotel Partners LLC vs. Amalgamated Bank, the court is considering whether to agree with a lower court decision that creditors can exchange their debt for property in Chapter 11 bankruptcy.
Two years ago, two appellate courts ruled that creditors didn't have to be allowed debtors to bid the amount of the secured debt they hold instead of cash, the process known as “credit bidding.”
Last year a third court, the 7th U.S. Circuit Court of Appeals, went the other way and the U.S. Supreme Court took that case — River Road-Amalgamated Bank — to decide the issue. The court is expected to rule on the case this summer.
Real estate debt in general has become a popular investment with investors: $40 billion was raised last year by North American firms for closed-end real estate funds aiming to invest in real estate debt and distressed debt, according to London-based alternative investment research firm Preqin.
If the Supreme Court sides with creditors against debtors, it would change the balance of power in real estate debt investing, said Jeffrey Krieger, partner of the Los Angeles law firm of Greenberg Glusker Fields Claman & Machtinger LLP. Distressed debt investors would have to come up with more cash to get the underlying property, which is not very appealing for most of them, he said.
Taken together with the 2004 U.S. Supreme Court decision Till v. SCS Credit Corp. that allows a bankruptcy court to change the terms of a loan, a ruling against the lender in the River Road case would be a one-two punch to distressed debt investors, Mr. Krieger said.
Already the Till decision makes it possible for a bankruptcy court to change key loan terms, including interest rates — the first punch.
If the River Road ruling goes against the lender, it “would have a negative impact for non-performing loan buyers who traditionally use credit bidding as a means to take control of the property and generate value,” Eliza Bailey, senior vice president at Partners Group, a global private markets and real estate investment management firm, wrote in an e-mail.
This creates additional risk and uncertainty, which would likely lead to higher prices and tighter restrictions, she said.
“The overall effect may be to further restrict availability of real estate debt,” Ms. Bailey stated. “For real estate investors in non-performing loans, this would likely put further downward pressure on pricing to account for the uncertainty in the bankruptcy outcome.”
Investors have been buying distressed debt because they think they will end up with the property or, at least, a mortgage at the original interest rate. But the Till ruling and River Road case could mean the investor might end up without the property and holding a mortgage with a much lower interest rate, Mr. Krieger said.
Given the global economic meltdown in 2008-"09, there is a fairly active market for distressed mortgages of all kinds.
Jun Chen, senior director of research in the San Francisco office of Moody's Analytics, an economic research firm, estimates 20% to 25% of commercial mortgages are underwater or close to it, meaning the debt exceeds the property value.