Consider the following problem. Because of a downturn in the real estate market, the owner of a major office building faces a situation in which the cash flow produced by the building is now less than the interest payment on the mortgage. The building is not divisible, so a fraction of it cannot be sold piecemeal to meet the mortgage payment. In addition, the drop in the value of the property has increased leverage to the point where further borrowing is no longer possible. As a result, the owner has only two choices: (1) make up any interest shortfall by injecting new equity into the project; or (2) walk away and give the building back to the lender.
This problem is not unique to real estate. Highly-leveraged enterprises often face the same tradeoff if assets are illiquid or if further borrowing is not feasible. Because real estate projects are usually highly leveraged, the analysis is particularly applicable to real estate.
The injection of new capital into real estate projects occurs frequently; from 1990 to 1993 dozens of private partnerships and closely-held real estate firms injected cash in order to retain control of their operations. High profile examples include numerous injections by Olympia and York into the Canary Wharf project before it finally collapsed. More recently, this scenario has been repeated by the Canadian real estate firm Trizec, which has been infusing cash into projects for the last three years.
These examples raise questions regarding the circumstances under which it is optimal for owners to inject cash to retain control of a project and regarding the valuation effects of such infusions. The analysis developed here provides an answer to these questions in the context of the familiar contingent claims model of capital structure developed by Black and Scholes (1973), Merton (1974) and Black and Cox (1976). A number of interesting insights emerge from this analysis. We show that it is not optimal for the owner to default as soon as the net cash flow of the project becomes negative.(1) The owner has a strong incentive to inject capital and continuing meeting debt-service obligations until the cash drain reaches a critical value.
A surprising implication of this analysis is that if the owner follows the optimal strategy of injecting capital into the project and continuing to make mortgage payments, the mortgage lender can actually be worse off. The intuition for this striking result is that even though the mortgage lender may receive more interest payments when the owner injects cash, the lender is harmed because default is postponed until the value of the property is much less. Thus, mortgage lenders experience greater losses if default ultimately occurs.
An important implication of our analysis is that the benefits to the owner from following the optimal strategy can be many times larger than the present-value costs of the necessary cash injections. The intuition for this is that the cost of relaxing cash-flow constraints is not directly related to the corresponding transfer of wealth from the mortgage lender to the owner of the project. These results indicate that there are significant economic rents to be obtained from providing funds to distressed real estate ventures. This may explain why real estate organizations are often structured in a fashion that facilitates making cash infusions. Finally, we show that the optimal cash-injection policy may explain the well-known tendency for real estate transaction volume to decline when market prices fall, and to recover only after a significant drop in value.
Because our analysis is set in the context of rational option pricing, there are aspects of real estate restructuring that it cannot address. Most importantly, it does not take account of strategic and agency theoretic issues that arise when the entire financial structure of a distressed property is renegotiated under incomplete information. These …