Gravel2Gavel Construction & Real Estate Law Blog
Single asset real estate (SARE) is a unique classification under the Bankruptcy Code with implications for both debtors and lenders. SARE classification is apparent for a property such as a shopping center, apartment complex or office building where the debtor’s income is generated exclusively from real estate operations, but is less apparent for a hospitality property where the debtor may provide incidental services. Although a full-service hotel with a pool, fitness center and restaurant is not a SARE property, recent trends indicate that even hourly motels offering little-to-no onsite amenities may not qualify for SARE classification. Because SARE classification is viewed as providing lenders with distinct advantages in a chapter 11 case, property owners seeking chapter 11 protection to reorganize often try to avoid that classification, while lenders seek to impose it through sometimes costly litigation.
What Is a SARE?
Single asset real estate is real property constituting a single property or project, other than residential property with fewer than four residential units, which generates substantially all of the debtor’s gross income and on which no substantial business is conducted other than the business of operating the real property and activities incidental thereto.
A real estate class potentially categorized as SARE are hospitality properties. There is no bright-line rule for when a hotel should be classified as SARE, so bankruptcy courts assess the facts and circumstances to determine whether a hotel bankruptcy fits within the SARE definition of the U.S. Bankruptcy Code. Most courts have found that full-service hotels that offer onsite amenities are not SARE properties because they engage in activities beyond mere operation of the property. For example, providing cleaning services, maintaining a fitness center and swimming pool, operating a conference center, and providing meal, laundry, internet and phone services are amenities and services that have allowed hotels to avoid SARE classification.
But what happens when amenities and services are stripped away? Will an hourly motel or budget hotel that offers no onsite amenities escape SARE classification?
In re Caribbean Motel: Motels Are Not SAREs, Either
The U.S. Bankruptcy Court for the District of Puerto Rico recently considered whether a by-the-hour motel should be redesignated a single asset real estate debtor in In re Caribbean Motel Corporation, No. 21-01831 (EAG), 2022 WL 50401 (Jan. 5, 2022). The debtor operated Motel Caribbean, a by-the-hour motel, and filed for relief under subchapter V of chapter 11. Out of 40 rooms, only 22 were operational. The debtor employed nine to 11 employees to assist with check-in, answer requests for food, accept payment, provide routine maintenance upon checkout, clean and replenish linens, and complete necessary repairs. Though the debtor’s income was primarily generated by room fees, five percent to seven percent of its income came from food service and the sale of select goods. Still, the motel lacked many of the features that often render hotels outside the scope of SARE.
The motel was encumbered by a lien in favor of OSP Consortium LLC. Focusing on the lack of amenities and arguing that the debtor derived substantially all of its income from room rentals, OSP sought to redesignate the debtor as a SARE debtor, which would render the debtor ineligible for reorganization under subchapter V—a streamlined option in Chapter 11 for smaller businesses. The debtor opposed by focusing on the revenues it generated aside from room rentals.
In declining to redesignate the debtor as a SARE, the court explained that, regardless of whether the services provided by Motel Caribbean were included in the room fee, the debtor operated an active business that engaged employees, which was not incidental to merely renting or managing real estate. The court was not swayed by the lack of a pool, internet or continental breakfast. Instead, the court emphasized that the debtor engaged in additional services that generated revenue. Together, these factors allowed the debtor to escape SARE classification.
Why SARE Designation Matters
SARE designation can greatly tilt restructuring cases in favor of a lender secured by the SARE property through expedited timelines and relief from the automatic stay (i.e., the statutory injunction that prohibits most acts against the debtor or its property after the commencement of the bankruptcy case). Specifically, a debtor has until the later of 90 days after the commencement of a voluntary bankruptcy case or 30 days after the court determines the debtor is a SARE debtor to either file a plan of reorganization that has a reasonable possibility of being confirmed within a reasonable time or commence monthly payments to the lender in an amount at least equal to interest at the applicable nondefault contract rate on the value of the lender’s interest in the property, which may be difficult to achieve unless the debtor has positive cash flow early in the case or a sponsor. If the debtor fails to file a plan or commence payments within the required time, then the lender is very likely to obtain relief from the automatic stay to enforce its rights against the property.
Despite its benefits for lenders, it can be costly to litigate to impose SARE status on a debtor. Lenders should expect to litigate over SARE classification if the debtor does not make the election at the commencement of the case (and strategically, the lender may want to be prepared to quickly move for SARE designation for its benefits). The lender may move for SARE designation in a standalone motion or as alternative relief in motion for relief from the automatic stay or to dismiss the case. It can also be time consuming to litigate SARE issues; in Caribbean Motel, five months passed between the lender’s motion and the court’s ruling. Even if the lender is successful in obtaining SARE classification, litigation over the extent of the lender’s interest in the property or whether the debtor’s plan has a reasonable possibility of being confirmed should also be expected when facing a litigious debtor in need of additional time.
In sum, while secured lenders to distressed hotels or motels enjoy additional benefits in SARE cases, lenders may first face a legal battle over whether the property is a SARE. When faced with a potential hospitality bankruptcy, lenders should undertake a thorough assessment of their debtors’ activities to determine whether they go beyond mere operation of the property and assess whether pursuing SARE classification is worthwhile.