WORKING OUT troubled real estate properties is like the old folktale involving the traveler who made Stone Soup. This article shows readers how to do both.¹

When a property gets into trouble, the parties at interest typically react slowly. First, they refuse to believe that anything is wrong. Then, when reality sets in, they make an initial assessment that a workout would be "throwing good money after bad," decide that nothing can be done, and throw up their hands. So they seek to relieve their anger by looking for someone to blame.²

Participants in a troubled investment have lost confidence. Disillusioned, they may be questioning the worth of a workout for any number of reasons:

• They probably have forgotten the investment benefits they have received.
• They are reluctant to recognize the costs that failure will impose on them.
• They refuse to face the fact that their ownership will be forfeit upon termination.

The investment has left a sour taste in their mouths and they have no stomach for further involvement.

The first priority of the restructurer (assuming that he is persuaded that the real estate can be made physically viable) is to rekindle interest, and to compel the participants to resume thinking about solutions. The restructurer may be one of the parties or he may be an outsider. But he must have energy, vision, and enthusiasm, and he must step forward and say confidently, "This property can be saved."

Just as the traveler focuses the villagers' attention on the taste and aroma of Stone Soup and ignores the obstacles of making soup without ingredients, so the restructurer must get people to appreciate that a workout is desirable and possible.

Troubled real estate properties can be worked out in many ways. However, most of those who undertake the task discover that the solution is composed of six basic ingredients.

• Separate meetings with each interest group to collect information.
• A plan for the uses of funds.
• A constant rebuilding of dialogue among the parties.
• A refusal to discuss failure.
• Unflappable demeanor. The restructurer must be noncommittal until the workout is presented. And, ultimately,
• The dramatic announcement.

The restructurer meets with each interest group to learn what each wants from the workout. He attempts to obtain each group's responses to three sets of questions:

• Workout strategies. "Cost considerations aside," he asks, "what will it take to solve the property's problems?" Will physical changes like capital improvements be required? Do the parties recommend operational changes such as hiring new managers? What financial changes are necessary? A new subsidy? Restructuring current and ongoing debt service obligations? Balance-sheet changes such as rescheduling old bills?
• Cost considerations. What will each change cost? If some or all of the participants in the project have performed cost analyses, this information will be available. If they have not undertaken such initiatives, the restructurer must initiate careful studies.
• Financial contributions. The restructurer must ask how much each party would pay for a complete workout, what financial contribution each party will make, and in what form that contribution could best be made.

Psychologists encourage people who are trying to change their lives to visualize themselves doing the things they want--to see the answer first, then work toward it. In asking the questions listed above, the workout restructurer tries to have the participants focus on the components of a successful workout and to ignore the obstacles to achieving it. If the restructurer is successful in focusing the parties on their ultimate goal, they will be straightforward; their estimates of costs will be reasonable; and projections from different sources will tend to overlap.

The restructurer must not only listen, he must be sensitive to negotiational nuances. Participants in a workout have been dealing with one another for a long time, and they know one another well. Their misgivings and distrust of some answers affect the workout environment, and doubts must therefore be brought to the surface.

The restructurer should make clear that all conversations in which he participates are off the record. (A more relaxed atmosphere is achieved if lawyers are not present at these discussions.) He should ask nonjudgmental questions like the following:

• Are you comfortable dealing with the other parties?
• Which issues do you consider most important, and which are largely irrelevant?
• Can you give me copies of relevant documents that I may not have seen?
• What important elements will you look for in evaluating a workout proposal?

Whenever a cost item is discussed, the restructurer should incorporate it into a preliminary Uses of Funds analysis that he will present to each group. The following principles must govern the compilation of the uses of funds calculation:

• Make it safe. The workout will be appetizing only if everyone concerned agrees that it is safe.
• Don’t skimp. If a cost may or may not occur, assume that it will. Use high cost estimates, not low ones.
• Build in generous reserves. The workout should usually provide a capital reserve (money to cover deficits that last longer than expected).
• Don’t discuss sources. Discussions about uses usually generate consensus. Premature discussions about sources of funds, on the other hand, turn into arguments that can break down negotiations and lead to lawsuits.
• Don’t get bogged down. It is important to maintain momentum. If it becomes difficult to estimate a cost, make a preliminary conservative estimate. Assume a high cost that can be refined later. The dialogue must never be allowed to stop; discussion must always move forward.

In all attempts to work out troubled properties, communications periodically break down as positions harden. Because litigation is an ever-present threat, lawyers advise their clients to posture tough. They issue instructions to make no concessions, initiate no offers, and put nothing in writing.

Thus girded for battle, the parties usually can find no basis for reconstituting the partnership. Dialog becomes diatribe (who-did-what-to-whom-when), and people stop listening.

A new voice in the negotiations, sometimes a total outsider, can serve as a catalyst to restart dialogue. If the outsider is perceived as honest and disinterested, each participant will try to recruit him as an ally. This process encourages candor and information sharing.

If the workout fails, the course that each party must pursue will inevitably be one that is adverse to the interests of the other parties. Any discussion of possible failure during workout negotiations will focus the parties on this potential conflict. But if the property goes down the drain, even the most successful of the adversaries is worse off than it would be if the real estate were saved. To preserve any chances of working the property out, the parties must concentrate on success.

The restructurer should take few initial positions. During the period of investigation, he should listen, not talk. He should not promise anything or make any specific commitments.

Once the restructurer is satisfied that he has established a reasonable Uses of Funds, he must determine (1) the sources of funds (who will contribute to what), and (2) the acceptable contingency arrangements (how to allocate upside benefits and downside costs). Six principles should guide this analysis:

• Incremental benefits should be correlated with incremental costs.
• Money is fungible.
• It is sensible to follow the line of least resistance among non-economic constraints.
• Intangible benefits are worth money.
• Controls should be matched with guarantees.
• Incentives should be aligned among all participants.

If a workout succeeds, each group will benefit. Each group’s contribution should therefore correlate well with that group's benefits.

• Lender's benefits. Lenders benefit because outsiders inject new cash contributions. Usually they are able to restore the reconstituted loan to performing status (albeit possibly at a discount from original face). They avoid the possibility of becoming the property's owners, a consequence that consumes executives' time, and is expensive, cumbersome, and full of unknown perils. (Direct ownership could, for example, place the lender in the chain of environmental liability.) Lenders are often willing to accept large discounts or accruals in order to avoid these huge and hard-to-quantify risks.
• General partners' benefits. A successful workout releases general partners from past liabilities. They retain control of the property and its management contract (a profit source that has a quantifiable value), and fulfill their fiduciary duties to investors. They stand to profit from future appreciation. For these benefits, general partners should contribute the unfulfilled portion of any guarantees that they previously made and should make new guarantees commensurate with their projections.
• Limited partners' benefits. A successful workout gives both tax and economic benefits. The contingent recapture tax on deductions that investors previously received will continue to be deferred. New tax benefits will usually flow. Cash flow and residuals are also possible benefits. In return, investors should generally contribute all money that they owe but have not paid because of the defaults, plus an amount roughly equal to their incremental benefits, plus something to reflect the savings in taxes if foreclosure is deferred.

Usually the contributions that the interested parties agree to make are less than the total needs of the workout. If so, the restructurer must apportion the shortfall among all parties. A good rule is, share the misery. If a workout is skewed in one group’s favor, the other groups will refuse to go along.

Money comes in many different forms. A sensible restructurer tries to find sourcing mechanisms that maximize the amount that each party will contribute.

For example, a debt service arrearage is a use of funds that may be sourced by (1) cash, (2) a new mortgage from an outsider, (3) a reconstitution of the current mortgage by the present lender, (4) a restructuring of the mortgage into an accruing, nonforecloseable note, or (5) a complete waiver of debt.

Investor contributions may take many forms: (1) new capital contributions from current investors; (2) new capital contributions from new investors in exchange for new shares of limited partnership; (3) high interest loans; or (4) sales of various units of ownership to new investors who replace existing limited partners.

Participants in a workout often have constraints on their actions that limit their ability to do the economically sensible thing. Lenders may be prohibited from making certain loans in certain situations. Investor partnership agreements may require unanimity for some actions but only majority consent for others. Groups that have lost confidence may be unwilling to put up any money and thus may give up huge chunks of upside benefits in exchange for relief from a cash commitment.

Control, prestige, reputation, and public appearance all confer intangible benefits on different groups. General partners will pay extra for control. Quality organizations (whether developers, lenders, or regulators) will pay extra for solutions to which they can point with pride. Regulated bodies like banks or government lenders are sensitive not only to the substance but also to the appearance of proposals.

A balanced Uses and Sources of Funds chart is not by itself a workout plan. In a workout plan, every material risk must be matched by an appropriate guarantee from a guarantor that can either influence or manage the risk and which has the financial strength to make the guarantee meaningful. Workout participants will make guarantees if four circumstances are fulfilled:

• If they think their guarantee won't be called or will not be excessively costly.
• If they have some control over the operating facts that would cause the guarantee to be called.
• If they recognize the necessity of having someone make the guarantee to secure the workout.
• If a successful workout will yield them tangible benefits.

The above implies that guarantors desire control. It also implies a converse principle: those who have control should make guarantees. The entity that is in the best position to evaluate the risks involved in making the guarantee should also be the one to make it.

A typical workout must demonstrate that the property is viable even if the following worst case possibilities occur:

• Cost overruns in the capital improvements program. The logical guarantors are (1) the people who did the work in the first place, or (2) the people who will be performing the repairs.
• Time overruns in the capital improvements program. The person performing the repairs should be responsible.
• Worse-than-projected operating results. The logical guarantors are (1) the people who prepared the projections and thus believe in them, or (2) the general partner or management agent who will actually implement the program.
• Rising interest rates. The lender or another financial source is the logical guarantor because it can best evaluate and hedge the risk.

A workout structured according to the above principles will balance uses and sources, be perceived as safe, and have built-in control and guarantee features. But to induce the participants to go along, the workout must also show upside potential and share that potential fairly. The rules are simple.

• Share all success. If possible, each dollar of net cash should be shared by every participating group. The percent share that each participant receives must, of course, vary with repayment priorities.
• Last money in is first money out. New cash injections should receive the highest rate of return and top priority in the repayment queue.
• Old money should be discounted. This is the only place where the post-foreclosure environment should be considered. If the property had been sold before the workout was consummated, some parties would have received nothing. Those people should take bigger discounts or lower-priority paper.
• Observe existing repayment priorities. The existing documents (loans and partnership agreement) provide a repayment hierarchy. That hierarchy should be changed only for compelling reasons.
• Match control to incentives. When repayment tiering creates a plateau (a range of future value in which one party receives 100% of the incremental benefit), the groups excluded at that plateau should have some control that will permit them to prevent the benefiting party from selling the property.

The most successful plan will come to naught if the parties cannot be persuaded to accept it. How does one sell a workout plan?

In fancy restaurants, multiple waiters approach the dinner party, bringing food on large plates with each entrée covered by a silver chafing dish. At a sign, the waiters whip off the covers and reveal all the meals simultaneously.

The approach builds suspense and implies that the revelation is a moment of triumph. The presentation of a workout plan should be equally dramatic. It makes the proposal appear to be independent of any interest group, something to be studied on its own merits. No group has been required to commit itself publicly before it sees the preliminary reactions of the other groups. The fact that the plan is not revealed until each party has made its private commitments makes the plan seem logical, serious, and well thought out. Each party also sees its fingerprints in the plan.

Going public creates new alliances. Although each group will complain that its individual contribution is, of course, far too large, each will also agree that everyone else’s contribution is reasonable.

Not all workout deals succeed. They fail under six common types of circumstances:

• When a participant makes an uneconomic decision (usually for policy reasons). Lenders and regulators are the most common culprits, although investor groups can sometimes be pigheaded.
• When the emotional commitment to litigation can't be derailed. This is a special case of the pigheaded syndrome.
• When bad blood prevails among the partners. Emotions are sometimes so strong that a group decides it would rather hurt another group than save itself. The best thing to do here is to appeal to another individual in the same organization.
• When a participant negotiates in bad faith. The workout process will usually uncover this fact and the party acting in bad faith can be pressured by all the other parties. It's harder to be a dog in the manger when everybody points a finger at the offending party.
• When the failed property is worth substantially more after failure than the saved property. Aspects of tax law can create this situation. So can regulations that prohibit giving aid to an existing entity but make it available to successors. (Some government subsidies work this way.)
• When economic and tax incentives to current owners are low. Workouts were much easier in the early 1980s, when ordinary income tax rates were 50 percent, than in recent years with lower brackets and passive loss restrictions.