The LANDCO View On “Opportunities In Distress”

CRE Finance Council May 2013 Distressed Debt Summit

The CRE Financial Council’s Distress Debt Summit, held in Santa Monica on May 9th and 10th, was well worth attending. LANDCO selectively participates in panel discussions, sponsors events, and hosts retreats for its own employees to better understand markets and for collaborating on matters affecting the future of its business. In more recent years, we have been less visible and more observant of our colleagues, contemporaries, and competitors, hoping to identify trends and, of course, target opportunities. That is changing now as we endeavor to develop new opportunities in six marketplaces.

All in, the attendees at the Distress Debt Summit numbered approximately 130 which is very small. To our liking, the smaller conference allowed for all of the sessions to be attended and for more effectiveness in talking to folks representing capital sources, government regulatory agencies, special asset handlers, special servicers, and investors seeking opportunities to acquire both MBS and loans. What follows are a few conference topics and what

we felt were views sharing significant consensus or opposition. We hope you will find this as interesting as we did.

On Distressed Debt Opportunities

We will begin the expiration of FDIC loss sharing agreements this summer as banks will need to decide how to proceed. Any bank holding assets under a loss sharing agreement will need to ask itself if it is worth holding or disposing of loans before the agreement expires. We predict two possible outcomes:

  1. The frequency of loan sales may spike as banks take advantage of the “insurance” before expiration; or
  2. Renegotiation of loss share terms are considered.

Alternative number 2 is a more likely scenario.

The FDIC is in need of cash flow. A successful sale of a bank asset is much more likely to occur if the FDIC is not paying on loss share. No surprise here. The FDIC behaves like any insurance company and can be expected to resist the idea of paying out. Will opportunities play out here? Conference panelists would support a “yes” consensus with likely outcome of accelerated bank consolidation among the smaller banks. This can / will happen if the FDIC sees a less expensive way out of bad assets by forcing consolidation. This should free up more distress debt for sale and might accelerate the appetite for foreclosure in favor of workout.

On Coming Regulations

Smaller banks have much higher concentrations of real estate loans and will struggle with increasing bank regulations. Further consolidation is imminent.

Some of the reluctance to lend is rooted in the fear the unknown regulations to come. This is more the case of smaller banks that have fewer non-interest income revenue sources to rely on.

Future bank capital requirements are likely to be determined by what the examiners determine the risk to be in the loan portfolios, and therein lies the question(s):

  • How will risk be determined?
  • What kinds of loans will be considered riskier and, therefore, more prone to larger capital requirements?
  • And how will these new policies affect a bank’s profitability and growth prospects?

One situation that

apparently has repeated itself many times, and intrigued us, was the apparent refusal, in certain circumstances, by the FDIC to approve bank requested sales of certain loan assets. This is happening exclusively where FDIC is required to payout under the loss sharing agreements.

This summer we will see the banks paying regular insurance premiums to the FDIC again. Recall, at the inception of the bailout, banks were required to put up three years of premium. According to several familiar with the FDIC, the advance payments of premiums have been spent. With cash flow back there may be more flexibility on loan sale terms.

On Equity and Product

Lower return thresholds on smaller deals are becoming more common. Larger portfolio and loan transactions have moved through the system once and as such have tightened the market a bit.

There are major concerns over retail product and whether certain developments can ever function as originally envisioned (for more on this, read LANDCO Principal David Rosenbaum’s Situation Accessment, Retail Risk: A First Mortgage Doesn’t Mean What It Once Meant). For example: a name grocer does not renew a lease and hollows a neighborhood center. The landlord takes on a new tenant that can pay rent as cash flow is needed to service operating costs

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an ideal complement to the remaining tenant mix in the center and as such can drive down the value of the asset well beyond any short term loss in cash flow. If / when this happens the investor will likely underwrite the value at industrial property rents and cap rates.

Multifamily is the industry darling. It is most effectively underwritten and least exposed to unpredictable forces like technology shifts. People need places to live and are generally willing to pay up for well-located housing and when necessary, not so well-located housing Rents or mortgage payments are the most direct derivatives of income / jobs. Although all real estate values are derived ultimately from income, retail, commercial and other forms of real estate are driven by consumerism, some less essential than others.

East and West Coast markets and other MSAs such as Houston and Dallas remain highly desirable

investment areas. In markets where job growth is present and sustainable the economies are typically robust. Markets not experiencing job growth due to the development of offshore manufacturing alternatives, technological advances which are in some cases subsidized by the US, and increasingly rising US labor costs are not as attractive.

On Loan Servicer Perspectives

The conference culminated with a panel of loan servicers opining on a case study involving a CMBS loan in default. The servicers agreed for the most part on the objective, but differed greatly on how they might go about achieving it. Few seemed amenable to work out terms for existing

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owner / borrowers and seemed to prefer doing business with unrelated third parties.

Why wouldn’t a lender prefer workout terms for owner/borrowers to other investors new to the transactions? Answers ranged from, “financial condition of the owner / borrower unknown or less than optimal,” to, “threats of bankruptcy are not acceptable and deserve no consideration” and more. We were intrigued by this as well.

There were a number of questions from the audience having to do with how best to communicate on matters surrounding distress debt if ownership was willing and able to perform. Without a clear consensus, the one item that could be agreed was the requirement of agreement of value. As long as the value of the asset was understood and the owner / borrower was willing to capitalize under terms that were at market then modifications were in order. Having said that, there have been and continue to be policies that preclude what would seem to be the most logical workout steps and best financial decisions for lenders particularly in the agencies.

There was a hint of hostility toward defaulted borrowers. The sense we got from several conversations with industry veterans on the ownership side was that a double standard was prevailing. Lenders were receiving bailouts to save their businesses and not passing along some of the flexibilities.

LANDCO Advisory Services Solution

There will always be a preference to do business with investors who have purchased distressed loans and demonstrable capability for repositioning assets as needed and as LANDCO has done over the years.

LANDCO Advisory Services seeks to reconcile differences between borrowers and lenders by developing a transparent transaction format with enough qualitative information from both parties to become comfortable with the terms wherever and whenever possible.

Many thanks to the organizers of the conference and to those who participated in the panels. We look forward to seeing you at the next event.