2011 ANNUAL SPRING INVESTMENT FORUM American College of Investment Counsel Chicago, IL Time for a Digestif Primer on Credit Tenant Leases Friday, April 29, 2011 11:15 a.m. - 12:15 p.m. Daniel J. Favero Mayer Brown LLP (Moderator) Bradford H. Buck Phoenix Life Insurance Company Luke Stifflear PPM America Inc.
Primer on Credit Tenant Loans Daniel J. Favero +1 312 701 8460 dfavero@mayerbrown.com Mayer Brown is a global legal services organization comprising legal practices that are separate entities ("Mayer Brown Practices"). The Mayer Brown Practices are: Mayer Brown LLP, a limited liability partnership established in the United States; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales; Mayer Brown JSM, a Hong Kong partnership, and its associated entities in Asia; and Tauil & Chequer Advogados, a Brazilian law partnership with which Mayer Brown is associated. "Mayer Brown" and the Mayer Brown logo are the trademarks of the Mayer Brown Practices in their respective jurisdictions. Table of Contents I. Basic CTL Structure II. Regulatory History III. NAIC Guidelines IV. Legal and Structural Issues V. Cashflow Analysis Diagram 2 1
I. Basic CTL Structure 3 I. Basic CTL Structure you see theme, variation, you see symmetry, asymmetry, you see structure. Dave Van Ronk A. It all starts with the Lease 1. NAIC Schedule D (Bond) treatment 2. Not a real estate loan (but equivalent due diligence to a real estate loan) 3. Priced like a bond rather than a mortgage usually (some premium for structure) 4. Underwriting analysis looks at Tenant s credit rating and ability to pay rent as primary concern rather than go-dark value of real estate 4 2
I. Basic CTL Structure (cont d) 5. Cashflow a. Amazon River or Colorado River 6. Financial covenants and cross-default from Tenant are rare. Collateral replaces financial covenants. Also, note difference in remedies between Lease and Loan. 7. Purported advantages of CTLs over unsecured corporate bonds: (a) higher yield for same credit, (b) lower default rate and holds value better in distressed situation. 8. Purported disadvantages of CTLs compared to unsecured corporate bonds: (a) smaller claim in bankruptcy, (b) CTLs are usually much longer term, (c) no financial covenants to allow lender to get to the table sooner. 5 I. Basic CTL Structure (cont d) The difference between the almost right word and the right word is really a large matter it s the difference between the lightning bug and the lightening Mark Twain B. Nomenclature 1. Bond Lease (Tenant must pay come hell or high water) 2. Triple Net Lease (Tenant must pay rent net of predictable, ongoing expenses: taxes, maintenance and insurance (and utilities) (i.e., the Big Three ) a. Landlord may have certain obligations for non-predictable expenses such as repair latent defects in construction, environmental cleanup, repair roof and structure, enforce declaration of covenants, etc. 3. Double Net Lease (Landlord responsible for one of the Big Three expenses) 4. Gross Lease (Landlord responsible for all expenses relating to the property) a. Usually at least partially reimbursed by Tenant 5. Credit Tenant Lease/Credit Tenant Loan 6 3
I. Basic CTL Structure (cont d) C. A CTL is a Private Placement D. What can be the subject of a CTL? 1. Any Real Estate a. Turtle farm/dolphin pond b. Air rights c. Building facade and systems d. Leasehold interest (to the nth power) e. Condominiums f. Retail, office, distribution center, computer center, call center, hotel, laboratory, hospital, warehouse, factory, special use 2. Anywhere 3. Leased by any credit tenant 7 II. Regulatory History 8 4
II. Regulatory History If you have ten thousand regulations you destroy all respect for the law. Winston Churchill A. Prior to 1990 1. Traditional statutory insurance capital requirements mandated a minimum capital reserve requirement for all investments regardless of risk profile 2. Savings and loan crisis began in the late 1980s a. Over 1,000 S&Ls failed (from 1/1/86 to 12/31/95 the number of S&Ls declined by 50% 3,234 to 1,645) 1 b. $160 Billion Total Loss; $125 Billion taxpayer loss c. Due primarily to unsound real estate lending. (Also, the effect of rising interest rates on the value of fixed rate mortgage portfolios) 3. FIRREA (1989) (Financial Institutions Reform, Recovery and Enforcement Act of 1989) (i.e., taxpayer bailout) 1 See The Cost of the Savings and Loan Crisis: Truth and Consequences. by Timothy Curry and Lynn Shibut. FDIC Banking Review 9 II. Regulatory History (cont d) B. In 1990, NAIC adopted Risk Based Capital classification. 1. Mortgage Loans required significantly greater reserve requirements than other classes. 2. CTLs were initially included as mortgage loans C. In 1991, NAIC recognized that CTLs are more akin to bonds in risk profile. 1. There was widespread abuse by investors of what constitutes a CTL 2. SVO was overwhelmed by Loan submissions seeking Schedule D treatment for transactions that bore little or no structural relationship to CTLs. D. In 1994, SVO declared a moratorium on processing CTL submissions while the Guidelines were re-evaluated and later that same year implemented CTL Guidelines (much as we know them today). 1. Bond Lease Based CTLs 2. Credit Lease Based CTLs 10 5
III. NAIC Guidelines 11 III. NAIC Guidelines A. Tenant Terminations 1. Landlord Defaults 2. Environmental contamination and/or cleanup 3. Casualty 4. Condemnation a. Insurance B. Rent Abatement a. Interruption of Tenant s ability to operate business C. Landlord Obligations 1. Reserves 2. Contractual Protections in Lease 3. Recourse carveouts 12 6
IV. Legal and Structural Concerns 13 IV. Legal and Structural Concerns His lack of education is more than compensated for by his keenly developed moral bankruptcy. Woody Allen A. Bankruptcy 1. Section 365 of the Bankruptcy Code a. Tenant can assume or reject unexpired lease b. If rejected, claim against tenant is limited ( 502(b)(G)) to the rent reserved by such lease, without acceleration, for the greater of one year, or 15% of the remaining term, not to exceed 3 years of the remaining term 2. Adequate Assurance to assume lease obligations 3. Designation rights 14 7
IV. Legal and Structural Concerns (cont d) B. SNDA/Estoppel. 1. Subordination of lease is misunderstood (although NAIC Guidelines require first lien mortgage) 2. Estoppel should be addressed to lender to ensure that lender can rely on it 3. Usually, no real representations and warranties from tenant in the Estoppel 15 IV. Legal and Structural Concerns (cont d) Early on, they were timing my contract with an egg timer. Conan O Brien C. Extra-Contractual Concerns 1. Constructive eviction 2. Compliance with laws D. Title 1. Declaration of Covenants E. Ground Lease 1. Ground Lease as CTL 2. CTL subject to ground lease a. Subordinated ground lease 16 8
IV. Legal and Structural Concerns (cont d) F. Miscellaneous 1. Alterations 2. Assignment 3. Subleases 4. Real Estate Value 5. Essentiality of Use 6. Special Use Facility 7. Financial Statements 8. Exclusive Use 17 V. Cashflow 18 9
Repairs, Latent Defects Replacements Capital Improvements Environmental Cleanup & Indemnity, Mold, Mildew, Pest Control Enforce/ Comply w/ CCRS Property Mgmt. Compliance w/ Law (ADA, OSHA, Zoning, etc.) Non-R.E. Taxes (e.g. on Rent, Impact Fees, Ground Lease Rent Special Assessment Sewer Charges) Debt Servicer Coverage Ratio Req. Fees: Trustee Servicer Escrow Agent Collateral Agent Paying Agent Placement Agent Cash Flow Available for Debt Service Abatement/Cancellation/ Termination Rights Landlord Defaults Interruption to business operations Environmental cleanup Repairs and maintenance Casualty Condemnation Loss of ground lease Landlord violation of law Relieved of obligation after assignment Exclusive Use violation 19 This document has been prepared by Mayer Brown LLP attorneys for informational purposes only. It is general in nature and based on authorities that are subject to change. It is not intended as legal advice. Accordingly, readers should consult with, and seek the advice of, their own counsel with respect to any individual situation that involves the material contained in this document, the application of such material to their specific circumstances, or any questions relating to their own affairs that may be raised by such material. 2011 Mayer Brown LLP 20 10