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.

Receiverships Now: Bill Hoffman of Trigild talks

Recently I had the pleasure to talk with Bill Hoffman, of Trigild, which is a receiver based in San Diego that handles receiverships of troubled assets across the country.  I asked Bill to tell us a bit about what he and his colleagues at Trigild are encountering in the current commercial real estate markets they serve.

O’Connor:  What are you seeing in the market now?

Hoffman:  We first saw housing developments, condominium construction and conversions failing in 2008. Also, restaurants started to fail early in this cycle, at a rate worse than lenders believed possible.

Next, shopping centers started to fail early in 2009 and calls on failing shopping center projects are now coming in daily. The pace of these business failures has accelerated rapidly and we don’t see a bottom yet. Calls to our offices on distressed hotels are increasing daily and many of those hotels have already been in default for many months or longer. Some experts estimate that as many as 500 hotels in California are already in default, but awaiting action from lenders and servicers, who are already swamped with other product types. In previous hotel down cycles, it was the smaller independent, often family operated properties that were the early defaults. However, in this cycle higher end, nationally branded hotels have been the first to go down, with current values being far below even the debt amount, and those values expected to decline further. Bigger hotel players are just walking away because there is no near-term likelihood of recovery, and they see no equity returning for many years. With the smaller properties, the franchise is often switched to a lower category, but the luxury branded hotels are much more likely to stay in place, keeping their market presence and avoiding the stigma of “losing” property. The public rarely realizes that it is the franchisee/owner who has failed, and merely connects the failure with the brand name.

As lenders and servicers continue to add staff and begin to get better control over the sudden flood of defaults, we will begin to see earlier action toward foreclosure or bankruptcy.  Few sources in any sector of commercial real estate see a light at the end of the tunnel yet.

Many of the impending loan defaults are not a matter of failing to make regular debt service payments; instead the mortgage is maturing and needs to be replaced. Loans on properties whose values have already shrunk to less than the current debt are not viable candidates for re-financing, especially in this current dry well of financing.

We are also seeing an extraordinary number of “jingle mail” defaults: a property worth perhaps only half of the outstanding debt has no value to the borrower, and property owners are sending keys back to the banks. A side effect of this flood of defaults combined with so many developers, management companies, brokerage firms and other real estate people seeing huge drops in their normal business income, we are seeing a huge increase in people claiming to be qualified to serve as receivers – perhaps 10 times the number of just 2 years ago. We can expect to see a variety of other problems for lenders as a result.

O’Connor:  What do you think you’ll see in the next 6 months to 1 year?

Hoffman:  In next 6 months to 1 year, we think we’ll see 4 – 5 times the number of hotels going into receivership and/or bankruptcy than we did just 12 months ago. Historically, down cycles are slow at the beginning, then speed up once lenders start dumping inventory, leading to even greater discounts in selling prices. Hotels are already being auctioned – a rare disposition method in previous down cycles. We will see unfinished construction of hotels stop, with some simply being mothballed for a few years.

We think the climate for commercial real estate will get worse before it gets better.  Commercial real estate is in trouble all over:  the long spell of increasing occupancies and rates came to a screeching halt, and those loans made on the basis of overly optimistic projections have reversed loan-to-value equations in most asset classes.  Higher end hotels are forced to compete by lowering their rates dramatically without compromising service, with resulting massive losses. Many try to maintain their apparent “rack rate” by offering other discounts – free nights, meal credits, etc.

O’Connor:   In your opinion, what is different about this down cycle as compared to the 1990’s?

Hoffman:  The sudden and dramatic drops in value, with most experts predicting that the bottom is still in the future and will be much deeper.  The consensus also seems to still be extending the predicted date of the bottom, the length on the bottom, and the length of recovery.  Originally, CMBS loans were a vehicle which allowed the RTC to get commercial property back into the hands of owners rather than lenders.  The billions of dollars currently in CMBS loans do not yet have a magic bullet to accomplish that same recovery.  Many commercial borrowers are now dealing with special servicers who did not originate the loans, have no relationship with the borrower, and work under very strict guidelines and regulations which limit the options for resolutions.

Special servicers’ asset managers, like their banking colleagues, are dealing with extraordinary numbers of loans, and many are relatively new to non-performing loans,  sometimes recently moving from the origination side. There is of course a learning curve which further slows the process in dealing with the record volume.  Our staff spends a fair amount of time helping asset managers understand issues of receivership, bankruptcy, franchising, liquor license issues and a full menu of additional factors impacting their jobs.  This includes understanding the costs of maintaining any property, but further complicated for hotels, restaurants, convenience stores, truck stops, water parks and any other real estate project with a business enterprise aspect.

If several lenders are involved in the same project, Trigild often will be asked to serve as the one receiver for all lenders’ security.  This can simplify the process and operation and also dramatically reduce fees and costs. Unlike many other receivers, Trigild has operated hundreds of businesses like those mentioned above, and being able to perform both roles avoids overlapping fees for the receiver to “oversee” the management company.

Another development rarely seen in previous downturns is borrowers cooperating with lenders to have receivers sell property during the receivership, rather than waiting until the end of the foreclosure period, which can be very lengthy.  “The sooner the sale the higher the price” is a given in this economy, and often the borrower recognizes that there will be no equity even in the distant future.  Sales by receivers are becoming more commonplace in many state jurisdictions, and are already recognized in federal rules for receivers.  In the case of CMBS loans, sale by the receiver before foreclosure also allows the servicer to provide some financing from the existing loan.

O’Connor:  What should a lender/servicer seek in a receiver?

Hoffman:  Experience, experience, experience. The number of people claiming to be qualified to serve as a receiver has probably increased 1000% just this year.  There are few if any formal requirements for a receiver in many states, and some management companies, etc. will offer to do the receivership work “free” in order to get the management assignment.  The potential danger to a lender from receiver mistakes can be monumental.  A receiver who involves the lender in decision making for the property can open a claim of lender liability by a disgruntled borrower and cause the lender to end up legally as an owner or owner’s partner, losing its status as a secured lender.  We have seen hundreds of thousands of dollars paid to utilities, vendors, franchisors and other borrower’s creditors which were not receivership estate obligations.  Loss of liquor licenses, gaming licenses and other critical assets are not uncommon with less experienced receivers.

Relatively few lawyers and judges deal with receiverships, and receivership law is very fluid, with no instruction books and few specific rules.  Judges will usually honor the lender’s recommendation of the specific receiver, and show little sympathy for the lender when mistakes are made.  Experienced receivers have earned the courts’ respect and judges rely on those receivers.  A receiver who plans to immediately retain legal and other counsel for advice on how to operate is unqualified.  Most judges will not allow for such immediate professional help without a more specific showing, since they expect the receivers to know the job.

O’Connor:  What distinguishes Trigild as a receiver?

Hoffman:  While Trigild has managed and acted as receiver for traditional real estate (office, retail, multi-family) for 33 years, we are known for our unique ability to act as a receiver for operating businesses, such as restaurants, convenience stores, truck stops and hotels, where the major value is the business enterprise, not merely the real estate.  We field a team of experts who have the experience to operate these businesses, and have done over 1,500.

We have been called upon to take over as many as 100 individual restaurants at one time using our affiliate company, Trigild Associates, as the new employer for sometimes thousands of employees in multiple states. Our staff covers every area of expertise and includes lawyers, paralegals, MBA’s, CPA’s and recognized experts in every branch of commercial real estate.

Finally, we also have a group of skilled real estate agents who are uniquely qualified to direct all aspects of selling these properties, working from our own extensive database and business relationships, and working in cooperation with other brokers through the country.

Beware of green shoots: there may be snakes in the grass

There’s good economic news breaking out all over,  it seems.  The Fed’s Beige Book report, released July 29, suggests that the pace of economic decline has started to slow.  The stock market liked this news, responding with gains per Bloomberg. But does a little bit of economic improvement mean that the worst is over for commercial real estate?  or that we’ll have a fast recovery in CRE?  I don’t think so.

Despite all the talk of “green shoots” and economic improvement,  it is likely that CRE will suffer for a significant amount of time.

Why?  There is simply not enough growth to increase demand for commercial space.   Consumer demand, which for better or worse drives our economy, is way down, for a number of reasons:

• The continuing high rate of unemployment (14.5 million Americans were out of work in July per the Boston Globe) scares even those consumers who have jobs.  So they spend less.
• So many people overleveraged themselves through home equity extraction (and must either repay that money or have their houses foreclosed upon) that they don’t have much money to spend.  (Bloomberg reports that banks held a record $674 billion of HELOCs and $211 billion of closed- end home-equity debt as of March 31, according to FDIC data.)
• So many people overleveraged themselves through credit card and other debt that they don’t have much money to spend.  And instead of buying more, they are apparently paying down their debts — probably good for them personally, but collectively not great for increasing demand and growth in the economy.  CNNMoney reported that since last August, the amount of outstanding consumer credit has declined, according to the Federal Reserve, with total consumer borrowing sinking a seasonally adjusted $10.3 billion, or 4.9%, to $2.503 trillion, and revolving credit, which includes credit card debt, fell $5.3 billion, or 6.8%, to $917 billion. 

Until consumer demand increases for goods and services, companies have no reason to increase their use of commercial real estate by taking on new leases or purchases of retail, office or industrial space.   In fact, since demand is down, many users of CRE will continue to look for ways to cut their expenses for CRE as a way to reduce their expenses overall — and to survive the downturn.   Obviously, if enough tenants default on their leases, this creates problems for landlords, who in turn may default on their mortgages.  This is happening now; for example, prominent Southern California developer Maguire Properties recently announced it will sell or return to lenders seven buildings in Southern California per Business Week.

In addition, the death (or serious incapacity) of the CMBS market has wiped out about 40% of the total financing capacity that was available to finance CRE.   That means that, over the next few years, unless an alternative source of funding is found, many CRE projects will have trouble finding refinancing at maturity.   Since CRE prices have fallen significantly, it is very difficult for many CRE owners to get financing.  For that reason, we should expect to see a lot more defaults (including maturity defaults), workouts and foreclosures. 

Many banks have been quick to extend loans and slow to foreclose, because they could not afford to recognize losses as doing so would increase their capital requirements and perhaps push them into insolvency — and the undesired embrace of the FDIC.  However, as banks move toward recovery, assisted by the massive federal bailout, their capital reserves should improve.  This should allow them to move forward to recognize their losses and foreclose on their troubled CRE loans over time.

So instead of thinking that CRE will recover soon, based on what I’m seeing,  CRE has not yet absorbed the brunt of the recession, and will likely continue to get worse over the next couple of years, until much of the CRE market has been significantly repriced downward.

Of course, the wild card in this is government intervention:  if the federal government decides that massive CRE failures would destabilize the financial system, it might well retool existing governmental bailout programs, invent new ones or change tax policies to cause the injection of more liquidity into the CRE market.   It is hard to guess at the government’s likely intervention, but this Fed and this administration have been very willing to use taxpayer money to stabilize the financial markets, and so might do the same for CRE. 

What do you think?  Share your views by replying below.

The approaching tidal wave: Maturity defaults in CRE loans

 

Bloomberg has reported this week that “almost $165 billion in U.S. commercial real estate loans will mature this year and need to be sold or refinanced as rents and occupancies fall, according to First American CoreLogic.  The U.S. South has the most maturing loans with 60,893 mortgages valued at $96 billion coming due on shops, offices, hotels, apartment buildings and land . . . .The West is second with 20,549 mortgages maturing for a value of $35 billion.  Commercial property owners are struggling to pay debt as the recession reduces demand and forces landlords to cut rent. . . . Properties worth more than $108 billion were in default, foreclosure or bankruptcy as of July 8, according to data firm Real Capital Analytics Inc.  .  .  .  U.S. commercial property prices fell 7.6 percent in May from a month earlier, bringing the total decline to 35 percent since the market’s peak, Moody’s Investors Service said last week.  .  .  . More than 5,000 commercial properties in the 10 biggest U.S. metropolitan areas got at least one default notice in March, marking the first time that’s happened in First American records going back to January 2003. ”

This looks like an approaching tsunami to me for banks, special servicers and other CRE lenders. 

Now we’re seeing lenders generally extending their loans when possible to avoid having to sell properties at current low prices and into a market where potential buyers are having difficulty arranging new financing.   (The smart lenders are using this as an opportunity to review their loan documents and fix anything that could block or hamper later enforcement through foreclosure.) 

These extensions are, essentially,  bets that the economy will recover soon enough that these lenders won’t have to foreclose or do larger scale workouts.  Extensions are also protective measures for each individual institution —  by postponing any writedown, the lender preserves its own capital and protects its short term solvency.  And it is possible that the massive governmental stimulus will reinflate the economy and the demand for CRE (though I am skeptical about this).

But I can’t figure out where the needed replacement financing is going to come from, especially since the CMBS market appears to be dead, leaving a huge gap (perhaps 40%) in the financing available for CRE.  (Few banks have an appetite for more real estate loans.  Haven’t heard a lot about life insurance companies wanting more  CRE loans either.  One of my partners has done one of the two covered bond deals completed to date, and thinks that structure is unlikely to replace the missing CMBS financing.)   Do any of you have any ideas about what will replace this missing financing?