The current state of real estate markets is providing investors with significant opportunities to acquire distressed property at rock-bottom prices. However, those assets are often owned by a company in bankruptcy. So the question is: How exactly do you go about buying real estate out of a bankrupt estate? There are two important and practical rules to keep in mind when shopping for real estate that is subject to a bankruptcy court's jurisdiction. First, any owner of property with equity remaining will almost always file for bankruptcy protection in an attempt to preserve that equity and to buy time within which to sell the asset, repay the lender and emerge from bankruptcy with its equity in hand.

Second, an owner with no equity in the property will seldom spend the money to file for bankruptcy protection (although occasionally owners with no equity may file in an often unsuccessful attempt to exert some leverage over the mortgage holder). Thus, it is more likely than not that the value of the property in bankruptcy exceeds the mortgage debt.

The problem, however, is that any offer to buy real estate in foreclosure is subject both to bankruptcy-court approval and over-bidding at the hearing to approve the sale. If the value of the property exceeds the mortgage debt, the court will generally approve the sale (assuming that there are no significant creditors other than the mortgage holder). The over-bidding element is required in order to ensure that the seller has always maximized the prospective sale proceeds. In that case, a potential buyer has to worry if it is worth the effort to draft and negotiate a purchase agreement and to begin due diligence, when the property may be snatched away by an over-bidder.

In such a situation, the prospective buyer is considered a stalking horse. There are a number of steps a stalking horse buyer can take to protect itself. The most common of these is to negotiate a breakup fee with the seller. This is a fee paid to the stalking-horse buyer to compensate it for having played a role in generating an over-bid, which is to the seller's benefit. Further, a portion of the fee is intended to reimburse the stalking horse for its due-diligence expenses. However, if a breakup-fee arrangement has been agreed upon by the parties, it is equally important for the seller and the bankruptcy court to agree on the minimum over-bid amount. Generally, this is the same amount as the breakup fee and is designed to ensure that the seller will not be out of pocket after sale of the property and payment of the fee. An offshore client recently contacted me to draft a purchase agreement to acquire a mixed-use project in Northern California for $87 million. However, we immediately discovered that the seller had just filed for protection under Chapter 11 of the US Bankruptcy Code, primarily to protect its equity and stall foreclosure while seeking a buyer. As a result, we revised the buyer's offer to provide for a breakup fee of $1 million, plus up to $250,000 in reimbursement of due-diligence costs, if the buyer's offer was over-bid. Further, in order for this to make sense for the seller, the minimum over-bid would have to come in at around $1.2 million over the buyer's offer. The seller accepted our proposal and we now await a hearing in bankruptcy court for its approval of the breakup fee, the due diligence cost reimbursement and the minimum over-bid amount.

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