Just when courts appeared to be developing a consensus on how to value affordable housing projects in bankruptcy, an opinion from the 9th Circuit Court of Appeals has muddied the landscape. In In re Sunnyslope Housing Ltd. Partnership, a divided panel of the 9th Circuit Court of Appeals recently held that rent restrictions should not be considered when valuing a secured creditor’s interest in an affordable housing project that the debtor proposes to retain under a plan of reorganization (at least when such restrictions depress the value of the lender’s secured claim).
Facts of Sunnyslope
Sunnyslope owns a 150-unit affordable housing project in Phoenix, Arizona. The project was financed in 2003 by an $8.5 million senior loan secured by a deed of trust and guaranteed by HUD and by subordinate loans from the State of Arizona and the City of Phoenix. The project qualified for low-income housing tax credits (LIHTCs) to be allocated to Sunnyslope’s limited partners on account of their equity interests in the project. The loans and tax credits required Sunnyslope to operate the property in accordance with rent restrictions typical for affordable housing projects. However, as is also typical, the restrictions were subordinate in priority to the senior lender’s deed of trust and could be terminated in the event of a foreclosure by the senior lender.
After Sunnyslope defaulted on the senior loan, HUD took over the loan and sold it to a new lender. The new lender took action to foreclose on the loan and obtained the appointment of a receiver. The receiver negotiated an agreement to sell the property post-foreclosure (after the rent and occupancy restrictions were foreclosed away) for $7.6 million. However, before the foreclosure could be completed, an involuntary bankruptcy petition was filed against Sunnyslope by its general partner.
After converting the bankruptcy case to a voluntary Chapter 11, Sunnyslope filed a plan of reorganization seeking to cram-down the senior lender’s claim to the value of its interest in the project. At a valuation hearing, Sunnyslope asserted that the lender’s secured claim should be limited to $2.6 million – the purported value of the property with the rent restrictions still in place – and should not include any enhancement for the value of the tax credits. The lender, on the other hand, argued that because the rent restrictions were subordinate to its lien and could be eliminated by the foreclosure of its deed of trust, its secured claim should be valued at $7.7 – the purported market value of the property if it were not subject to any rent restrictions.
Alternatively, the lender argued that its secured claim should be valued at $7.8 million because the property itself was worth $4.9 million as a rent-restricted property and the tax credits added an additional $2.9 million in value because they are inextricably linked to the real estate. The bankruptcy court agreed with Sunnyslope and concluded that the secured value of the project was $2.6 million as a result of the rent restrictions, and further concluded that the lender had no right to include the value of the tax credits as part of its secured claim.
The lender appealed to the District Court, which held that the valuation was properly limited by the rent restrictions, but that the senior lender’s secured claim should include the value of the tax credits. Following remand, the bankruptcy court determined the value of the tax credits to be $1.3 million, bringing the total secured value of the lender’s lien to $3.9 million.
9th Circuit decision
On appeal, a divided panel of the 9th Circuit Court of Appeals held that the rent restrictions imposed on the property should not apply to limit the value of the secured lender’s claim and that the property should be valued as a market-rate property, rather than a rent-restricted property.
The majority started its analysis from the perspective of the secured creditor and concluded that, as a matter of law, the property’s rent restrictions should not limit the value of the creditor’s claim because they are subordinate to the lender’s lien and may be “swept away” through a foreclosure sale initiated by the lender. The majority further concluded that the “replacement-value” standard commanded by the Supreme Court in Associates Commercial Corporation v. Rash, 520 U.S. 953 (1997), does not support a valuation based on the debtor’s specific use of the property as an affordable housing complex. Rather, the replacement-value standard espoused by Rash “is a measure of what it would cost to produce or acquire an equivalent piece of property” without taking into consideration the debtor’s specific use of the property. “[Just as] the seller of a tractor to the Rashes would not be expected to sell it to the Rashes cheaper because the Rashes planned to use it in a way that would not generate much income, . . . the replacement value of a 150-unit apartment complex does not take into account the fact that there is a restriction on the use of that complex.”
In contrast, the dissent began its analysis from the perspective of the debtor and how the debtor proposes (and, in fact is required) to use the property. According to the dissent, “the Supreme Court expressly rejected starting the valuation from the creditor’s perspective. . . Instead, the collateral must be valued from the debtor’s perspective and in light of the ‘economic benefit for the debtor derived from the Collateral.’” Thus, the dissent concludes that the bankruptcy court correctly valued the property on remand with the rent restrictions in place and including the value of the remaining tax credits.
Analysis
The majority opinion in Sunnyslope is a significant departure from other cases that have addressed the valuation of a secured lender’s interest in an affordable housing project. Similar to the dissent in Sunnyslope, other courts have consistently concluded that Section 506(a) and Rash require a valuation based on the debtor’s proposed use of the property. From that starting point, such courts have concluded that a valuation of the property must consider both the impact of the rent restrictions and the availability of any remaining tax credits. Thus, for example, in In re Lewis & Clark Apartments, the Court stated:
In the same way that the caps and other restrictions on the use of the property may affect its value negatively, the tax credits available to the owners as a result affect its value positively. For that reason, valuation without consideration of the tax credits does not accurately reflect what a willing buyer would pay to purchase the property from the Debtor.
However, if the starting point is from the perspective of the secured lender, as the majority in Sunnyslope holds, the question becomes when, if ever, should a valuation include the specific attributes of an affordable housing project (i.e. the rent restrictions and any remaining tax credits).
On its facts, the majority opinion in Sunnyslope holds that rent restrictions and any remaining tax credits should not be included where such attributes, when taken together, suppress the value of a secured creditor’s claim. But what if such attributes enhance (rather than suppress) the value of a secured creditor’s claim – should such attributes then be included when valuing the claim?
Given the majority’s emphasis on protecting the secured creditor against the “suppression” of its claim, it is difficult to imagine that the majority would deny the creditor the benefit of rent restrictions and tax credits in the event that they enhance (rather than suppress) the value of the creditor’s secured claim. On the other hand, the majority’s focus on what it would cost the debtor to acquire an equivalent piece of property in the abstract, without taking into consideration the proposed use of the property, seems to suggest that specific attributes of the property that are created or developed by the debtor (such affordable housing attributes) should never be considered.
In one sense, the majority’s opinion may be read as standing for the proposition that real estate should always be valued at its highest and best use. This proposition is consistent with general valuation principles. However, the unique consequence of this proposition is that where the highest and best use of an existing affordable housing property is as a market-rate property, the debtor or a trustee will have no way to achieve the highest and best value and the property will likely be lost to the secured creditor, who is the only party that may strip off the rent restrictions. If the property is within one year of the end of its “compliance period,” the debtor may be able to take advantage of the “qualified contract” provisions set forth in Section 42 of the Internal Revenue Code to strip off the rent and occupancy restrictions. However, if the property is earlier in the compliance period, there is little the debtor can do to strip off of the restrictions.
Whether the majority opinion in Sunnyslope will remain the law in the 9th Circuit is yet to be determined. The opinion is under reconsideration by the 9th Circuit Court of Appeals en banc.
Update: The 9th Circuit Court of Appeals has vacated the opinion of the panel in Sunnyslope and will re-hear the case en banc.
Mark Bossi is co-chair of Thompson Coburn’s Financial Restructuring Group. You can reach Mark at 314-552-6015 or mbossi@thompsoncoburn.com.