Sharpening the Real Estate Focus

Commercial banks' portfolios of troubled real estate loans have grown tremendously in the past few years.

With the market for new real estate lending at a standstill, many banks are experiencing internal havoc as they make the transition from creditors to owners and managers of real estate.

Many institutions have adjusted their operating structures to handle the massive amount of foreclosed property.

And many are doing it wrong. Former loan officers are now operating and managing foreclosed real estate.

Real Estate Managers

Typically, these officers move to new departments -- called an asset management groups, workout departments, or real estate-owned (REO) groups -- and assume new job titles.

Their new duties may include asset management, property management, financial analysis (preparing operating statements and rent rolls on the properties), on-site management, lease reviews, construction and renovation, leasing, and property disposition.

These duties, standard for real estate practitioners, are new to many banks.

The High-Roller Syndrome

In the realty lending boom of the '80s, many loans were made by young, inexperienced officers who lacked a solid grasp of real estate.

And even after the lesson from Texas in the mid-'80s, many financial institutions succumbed to the high-roller syndrome.

This occurs when the large, flashy real estate developer or investor overwhelms the lending institution and proceeds to borrow tens of millions of dollars, or even hundreds of millions, in real estate loans on overly optimistic and questionable projects.

Many banks, caught up in the euphoria, made loans on charisma, glitter, and reputation.

I have seen many economically viable real estate projects encounter financing difficulty because the owner or developer was a small real estate entrepreneur, not a high-profile real estate player.

The bigger the developer or borrower -- and the more money borrowed -- the harder it is to get the loan paid back when times are tough.

A smart, honest entrepreneur will usually work diligently to pay back a troubled real estate credit.

A large, nationwide real estate firm or a high-rolling real estate developer who owes hundreds of millions of dollars to dozens of banks will probably seek bankruptcy-court protection or return the property in a major workout -- and walk away unscathed.

There is an old saying in the banking business: If you owe the banks a lot, you control the banks; but if you owe them a little, they control you.

This is certainly true today with the large number of highly leveraged real estate firms.

Time for a Change

Financial institutions continue to make poor judgments in handling foreclosed property.

Many banks that have obtained title to real estate through foreclosure keep the defaulted borrower in the transaction to handle property management and leasing.

This makes no sense.

What can defaulted borrowers do that they could not do when they owned the property? You say they know the property and can do a better job leasing? Well if that's the case, why isn't the project leased -- and why was it foreclosed?

Outside Help

In most cases, the defaulted party should be replaced with independent contractors to supply management, leasing, or other services.

Many companies with substantial expertise in all areas of real estate -- brokers, management companies, developers, and workout and restructuring firms -- can easily be hired for these various services.

An independent contractor brings new ideas, methods, and experience to the transaction.

Sometimes, an underperforming real estate project needs only new management and a fresh leasing program to succeed.

A Different Ball Game

Banks need to reexamine the internal management of REO (real estated owned).

Repackaging loan departments as real estate management departments may work when only a few properties need management.

For larger portfolios, this approach is usually counterproductive.

At most financial institutions, the expertise is in originating, underwriting, and closing loans. Real estate financial analysis, management, leasing, renovation, and disposition are usually unfamiliar subjects.

Lean and Smart

Instead of creating a big internal bureaucracy to do these jobs, a bank should hire outside professionals. The bank can then create a core group of experienced people just to handle the administrative and decision-making functions.

Many banks in the Northeast have REO departments as large as their former lending groups. This makes no sense. Personnel is the largest fixed cost in a bank. Third-party specialists can perform REO functions more quickly, cheaply, and efficiently.

In-house management can become an administrative nightmare when new leases have to be signed, a roof has to be replaced, or a project has to be sold.

Who makes the decisions for these items? In many cases, no one. Meanwhile, the property's value deteriorates further.

To manage and dispose of REO successfully, financial institutions should establish the following policies:

* Convert a few key individuals of former lending group to handle REO property.

* Assign individual properties to specific individuals for accountability.

* Streamline decision-making, with department head reporting to senior bank management.

* Limit the new REO group to decision-making, review, and administration. Leasing, property management, renovation, disposition, and other critical real estate functions should be contracted to outside professionals.

* Separate the former borrower from the project, in most cases. It is more beneficial to bring in new talent with different ideas and contacts to manage, lease, and enhance the value of a troubled project.

Get Rid of It

Finally, banks should dispose of REO property as quickly as possible, unless there are special circumstances to the contrary. If the institution thinks a better value can be obtained in the future, a sale with participating financing or a passive equity interest should be structured to realize this perceived value.

Holding REO increases fixed costs, reduces the net interest margin, derails asset and liability matching, and hinders quick decision-making -- critical for success in real estate. Holding the property invariably causes further deterioration in real estate values and contributes to market stagnation, because poorly performing properties are not quickly recycled into the marketplace.

Mr. Joseph J. Ori is managing partner of Paramount Realty Advisors, Schaumburg, Ill.

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