Betting on Bad Debt Becoming a Growing Investment Play

With the Great Recession in mid-stream and commercial real estate being a lagging component of the economy as demand for CRE space is a derived demand once potential tenants outgrow their current space needs and feel confident in the future, the declining property fundamentals, lack of liquidity in the market and rising investor yield requirements as reflected in cap rates, a large percentage of commmercial properties are not worth the face amount of the debt.

In this week's CoStar Watch List, A weekly column focusing on distressed market conditions, commercial real estate properties, mortgages and Corporations Published by CoStar News, the opportunity to buy distressed debt is highlighted. The article is below. You can sign up for the eblast from CoStar through their website www.costar.com.

The key is to recognize that buying a loan, while based on a thorough underwriting of the collateral (the foundation is always the real estate), is not buying a property and has a different cash flow characteristics and risks. I will be addressing issues in the loan valuation/pricing process in future blogs but awareness of the opportunity is the first step for many investors.

For many this is back to the future going back to the RTC days, but for others, this is the first time to pursue the acquisition of commercial mortgage debt on the secondary market. I have significant experience in this arena - from both the buy and sale side as well as a loan sale advisor and due diligence provider. Please let me know if I can be of service.



Betting on Bad Debt Becoming a Growing Investment Play
With Distressed CRE Debt Mounting, Investors Are Scouring Loan Books for Good Property Deals
By Mark Heschmeyer
With most if not all facets of commercial real estate investment mired in the dumps, one area is burgeoning -- the market for distressed debt. Indeed, investors say the distressed debt market is more active now than it has ever been, and still nowhere near where players see it going over the next couple of years. Spurring the action is new paradigm in property acquisition. Debt buyers are keen on the notion that properties can be acquired at significant discounts to their loan values - offering even bigger savings than the cost of purchasing a property outright.

Examples of this new arrangement are abundant, with AION Partners, a real estate private equity company in New York, being just one. AION is utilizing this loan-to-own strategy as a starting point for increasing its ownership portfolio. It recently purchased a portfolio of eight loan-to-own assets in opportunistic markets throughout the Sunbelt with a value in excess of $110 million. Since acquiring the loans, AION Partners has already foreclosed, or taken a deed in lieu on five of these non-performing first mortgage loans and plans to take control of the remaining properties in 2010.

The eight loans purchased in 2009 include: a 234-unit multifamily complex in North Miami, FL; a 192-unit multifamily property in West Palm Beach, FL; a 178-unit assisted living facility in Arlington, TX; a 287,000-square-foot distribution warehouse in Chester, NY; a 150-unit multifamily complex in Phoenix, AZ; a 196-unit multifamily property in Tucson, AZ; a 480-unit multifamily community in Atlanta, GA; and a 220-unit multifamily building in Charlotte, NC.

"We are committed to building a large, national portfolio of multifamily assets and are executing this strategy through the acquisition of distressed loans and properties and then employing our experience as investors, developers and managers to stabilize and build value," said Michael Betancourt, principal of AION Partners, which also owns office, retail and condominium properties in major cities including New York, Washington, DC, and Los Angeles. "If our success during 2009 is any indication of things to come, we anticipate activity in 2010 both on the investment and asset management fronts to surpass our initial projections for our partners and ourselves."

The bulk of the distressed debt sales in 2009 were in the CMBS arena and from the Federal Deposit Insurance Corp. and industry participants expect those numbers to continue growing this year.

The FDIC alone sold about 3,500 commercial real estate loans with a book value of more than $6.1 billion last year; that compares to commercial real estate loans sales in 2008 of just $153 million. Nonperforming loans went for 37 cents on the dollar last year but November and December 2009 sales prices coming in closer to 30 cents. Performing loans sold for about 57 cents on the dollar, but with the most recent sales coming in at 44 cents.

Also, the FDIC has a growing portfolio of bad loans to deal with as regulators are closing banks in record numbers.

According to analysis by Property and Portfolio Research (PPR), a CoStar Group subsidiary, as commercial real estate fundamentals continue to deteriorate through 2010, banks with large exposure to the commercial real estate sector will face increased pressure on their balance sheets. FDIC guidelines suggest that a bank whose commercial real estate holdings exceed 300% of capital is "overexposed" to the sector. Based on that metric, PPR says there is no shortage of candidates that the FDIC could seize in 2010. As of the end of the third quarter 2009, more 1,200 banks had commercial real estate exposure of greater than 300% of capital, and 500 of these banks had exposure greater than 400% of capital. The assets of those banks total approximately $650 billion.

So as far as the growth in the amount of debt the FDIC can dispose of, Steve Miller, director of debt research and risk management at PPR, says it is limited only by the FDIC's ability to deal with the growing volume of distressed financial institutions.

CMBS loan liquidations were averaging about $108 million a month in 2008 and last year the average jumped $182 million with November's totaling hitting $255 million and December's ballooning to $585 million, according to CMBS bond rating agency Realpoint. Loans were being liquidated at losses near 66%.

In addition, the rate at which liquidated or resolved CMBS credits are replenished by newly delinquent loans is growing and remains a high concern, especially regarding further growth in the foreclosure and REO categories (evidence of additional loan workouts and liquidations on the horizon for 2010).

To the selling side of the equation, industry participants also expect to see heretofore reluctant community and regional banks begin to dispose of more of their distressed commercial real estate assets.

"The secondary market for buying loans is a crowded space right now," said Barry C. Smith, president of LoanSaleCorp.com in Scottsdale, AZ. "There are many groups seeking deals, but transactions (other than the FDIC sales) actually taking place are not as great as one might think. Bid / ask spreads are still wide, but we do see things narrowing somewhat."

"January was interesting; it is apparent that both buyers and sellers are ready to get things going after a dismal 2009," Smith said. "We see good momentum in the market currently and we are happy to report that the community and regional banks we deal with seem to be more interested in actually doing something proactive. This contrasts with what we saw in 2009. Some banks are starting to come out of their Zombie like state and explore the disposition of identified problems. This is an encouraging sign for the market."

Bill Looney, president of loan sales at DebtX in San Francisco, said the market for commercial real estate debt is as active as he has seen it in 10 years.

"That's a function of weakening conditions in the commercial real estate market and a recognition among financial institutions that they need to actively manage their portfolio to reduce risk and protect the bottom line," Looney said. "Many institutions realize that a loan sale can expeditiously dispose of a loan at fair market value. By selling, rather than holding onto the loan in workout, institutions can remove the headwind from their balance sheet and get back to the business of making profitable loans again."

In addition to selling a significant volume of non-performing loans, Looney said he also expects to sell a fair amount of performing debt start coming to market.

New York-based Mission Capital Advisors conducted $9.2 billion in loan sales last year including $571 million of CMBS loan sales, a 77% increase year over year versus 2008. "We see the market as extremely active, with the most active sellers being the healthier community and regional banks who have successfully raised capital and nearly all special servicers (regardless of financial condition)," said William David Tobin, principal of Mission Capital Advisors. "Mission's commercial loan sale business was up 57% in 2009 versus 2008 in terms of balance offered. We expect a similar increase in 2010."

"The most active buyers are localized operators teamed with high net worth individuals or groups of individuals, with a strategic use for the property (and accordingly, a price advantage over strictly financial buyers)," Tobin said. "The second most active buyer profile is $50 million to $500 million private equity / high net worth investment funds."

In terms of buyers, Bill Looney said DebtX is seeing a lot of bidding and purchasing by opportunity funds, private equity funds and hedge funds.

"In addition, we're seeing a number of equity buyers who previously owned property, but have been in cash looking to get back in," Looney said. "Because many distressed properties are mired in default or are unable to service their debt, some equity players are seeking to re-enter the property market by purchasing the loans. Finally, we're seeing local players, such as community banks, selectively buying loans. Community banks often have a local market advantage because they are tied so closely to their communities."

Barry Smith at LoanSaleCorp.com said the major buying activity presently is in the sub- and nonperforming loan space. Buyers are not showing a clear preference for property types but that clearly loans in the major metropolitan markets are of the most interest.

Ken Cohen, chairman and CEO of The Mortgage Acquisition Co. in San Francisco, which has been active buyer in the capital markets since 1990, said the current market is tremendously active and is going to stay active.

"As a buyer we look at performing and nonperforming loans, although right now we're seeing many more nonperforming situations as borrowers are starting to miss payments," Cohen said. "We look at a lot of property types, but we stay away from land loans and major lease up issues - empty retail, big box office, big box anything."

In terms of pricing, Cohen said he is looks at the underlying cash flow of the property and strength of the sponsor backing the loan.