Distressed Asset Sales Are a Growth Market
The current crisis in our nation's banking and real estate industries is dramatically altering the capital markets for real estate financing and investment. In the midst of massive real estate dispositions and loan restructurings, a new secondary market is taking shape -- the "distressed" asset market.
By distressed assets, I refer particularly to repossessed commercial real estate, and nonperforming or underperforming commercial real estate mortgages. In today's sluggish environment, even the most viable real estate projects are overfinanced to some extent.
The "go-go" optimism of the 1980s has been replaced by unprecedented illiquidity and plummeting real estate values. The banking, S&L, and insurance industries are busy taking a major "haircut" on these over-financed assets.
A Lesson from the RTC
Although the next five years will be fraught with bankrupt borrowers, bitter legal disputes, and the displacement of human and economic resources, the distressed asset market will play a key role in speeding up this necessary haircut and bringing liquidity back to the real estate industry.
The Resolution Trust Corp. holds more than $50 billion in distressed assets. A year ago, this inventory cast an ominous shadow on the real estate market.
Some predicted that these assets would wallow in bureaucratic mud for the rest of the decade. However, after a slow start, the RTC's bulk sales program is gaining momentum.
The reason is simple: the RTC has effectively responded to private investors and priced these assets according to risk-adjusted market yields. Recent sales are occurring at 20% to 40% of original book value.
Big Players Interested
The capital markets are seriously interested in distressed assets. For example, the Bass Group and GE Capital Corp. recently joined forces to acquire the RTC's West Coast asset pool, with a bid of $527 million. And before that, GE financed Maxxam's $132 million acquisition of an RTC portfolio.
These major acquisitions have rapidly increased the perceived liquidity of distressed assets. With the exception of land, the RTC's real estate inventory should begin to dry up over the next two years as low-quality loans are sold instead of remaining under management by the agency.
For the most part, this effort by the RTC to sell distressed assets will be good news for the real estate industry, the financial services industry, and the tax-payers. Value and liquidity will be better realized by private sector investors with capital at risk than by any publicly accountable (and constrained) agency. The nation will be better off if the economic and psychological weight of the RTC is lifted sooner rather than later.
The New Intermediaries
Bulk purchasers of RTC and Federal Deposit Insurance Corp. assets are setting the foundation for a larger, more intricate secondary market. Many bulk asset purchasers do not view themselves as long-term buy and hold investors.
Rather, they view their function as wholesalers and specialists in this emerging arena. They are the new intermediaries who stratify, restructure, incubate, and remarket assets to a broader investment audience.
Purchasers of nonperforming and underperforming loans have numerous options in pursuing their investment returns:
* They may attempt to gain control of the collateral underlying the mortgage note.
* They may restructure the debt at a level congruent with the property's current cash flow. Loans can be split, with the high quality, performing portion sold or placed and a residual interest retained.
* The loans may simply be resold to a similar (albeit smaller) investor who has a distinct re-possession or restructure strategy in mind.
Most likely, the bulk investor's "exit" strategy on these portfolios will not be via the traditional bank and insurance company sources.
Since pressure from regulators, rating agencies, and stockholders will continue to discourage lending and investment in commercial real estate, private capital will progressively fill this void.
In order for this secondary market to become relatively efficient, loan valuation methodologies will become more complex and standardized. In each subsequent bulk asset sale, more intricate and extensively researched discounted cash flow frameworks seem to be utilized.
To arrive at a reasonable purchase price, investors are painstakingly trying to assign economic costs to the legal, title, credit, and environmental issues that surround distressed assets.
For the majority of investors in the real estate market, the bulk wholesalers will eventually become a more common source of product than the RTC and FDIC themselves.
Some of the most successful investors will be those who "clean up" after bulk purchasers who overpay for assets or mismanage their portfolios. No one can accurately assess just how the distressed asset market will ultimately take shape, but for those involved, I have the following initial thoughts:
Advice for investors: No matter how "efficient" the distressed asset market becomes, always remember the substantial and unavoidable risk involved with these investments.
Like other potentially high-yielding investments, distressed assets may become so alluring that investors lose sight of the fundamentals. Though the market may develop standardized approaches to evaluate assets, each asset will continue to have unique recovery issues, and most likely, a distinct skeleton or two in its closet.
Be wary of deals that happen too fast without a detailed due diligence conducted by qualified professionals, and watch for deal promoters who kill the economics of an investment with heavy up-front fees, high management overhead, and limited accountability or incentive to perform.
For these risky, management-intensive acquisitions, I believe its best to keep the structure lean and entrepreneurial, with management and equity closely tied.
Advice for the government: Pay little attention to the criticism that will come concerning the "dumping" of assets.
Critics who warn against dumping do not realize the tremendous overhead costs and inefficiencies involved with any public agency that is consigned to a political fishbowl.
They do not sense how urgent the self-liquidation of the RTC is to our real estate markets and overall economy. Those in oversight capacities should not second guess the RTC's actions when bulk asset purchasers make substantial profits.
Investors with their necks on the block and capital at risk can achieve remarkable feats. It is unwise to believe that the same results would have been produced by a government-controlled entity. These deals will be risky and there will be big winners. But there will be big losers as well.
Advice for borrowers: Understand the objectives and motivations of the new owner of your loan.
These lenders cannot be warded off by phone calls from a congressman or slowed by an inefficient bureaucracy. Since they do not face the capital and regulatory issues of a bank or S&L, they will shun proposals to hang in with borrowers on submarket loan restructures.
Borrowers interested in maintaining control of a property and hoping to salvage a portion of their equity investments must propose join workouts that address the new lender's two major objectives: maximization of recovery and liquidity.
One-sided haircuts won't be acceptable to these lenders. Borrowers must make a rational case to the lender and sacrifice enough equity to demonstrate that their workouts will bring a higher recovery than the foreclosure and bankruptcy route. Liquidity will be of paramount concern to these lenders. Thus, cash payout offers will get the most attention.
Additionally, borrowers should keep accurate records of loan payments and communications with lenders. Individual loans may pass hands numerous times among investors who are not traditional loan servicers.
The overall integrity of loan records and accounting information may diminish.
Obtaining take-out financing to pay off these new lenders will also be a significant challenge. Instead of simply approaching the nearest bank, thrift, or insurance company, borrowers will need to effectively package their financing requests and aggressively seek financing sources not only from traditional lenders, but from private capital investors.
Lenders Have Upper Hand
Financials, pro formas, and business plans will need to be much more sophisticated since the tables have effectively turned. In the 1980s, lenders called on borrowers. In the 1990s, borrowers will be marketing to lenders.
The distressed asset market will play a major role in realigning supply and demand for commercial properties and real estate debt. The RTC and FDIC's bulk sales effort are the government's surest way to quickly move these assets into private sector hands.