Posts Tagged 'CRE defaults'

Is the Slow-covery in Trouble?

Last week, the Fed’s Open Market Committee said the pace of the economic recovery had “slowed” and that growth “is likely to be more modest in the near term than had been anticipated.  The Fed announced it was going to take some of the payments it has received from CMBS bonds and other assets it purchased as part of the stimulus, and reinvest them in Treasuries – effectively holding down mid-term interest rates –  in an attempt to stimulate the economy further. The Fed noted that high unemployment, modest income growth, lower housing wealth and tight credit were holding back household spending.

Sudeep Reddy of the Wall Street Journal explained succinctly how the Fed’s plan is supposed to work:

“After cutting short-term interest rates nearly to zero in December 2008, the Fed essentially printed money to expand its portfolio of securities and loans to above $2 trillion, from $800 billion before the global financial crisis. Its purchases of mortgage-backed securities and U.S. Treasury debt, aimed at keeping long-term interest rates down, were discontinued in March. The Fed began talking about an “exit strategy” from the unprecedented steps it took to prevent an even deeper recession.

But on Tuesday, the Fed shifted its stance. It said it would act to keep its securities holdings constant at around $2.054 trillion, the level on Aug. 4. Had the Fed not acted, its mortgage portfolio was set to shrink by $10 billion to $20 billion a month, as mortgages matured or were paid off early. Now, the Fed will reinvest those proceeds in U.S. Treasury securities of between two- and 10-year maturities.

Some Fed officials have been uncomfortable with the size of the Fed’s position in the mortgage market. To assuage their concerns, the Fed won’t be enlarging its mortgage holdings.”

Will this further stimulus work? No one knows. But this move is generally not being seen as a good sign for an economy we’ve been repeatedly told is recovering.

The idea that the “recovery” isn’t going so well has been common for months across the bleaker reaches of the economic blogosphere (such as the comments sections of the Calculated Risk blog, or the ZeroHedge blog, or David Rosenberg’s well considered newletters for Gluskin Scheff — where he suggests today that we may not be headed for a double dip because the recession may not, in fact, have ever ended).

However, concern about the pace of the recovery has recently been cropping up more frequently in the mainstream media – especially since the Fed’s announcement. For example, in Saturday’s New York Times, Jeff Sommer questioned whether a double dip recession is likely, asking, “Will the economy pick up momentum or slip back into recession?”

 After noting that Ben Bernanke had recently called the current economic outlook “unusually uncertain”, that Lakshman Achuthan, Managing Director for the Economic Cycle Research Institute agreed that “growth has definitely slowed” and that Bill Gross of bond manager Pimco said, in essence, that the momentum of the economy from the first to the second quarter was downhill, and that it’s possible we’re close to a double-dip recession, Sommer stated:

“Still, the economic signs are ambiguous. . . . What’s been lacking is broad consumer demand, a revival of the housing market and sufficient business confidence in large-scale hiring.  And, of course, there are deep structural economic problems — the highest ratio of public debt to gross domestic product since World War II, for example — that will need to be dealt with over many years.”

At the risk of stating the obvious, with so many folks worried about their jobs, or underemployed, or paying down debt, and so many companies sitting on money but not hiring, it’s simply not clear what new business developments are likely to spur sufficient “consumer demand, a revival of the housing market and sufficient business confidence” to lead to large scale hiring.  I have a sneaking suspicion that we ultimately will regret greatly allowing so many jobs to be outsourced, especially manufacturing jobs – ultimately our economic viability as a country boils down to whether we can produce things that others want to buy — and in doing so, whether we can keep our own citizens employed.

Keeping interest rates down to stimulate the economy seems to work in smaller economic downturns, where there’s pent-up demand and ordinary folks can afford to buy things.  But, where so many households are wildly overleveraged and worried about their futures, the Fed may simply be “pushing on a string” – trying to create demand that simply won’t be there until the overhang of debt is paid off by borrowers, or written off by creditors (who of course then have to recognize their losses), or both.  (Maybe there’s another way to create demand and deal with that debt, but if so I don’t see it.)

And until the huge amounts of debt are somehow cleared or something else makes businesspeople more confident about hiring (and employees more confident about getting and keeping jobs), the current levels of distress in the commercial real estate market seem likely to continue and perhaps increase.  According to Costar’s Commercial Repeat-Sales Indices, the largest metro commercial real estate markets have been “attracting significant institutional capital and forcing prices upward over the first two quarters of 2010 . . . while the broader market has continued to soften. . . . This divergence of the two worlds may soon change as we are now witnessing a pause and softening even within the investment or institutional grade primary markets.”

Doesn’t sound much like a CRE recovery.

CoStar goes on:

Many of the opportunity funds continue to seek out distressed properties, which are affecting the prices shown here, but the expectations of a tsunami of opportunities have not materialized and overall transaction volumes remain below normal.

Distress is also a factor in the mix of properties being traded. Since 2007, the ratio of distressed sales to overall sales has gone from around 1% to above 23% currently. Hospitality properties are seeing the highest ratio, with 35% of all sales occurring being distressed. Multifamily properties are seeing the next highest level of distress at 28%, followed by office properties at 21%, retail properties at 18%, and industrial properties at 17%.

Since current governmental policies seem to be encouraging a “delay and pray” approach to resolving bad real estate loans, this approach (which I don’t think can really be called a strategy) seems to be to hope for a broad economic upturn.   It seems likely that the distress in commercial real estate won’t improve significantly unless hiring picks up, and the trend seems to be going the wrong way.  PRI’s The Takeaway reported that, according to Newsweek and Slate columnist Dan Gross :

“An unemployment rate of 9.6 percent in America may sound bad, but it doesn’t include millions of discouraged American workers. . . The real unemployment rate is closer to 16.5 percent . . . . That’s the Bureau of Labor’s U6 number, which takes into consideration so called “discouraged workers” who have given up looking for work, as well as people who are working part time but would like to be working full time. Overall, according to Gross, the number means that there is ‘one out of six adults in this country whose talents and time and skills are not being utilized anywhere near to the extent of their abilities.’ ”

I hope I’m wrong, or missing something about the economy, but it seems to me that the “Slow-covery” is getting even slower. Instead of a long hot summer, we may be looking at a long cold winter of discontent.


Will your deal survive the Devil’s Triangle? (part 4 of Bank Failure series)

As noted in the last post, what ultimately happens to a creditor’s specific claim against a financial institution often depends on what type of claim it is, and what priority it has.  This differs depending on whether the creditor is a  depositor, borrower, trade creditor, landlord or letter of credit holder.

Deposit Accounts.  Deposit accounts are a favored class of liability — provided that the accounts in question are federally insured.  FDIC coverage may be affected simply by the balance on deposit in the account.  Many business accounts (such as cash management, impound or lockbox accounts, through which a business’ essential daily cash flow moves) are likely to exceed this limit.  Therefore, businesses should carefully consider the effects of a freeze of, or partial loss from, such essential accounts, and should also give serious consideration to the stability of their banks.   One indication that a bank may be troubled occurs if it offers unusually high interest rates, because institutions trying to increase capital reserves sometimes offer high rates to attract deposits.  Deposit accounts which are not fully federally insured likely will experience losses or delays if they are not quickly transferred in a resolution to a new, solvent bank.

Secured Loans.  Another type of contract to which the FDIC as receiver may show relative deference is a loan secured by legitimate collateral.  A nondefaulted secured real estate loan, for example, with an adequate loan-to-value ratio and proper documentation, can be a valuable asset to the bank.  Even if moderately diminished in value, it may have a strong chance of being packaged into an asset sale, and surviving with a new, stable lender. 

Also, regulators are somewhat limited in their ability to abrogate or change vested property rights.  The FDIC has stated that it usually will not seek to reject properly perfected and documented security agreements (including real estate mortgages).  However, the outer limits of that protection are not well defined.

Securities, Swaps and Forward Contracts.  Regulatory laws also provide some limited protection for some kinds of specific derivative, option, swap and forward contracts (defined as “Qualified Financial Contracts”) and for some kinds of “true sale” asset structuring transactions for securitization.  Although a lengthy description of these “QFCs” is beyond the scope of this article, these generally are contracts with sophisticated parties, often executed at high speeds and in large denominations to serve specific financial risk management goals such as foreign currency exchange exposure, and are thought necessary in order to keep capital markets working well.

Unsecured Loans and Open Contracts.  Counterparties that have ongoing unsecured deals with a bank, such as unfunded loan commitments, agent bank responsibilities, real estate leases or servicing contracts, are less protected.  Such counterparties should evaluate the likely attractiveness their deal has to the bank and its successors in a potential resolution.  As noted, the FDIC may seek to take on only favorable contracts, or may reform contracts, accepting only the “good parts.”  For example, the FDIC might continue to collect on amounts due under a partially funded construction loan, but repudiate the duty to fund any future advances.

Another common case of an unsecured bank contract is a real estate lease in which the bank is either a tenant or a landlord.  Here, as in corporate bankruptcy, either kind of lease may be re-evaluated by the receiver and accepted, rejected, transferred in a sale, or partially assumed and partially rejected.  As with other unsecured obligations, the careful and timely filing of a proof of claim may be important to preserve a creditor’s priority for possible reimbursement.

Multiple Lender Transactions.  Multiple lender arrangements also may provide some safety.  The receivership of one member of a syndicated loan’s lender group may not be highly consequential to the borrower or the other lenders.  While that lender’s receiver probably will not fund future advances under the loan (especially on a construction loan), the typical syndicated deal has provisions for lender replacement, so long as the lender satisfies certain eligibility requirements (or other lenders in the group can make up the share).  The failed lender that does not advance will become a defaulting lender, and likely will lose its voting rights and its right to distributions.

A deal originated by a lender and then sold (as in securitization transactions) is even less likely to be affected by a receivership of the originating lender after the loan has been sold to others.   If the originating lender has retained loan servicing rights, they may be transferred with the loan, or to a new servicer, either by FDIC action, or by the new owner or trustee of the relevant special purpose entity if the FDIC repudiates the servicing contract.

Letters of Credit.  Letters of credit, often considered a rock-solid commitment in business transactions, do not necessarily fare well in bank receiverships.  Letters of credit constitute a bank’s forward commitment to pay an amount on demand to a beneficiary, based on the credit of another (the “account party”).  However, unlike the FDIC statement about perfected collateral, the FDIC does not give a clean assurance about letters of credit.  The FDIC states that “payment will be made to the extent of available collateral, up to . . . the outstanding principal amount . . . of the secured obligations, together with interest at the contract rate . . .” and certain contractual expenses.  But an unsecured or undersecured letter of credit, with a credit-impaired account party, is at risk of repudiation, as the FDIC is likely to view it as akin to an unfunded loan commitment to a shaky borrower.   That is little comfort to the letter of credit beneficiary.  However, the FDIC’s rationale appears to be that the beneficiary accepted the letter of credit based on the creditworthiness of the issuing bank, and that it should take the risk of having erred in that assessment.  Counterparties relying on letters of credit may want to re-examine the stability and credit risk presented by the banks that issued them.

No magic bullet will keep a deal with a bank facing regulatory resolution or receivership from being terminated or changed.  The legal processes for resolution are complex and discretionary.  However, counterparties still can exercise vigilance and take some steps to recognize and protect against risks in their deal structuring with banks.

Distressed Note and REO purchases (part 2)

Part 1 of this series dealt with representations and warranties that are typically provided in distressed note purchases and distressed REO purchases.  This post gives an overview of some of the diligence issues that must be addressed in purchases and sales of (whole) distressed notes.   (Other issues arise in the context of sales or purchases of participations in notes, which are not addressed in this post.) 

Why do due diligence?  When a lender chooses to sell, rather than to enforce, a distressed note secured by CRE, it may have made that decision for any one of a number of reasons.   For example, the lender’s regulator may have decided that the lender is carrying too many distressed real estate loans, and may have told the lender it needs to quickly rebalance its portfolio.  Or the lender may need to improve its liquidity quickly, and may determine it can do so faster by selling one or more distressed notes rather than by enforcing them, then selling the distressed REO after it is foreclosed upon by the lender.  Or it may have decided to get out of a given type of lending business, and therefore to sell all its loans in that line of business.  It may be rebalancing its risks geographically, or based on changes in the market.  Alternatively, the lender may need to improve the overall quality of its portfolio quickly.   Or it might be selling to change its yield and duration risks.   It might be selling the note due to its merger with another lender.  Another reason a lender might sell is because it thinks it will have a tough battle with the borrower to enforce the note, and does not want to commit the time or money.  Or the property may carry with it liabilities of one sort or another:  for example, foreclosing on a retirement home or a hospital may create public relations problems for a lender; or the lender may simply not want to, or have the resources to, manage certain types of property, such as land not yet subdivided; or a property may have environmental problems that concern a lender.   Or, in a declining market, the lender may decide it ultimately can collect more in a fast note sale (or lessen its costs — such as property taxes and other costs it must advance — to hold the declining property) than in a slow foreclosure (and possible bankruptcy). 

A potential buyer simply does not know why a lender is selling a distressed note, and so it needs to do diligence at two levels to understand and price the risk it is taking by buying the loan: 

  • First, it must do diligence to determine the status of the note, the other loan documents, the borrower, any guarantor, and the relationship and actions to date taken by the borrower and the selling lender, because the buyer will be stepping into the shoes of the selling lender; and
  • Second, it must do diligence to determine the status of the real property and any other collateral securing the note as if it were buying that property, so that it can understand, evaluate and price the current value and possible risks inherent in foreclosing upon that collateral.

“Due Diligence” defined.  Although most of you probably know what “due diligence” is, a simple definition is that “due diligence” means an appropriate investigation about all aspects of a note or an interest in property on behalf of a person or entity who plans to purchase an interest in it.  Generally, in commercial real estate transactions, the rule is “Buyer Beware!” which means the buyer must ferret out all the information it needs about what it is buying to make sure it is actually getting what it thinks it should be getting in its deal.

Lender/Seller’s position on due diligence.  A lender typically will agree to some diligence concerning the loan:  it should be willing to provide access to and copies of  its loan documents, correspondence to and from borrower and related parties, and loan file (other than any privileged documents and any appraisals) to the buyer and its counsel for review after a loan purchase agreement has been negotiated and before the buyer (and its deposit money) is irrevocably committed to complete the purchase.  Typically, a lender will require a buyer to enter into a nondisclosure and confidentiality agreement prior to providing such information, which is usually a reasonable thing to require.

It is in the lender’s interest, up to a point, to have the buyer do its own diligence on the loan documents and underlying collateral:  the lender’s goal is to get as close as possible to an “as-is” sale, and a lender will typically insist that the buyer make express representations that it has had the opportunity to perform diligence on the loan and on the collateral, and that the buyer is relying solely on its own diligence in electing to purchase the note.  Structuring a deal that way provides a selling lender some comfort that the sale will truly be final, and the buyer will not later be able to argue that the seller should be liable if the buyer has problems with the loan it buys.

Recommended due diligence for distressed note purchases.  While it’s pretty straightforward to review a lender’s loan file (assuming a complete loan file can be located), the process for evaluating the underlying collateral can be more complex. 

To review a loan file, one must carefully read (and preferably also have counsel read) all of the loan documents and all of the correspondence between the lender and the borrower.   The purpose of this review is to confirm the basic business terms of the loan (its amount, times and terms for payment, etc.) as well as the legal effects of the loan:  that the loan was made and documented properly, that it appears to be enforceable against the borrower and the property, and that the security documents work (create liens against the property that is collateral for the loan, whether personal or real property).   It’s usually a good idea to run a litigation search on the borrower to see if it or its principals have a history of litigation — that can be an indication of how hard it might be to enforce the loan.  Further, a legal analysis of the likelihood that the borrower has defenses to payment or other leverage (such as a fraud or other lender liability claim) that it could use to oppose the enforcement of the loan should be done by competent CRE counsel.  For example, my group has a standard form CRE loan checklist that we use to review loan documentation; it is quite long and detailed, and reminds us to check (and to document in summary form) a wide range of issues that can hamper the enforcement of a CRE loan.  After we complete initial diligence for a loan purchase, we provide that checklist (as well as an executive summary of it) to our client, so that it can make its internal determination about what to follow up on.  It is not uncommon for an initial round of diligence both to resolve certain issues and to uncover other issues that must be investigated further in order to really understand the risks of enforcing a particular loan. 

Typically in a loan purchase transaction, the buyer’s lawyer first looks at the lender’s loan file; if there are insurmountable problems in it, then the deal may be terminated before review of the collateral takes place.  But if the loan file seems okay, then the next order of business is typically the due diligence review of the real estate collateral securing the loan.

Diligence concerning the real property collateral should ideally be essentially like diligence on any purchase of real property.   What amount of diligence is “due” depends upon the circumstances, including the risks created by the prior use of the property, the risk tolerance of the buyer, the monetary value of the transaction, and the budget available.  The type of investigation that a buyer and its lawyer should perform in any real estate transaction depends upon both the type of transaction and the kind of land which is being purchased or encumbered.  However, some basic questions common to all types of land are outlined below:

  1. What interests in the property collateral are encumbered by the loan?
  2. What is the value of these interests?  Are they sufficiently valuable that if the note borrower fails to pay the note, the buyer can collect the amount owed by foreclosing on the land or taking other allowed liquidation actions?
  3. Who owns the property collateral? (Generally, it should be owned by the borrower.)
  4. What is the property used for? (This information is very important in determining the value of the land and the likelihood that it is environmentally contaminated.)
  5. Where is the property located? And can it be located with specificity on a survey? Has it been subdivided (so that it can be resold after a foreclosure if necessary)?
  6. How has the property been used in the past? (Also very important when determining environmental risks.)
  7. If it were to have to foreclose, what use could the buyer make of the land?
  8. Does anyone other than borrower (and typical easement holders, like utilities) have any rights to all or parts of the land?  If so, could such interest holders block buyer’s use of the property after a foreclosure?

The common goal of all of these questions is to find out precisely what the seller is selling and what the buyer is buying. This sounds simple but is not.  The key is to be able to find out about the property while relying only on sources of information that are known to be highly accurate (and, if possible, on sources that carry liability insurance against their own errors).  I could go on and on about the specifics of due diligence, but won’t:  just understand that in order to know whether it makes sense to buy a distressed CRE note, a buyer must do diligence on the collateral property as well as on the note. 

Key due diligence provisions in note purchase and sale agreement.  In negotiating the due diligence provisions of a note purchase and sale contract, the parties usually have to negotiate several points:  (a) the length of time the buyer has to  complete its due diligence; (b) whether the buyer can do environmental testing or physical inspection of the underlying property collateral (both are very important, but frequently the would-be note buyer’s access to the property is constrained by the seller/lender, which may itself only have limited rights to access the property; (c) the amount of cooperation during the diligence process that the selling lender must provide; (d) what happens if the buyer completes its diligence, then new information comes up about the status of the loan or the property collateral; and similar issues.  These issues and others are typically negotiated in the note purchase and sale agreement; once negotiated, both seller/lender and buyer must comply with those terms.

What we’re seeing now.  We’re seeing generally an uptick in distressed note purchases and sales.  However, there are fewer of these sales than one might expect.  It appears that regulators who in other CRE downturns might have pushed lenders to sell notes to maintain their liquidity, are instead allowing them to wait longer or go through foreclosures and other enforcement actions instead of doing faster note sales.  Many lenders think they can get a better return by enforcing the notes themselves, through foreclosure, then selling the real property collateral.  Further, there seem to be a lot of would-be investors in distressed notes relative to the number of distressed notes on the market, so there seems to be a fairly stiff competition to buy these notes — and many investors seem to be buying them at prices that do not take into consideration the potential costs and likelihood of enforcing these loans through foreclosure, or even despite a borrower bankruptcy; so it is unclear if many of these deals are actually healthy for the buyers.

Distressed REO and Note Purchases (part 1)

As more borrowers default on commercial RE loans, more lenders are starting to sell either the defaulted notes or, after foreclosing on the property securing the loan, the REO (real estate owned) properties.  These deals are typically “as is” deals, subject only to certain negotiated representations and warranties from the lender/seller to the buyer. 

I thought it might be useful to outline some of the typical representations and warranties we’re seeing in these deals; and also to set forth a reminder about the due diligence that should be done by buyers so they know what they are getting, and don’t just become knife catchers.  In today’s post, I’ve outlined typical reps and warranties.   I’ll outline typical due diligence issues in the next post.

First, at the risk of stating the obvious, there’s a big difference between buying foreclosed REO and buying a distressed note.   If you’re buying REO property, the borrower has already been foreclosed upon, and therefore you as buyer will not have to either foreclose the loan or take the risk that the borrower will file for bankruptcy.  If you are buying a note, however, you as buyer are taking those risks.  This means that a buyer of a note must take additional precautions and do additional diligence in order to make sure that the distressed note is actually worth what the buyer is willing to pay for it.

One way to determine the value of a distressed note, is to evaluate the market value of the underlying real estate collateral, then to take a discount from that in the amount estimated to reflect the likely cost to enforce the loan (possibly all the way through a borrower bankruptcy), adjusted by the likelihood that the borrower (and guarantors, if any) will fight the foreclosure.  This requires both a business and a legal analysis — the latter to determine if there are any defects in the loan documents that would make the loan harder or easier to enforce.

In purchases and sales of distressed REO, the terms of the deal are basically like other purchases and sales of real estate, with a few exceptions.  The seller of REO, typically a lender which has foreclosed upon the property, will not usually make a lot of representations about the property because it is not as knowledgeable as the typical seller — the lender’s position is usually that it made a loan, and will make representations about its ownership of the loan, but not about the underlying real property.  So most sellers of REO will generally represent and warrant as follows:

1.  that the lender/seller has the authority to enter into the sale of the REO, and that the agreement to sell the REO is enforceable against it;

2.  that no interests in the REO have been previously conveyed to others by the lender/seller;

3.  that there is no litigation concerning the REO  other than as disclosed in writing in an exhibit to the purchase and sale agreement;

4.   that the information provided by the lender/seller is true, complete and correct to the extent it has been created by the lender/seller (note that a lender/seller will usually provide copies of third party reports, such as environmental reports, but expressly will not accept liability for their accuracy — buyers need to either engage the provider of such original reports for downdates of them so that they can rely on such reports, or to have new reports done for them); and

5.  other representations typical in CRE purchase and sales agreements may be included.

If a distressed note is being sold, rather than REO, additional representations of lender/seller may include:

6.  that the lender/seller has provided to the buyer copies of all of the contents of its loan file, including all loan documents, modifications and copies of all correspondence relating to the loan;

7.  that the lender/seller is selling the whole loan (or, if the sale is of part of a loan, what part);

8. that the lender/seller owns the distressed loan, and has not conveyed any interests in it to any third party (except as disclosed in writing in the agreement).

In both REO and distressed note sales, there may be more representations and warranties running from the buyer to the lender/seller than in a typical CRE purchase agreement.  In a sale of REO property, in addition to the standard representations that the purchase contract is enforceable against the buyer and the buyer’s signatory has the authority to execute the contract,  the following representations may be included:

1. that buyer has investigated and completed its due diligence on the property, and will rely only on that diligence in electing to purchase the property;

2.  that the buyer expressly agrees its purchase of the REO is “as is, where is”;

3.  that the buyer complies with the Patriot Act;

4.  that the buyer is not an insider or affiliate of the lender/seller.

Sometimes in distressed note sales, a buyer will also represent that it is a sophisticated investor, and can bear the risks of purchasing a distressed note.  These lists of representations are not exhaustive, but should give you an idea of the sorts of reps you’ll typically see in these deals.

Next post:  Due diligence needed for purchases of REO and distressed CRE notes.

Fire or Ice in 2010?

Fire and Ice

Some say the world will end in fire,
Some say in ice.
From what I’ve tasted of desire
I hold with those who favor fire. . . .

— Robert Frost

Happy New Year, everyone!  Over the holidays, I spent some time  reading economic news, trying to figure out what’s happening,  and how it will affect the commercial real estate industry this year.  (As have you, probably.)

A lot of folks think that the federal government’s actions in 2009 and 2010  to “print money” to support the economy ultimately will result in inflation, or even hyperinflation.  Another group predicts deflation, as fewer buyers of various goods and servicers mean less demand, and more competition to make sales.  What if they’re both right?

It’s pretty clear from publicly available statistics that in real terms we did not grow the economy in 2009:   almost all of the GDP growth last year was triggered by the government stimulus, and not by private demand.  At least, that’s the view of a lot of economic pundits, including for example Stephen Pearlstein of the Washington Post, and’s own Robert Knakal.

I’m not an economist, but for what it’s worth, it looks like we might be heading into a period of both inflation and deflation:  inflation in necessities, commodities, interest rates and any supply constrained goods or services(which always seems to include anything I want to buy!); and deflation in the areas where there is an oversupply or room to lower costs.  

And we don’t have much growth coming from the private sector, so “stagflation”, an economic condition of slow growth and high unemployment  prevalent in the 1970’s,  may revisit us.  It was not fun the first time, and, like the color combination of harvest orange and avocado green so beloved then,  probably won’t have improved with age.

Unfortunately, commercial real estate looks like one of the deflationary sectors.  The 2010 prognosis looks poor, even though I expect more deals will get done than in 2009.   It looks like we’re heading into a time of price discovery as CMBS and other loans come due  or default, and owners can no longer fund the expenses of properties whose actual cash flow is coming short of their earlier projections.  (CMBS loans are reportedly at their highest default rate ever, over 6%, as reported by Jon Prior at Housing Wire.)

The last few years of construction may not have looked like overbuilding at the time because consumer sales were driving the economy, burning easy credit (including HELOCs).  But the growing number of hotel, broken condo and retail foreclosures suggests an overvaluation pattern more like the late 1980’s.  Virtually every business’ forecast of the demand for its own goods or services — and the space it would need to sell them — was too high.  These forecasts were based on faulty assumptions about continuing consumer purchasing power and easy credit.   Technology shifts like telecommuting, office sharing, internet shopping, videoconferencing and the like will continue to make more efficient use of commercial real estate, diminishing the need for offices, retail and hotels.

CRE values have sunk — no one knows exactly how far, but 40 – 55% off the peak is mentioned frequently.  Owners and lenders are generally, and understandably, reluctant to do deals at corrected low prices which would cost them money (or in the case of lenders force recognition of losses).  Still, eventually owners get tired of carrying properties, and loans come due.  Barring massive additional government stimulus directed at CRE,  circumstances will slowly forcibly close the bid-asked gap, at least on some deals.  That’s when price discovery will occur, and buyers and investors will become more likely to act. 

For players in the industry, the slow freeze of 2009, where so few deals were done, should thaw somewhat in 2010.    As time forces sellers’ hands, we’re starting to see more deals:  smart sellers with multiple properties are making triage decisions about which ones to hold on to, and which to sell to generate cash (or staunch the bleeding cash flow) so that they can survive this great recession.  Buyers are starting to buy properties and notes — though with significant discounts to face value, and at prices where a return is virtually guaranteed (even factoring in the cost of foreclosing in note sales).  Careful underwriting is back, and unlikely to change for some time.

On the legal side, this shift from a seller’s to a buyer’s market is leading to more careful  negotiation of deal terms, more attention to completing careful diligence, longer time periods for diligence and stronger representations, warranties and indemnities from sellers.  Perhaps as an industry we’re all shutting the barn door after the horse already ran away, but it’s an understandable reaction to the excesses of the last few years.

So, freely acknowledging my lack of an economics degree, I will put on my mystical “Deal Doer” turban instead, and predict that 2010 will be  a lot like 1992 was in California.  We’ll see  some deals, mostly heavily distressed/discounted, and the deal volume gradually will increase as the new reality of lower prices sinks into everyone’s consciousness.   The big unknown is what steps the government might take, if the downturn in CRE values appears to threaten the stability of the banking system or starts to cause a second downturn.  Fundamentally, and unfortunately, governmental intervention in real estate generally seems to be designed to keep real estate prices inflated even if that means rewarding folks who took inordinate risks.  The argument is that such support provides a slower and arguably softer landing, but it risks serious stasis, as in Japan and our own 1970’s stagflation, and I think is misguided.  Ultimately, just like the sun comes out after the rain, the CRE industry will eventually bounce back after price discovery.  Assets will find new prices, and new uses — people and businesses still need roofs over their heads.  Many owners and lenders will realize their losses.  Some sharp buyers will snap up deals.   But all of that can’t happen until the market is allowed to work to reset prices down to rational levels, and the overall business climate improves.

UPDATE:  Thursday January 7, 2010:

I just attended the Jones Lang LaSalle Forecast 2010 event in downtown LA this morning.  JLL fielded a strong array of speakers who have a considerably  more optimistic view of current economic conditions than I do. 

Notably, JLL’s Global CEO, Colin Dyer, informed the gathered real estate luminaries that JLL’s worldwide offices are seeing (1) a strong recovery in most Asian CRE markets driven by the economic expansion there; (2) a slower recovery in Europe, led by the historically strong commercial areas in London and Paris; and (3) the US CRE markets generally lagging, but picking up in coastal markets first.  Bob Hertzberg, former speaker of the California State Assembly, pointed out that 7 of the worst markets in the US are in California.

Richard Weiss, EVP and Chief Investment Officer of City National Bank was also generally positive, opining that the US economy is in recovery mode, and predicting that the recovery would be strong enough that the Fed would allow interest rates to start rising in April. 

Generally, the consensus view from the speakers at the JLL 2010 Forecast was that perhaps the lack of pressure on banks to recognize losses and foreclose, coupled with massive governmental stimulus, might in fact be creating a relatively soft landing — with CRE prices falling 35 – 55% from peak, but without an overcorrection.  Time will tell.

Happy Holidays, 2009: CRE is Scrooged

I’ve thought the market was overvalued, and that a wave of foreclosures was coming, for several years.  I was wrong in 2005 and 2006; by 2007 a fair number of folks thought the CRE market was overvalued, but we did not see many defaults, at least here in Southern California.  In 2008, the CRE  market seemed to be generally stuck.  This felt very similar to 1991 — everyone knew values of CRE had fallen, but no one wanted to take action — as if denying reality might make it go away. 

But many of us, including me, have been surprised by how long it has taken for the weakness in the overall economy to affect the CRE market this time, and how long it has taken before an uptick in defaults, workouts and foreclosures.   In some parts of the country, like Michigan and Florida, the wave of foreclosures brought on by falling values has already hit.   But in California, where we have generally seen only limited CRE foreclosures in 2009 (but a lot of modifications), it looks like we’re in the trough of activity looking up at the crest of the wave now.

Just today, in connection with a discussion of a consensual workout of some prominent San Francisco real estate, Bloomberg reports

“Commercial mortgage defaults more than doubled in the third quarter from a year earlier as occupancies fell, according to Real Estate Econometrics LLC.  .  . Property sales financed with commercial mortgage-backed securities plunged 95 percent from a record $237 billion in 2007, according to JPMorgan Chase & Co. “

Bloomberg goes on to quote Moodys, as saying that values “may fall 55 percent from their peak” due to a lack of securitized debt.

 Third quarter 2008 was bad enough:  double that default rate is ugly. 

A drop of CRE values anything like 55% obviously will be even worse news for highly leveraged projects — and could gouge the LTV ratios for even the most conservative lenders.

Probably we’ll see a greater number of underwater owners giving back their properties to lenders, either by deeds in lieu, agreements to not fight foreclosure, or the like.  Often these graceful surrenders are made in  exchange for limiting guaranty exposures.   In the case of CMBS loans, we’re starting to see lots of resales of the property made consensually through a receiver to a willing buyer/new borrower who is willing and able to assume the existing loan, as modified.    These can be fairly simple and effective workout deals, if documented correctly to avoid the traps presented by California law.  We’re also seeing some lenders who don’t want to battle through foreclosures quietly moving to sell their loans to buyers willing to undertake those legal fights in exchange for a discount on the note price.

True to 1991 form, we don’t seem see borrowers or lenders completely capitulating to reality yet:  there’s still a persistent gap (though a diminishing one) between what lenders are willing to sell distressed debt or foreclosed property for, and what buyers are willing to pay.

That’s what we seem to be seeing now, as we go into the holidays.  I’d be interested in hearing whether you are seeing that too — or seeing something different.  Please let us know by posting a comment.

CA Nonjudicial Foreclosures (Trustee’s Sales)

 “Nonjudicial foreclosures” (also known as “trustee’s sales”) are available in California to enforce defaulted real estate loans.  The procedures for nonjudicial foreclosure proceedings, including service and recordation of the notice of default and the posting and publication of the notice of trustee’s sale, are highly technical and are governed by various provisions of the Civil Code.   Borrowers’ advance waivers of these provisions are not effective.

Lenders generally prefer nonjudicial foreclosure to judicial foreclosure because (i) usually (barring a bankruptcy filing by the borrower) a nonjudicial foreclosure can be completed in a much shorter time period than a judicial foreclosure (in approximately four months versus up to two years), (ii) the borrower does not have a right of redemption following a nonjudicial foreclosure sale, and (iii) the legal and other fees incurred in connection with a nonjudicial foreclosure are usually much less expensive  than those incurred in a judicial foreclosure.  However, in a nonjudicial foreclosure, the tradeoff is that the lender loses up any the right it may have to pursue a deficiency judgment against the borrower:  under California law, a deficiency judgment is always prohibited after a nonjudicial foreclosure has been completed.

The timetable for nonjudicial foreclosures requires the trustee to wait three months after recording and serving the notice of default before giving 20 days’ notice of sale.  In addition, trustees customarily allow for an additional 11 days in scheduling the sale date in order to determine whether any federal tax liens were recorded as of 31 days before the sale date.  These timetables can be significantly extended if the borrower files for bankruptcy protection, triggering the automatic stay to preclude foreclosure, or if the borrower brings an action challenging a nonjudicial foreclosure.

The borrower has a right to cure the default under the loan up to 5 business days before the date that the real property collateral is sold in the nonjudicial foreclosure.  If the sale date is postponed, the borrower’s right to cure is extended.  If the lender fails to provide the borrower with the information about the amount that is due, and as a result the borrower tries to, but cannot, cure its default, the lender opens the foreclosure to challenge.

The lender may credit bid (bid up to the amount owed to it under the loan) at the nonjudicial foreclosure sale.  However, the lender must carefully ascertain the amount that is due to it under the loan, because if it claims amounts not due to it (for example, a usurious rate of interest if the loan was not exempt from California’s usury laws), the borrower may have grounds to challenge the foreclosure sale.

It is not uncommon for lenders and borrowers to extend the sale date for a nonjudicial foreclosure in order to continue workout discussions.   (Sometimes lenders unilaterally extend the sale date for other reasons.)  There are limits on how many extensions can be done before the trustee must provide a new formal “Notice of Sale” for the rescheduled nonjudicial foreclosure sale.

Many nonjudicial foreclosure sales of commercial real estate attract no bidders other than the foreclosing lender.  Because bidders other than the foreclosing lender must immediately pay their bid amounts in cash or cash equivalents, such as cashier’s checks, many would-be bidders would rather buy foreclosed properties after the foreclosure, from the foreclosing lender.  However, the foreclosing lender is not allowed to “chill the bidding” by taking certain steps to discourage other bidders from attempting to bid.  Specifically, it is unlawful to (1) to offer to accept or accept from another,
any consideration of any type not to bid, or (2) to fix or restrain
bidding in any manner, at a nonjudicial foreclosure sale; however, it is lawful for any person including the trustee, to state that a
property being foreclosed is being sold in an “as-is” condition.

Though bidding strategies can vary, many foreclosing lenders will credit bid not more than about 90% of the current appraised value of the property.    However, bid strategies vary considerably from lender to lender.  It is usually imprudent to bid in the entire amount of the debt owed, in case a problem with waste or fraud is discovered later, after the winning bidder (usually the foreclosing lender) takes title to the property.

[Under recently enacted legislation that expires January 1, 2013, certain additional requirements apply to foreclosures involving residential real property.  These requirements include the following:

  •  In the case of a mortgage loan made during 2003 through 2007 to a borrower whose principal residence is the mortgaged property, the foreclosing lender generally must contact (or take specified due diligence actions to contact) the borrower in person or by telephone in order to assess the borrower’s financial situation, discuss the borrower’s options for avoiding foreclosure and provide the borrower with certain additional information.  The lender must do this at least 30 days prior to recording the required notice of default.
  •  In the case of a loan secured by a property that includes one or more rental housing units, any tenant or subtenant in possession of a unit at the time of the foreclosure sale must be given at least 60 days’ notice (double the amount of time afforded under prior law) to move from the foreclosed property.
  • In all cases, the legal owner must maintain vacant residential property purchased at a foreclosure sale or acquired through foreclosure under a mortgage or deed of trust.  This maintenance requirement includes caring for the exterior of the property (such as preventing excessive foliage growth that diminishes the value of surrounding properties) and taking action to prevent trespassers or squatters from remaining on the property, to prevent mosquito larvae from growing in standing water and to prevent other conditions that create a public nuisance.  A governmental entity may impose civil fines and penalties (of up to $1,000 per day) for failure to do so.

 (The last two of the above requirements apply to both judicial and nonjudicial foreclosure proceedings.)]

Many technical requirements must be met in the various notices and other steps in a nonjudicial foreclosure.  In California, obtaining a trustee’s sale guaranty is virtually required in order for the lender to make sure it provides the required notices to the right parties.  If a lender makes a mistake in the notices or the process, the borrower may be able to challenge the validity of the foreclosure.


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Attorney Advertising. This blog is a periodical publication of Maura O'Connor, a partner of Seyfarth Shaw LLP and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. You are urged to consult a lawyer concerning any specific legal questions you may have. The contents are intended for general information purposes only and represent the individual views of Maura O'Connor only. Any tax information or advice contained herein is not intended to be and cannot be used by any taxpayer to avoid tax penalties that may be imposed on the taxpayer.