REO's Long, Slow Journey

" The time frame it takes for properties to get to REO status is still very long, from one to two years from the point of default," Bolour says. "Most high quality assets will be recapitalized by existing borrowers or the bank will do modifications. In some cases, where banks are failing or may be in trouble, they will sell the notes."

Clearly, the state of the distressed commercial real estate markets is perplexing, says Newport Beach, CA based John Strockis, managing director of asset services at Voit Real Estate Services. "Banks, special servicers and insurance companies that control the majority of distressed real estate nationally are generally frustrated by the amount of time and expense it takes to foreclose on an asset," he says.

To date, Strockis says, higher quality REO assets have generally not come to market. "Sure, lots of REO land and small-value owner/user condo projects have cycled through the foreclosure process, but the promise of the trophy assets has not come to realization."

One possible reason is that many lenders are choosing short-term loan modifications, hoping that increased absorption and rental growth will return, Strockis explains. "Markto-market accounting supports this strategy, but we all know that extending the inevitable foreclosure is a bad long term bet," he says.

Class Distinctions

The current REO story varies depending on whether the foreclosed property is held by a money center bank, a state-chartered regional financial institution or a special CMBS or conduit servicer, says Conrad Andersen, executive vice president and managing director for financial services asset management at Grubb & Ellis. "Most money center banks are relatively well capitalized and are in a position to do a mark-to-market on all classified or impaired loans," he says. "As a result, they can foreclose and make available REO for disposition. On the other hand, very few state-chartered regional banks are well-capitalized and most are not able to do ‘wholesale' mark-to-market without becoming insolvent."

Special servicers, he continues, have their own unique issues tied to REMIC requirements and the pooling and servicing agreement. Also, "most special servicers are in a first-loss position since they own the B piece and must demonstrate that their exit strategy meets the optimum net-present-value liquidation outcome." Anderson explains that the federal government "is allowing banks to amortize their loan problems even if a loan is under-collateralized if a borrower is able to meet the bank's new extended loan terms."

The general consensus from most insiders, though, is that REOs are generally increasing and will continue to do so. Banks have become more active sellers of both notes and REO, says Farzin Emrani, managing director in the L.A. office of Lucent Capital. "Banks have had time to build up their cash reserves and write down the assets to market levels," he says. "While many banks do not have a sense of urgency to sell-their thought being that time will improve asset values-they are generally sellers at today's market value."

Emrani continues that banks will bring higher-quality assets to the market. "As fundamentals stabilize and capital markets continue to improve, we expect to see many of the higher quality non-performing notes worked out or recapitalized rather than foreclosed."

Receiver Report

Bill Hoff man, president and CEO of San Diego-based receiver and distressed real estate specialist Trigild, which recently added 11 office and industrial properties totaling three million square feet to its national receivership assignments, says that all commercial property types continue to default and go into the foreclosure/receivership arena. "CMBS servicers seem to be somewhat more active in dispositions, but we expect all lenders and servicers to accelerate their activity in 2011 and continue to deal with defaults and maturities for another three to four years," he says.

Hoff man isn't sure whether asset quality is the deciding factor now when banks make assets available. "We are seeing all levels of quality and loan size currently, but the volume continues to increase, so we expect to see the number of properties coming to market to increase," he says. "But recovery prices may continue to decline for some time yet. Property type, quality and location weigh heavily on sales prices."

Grubb & Ellis' Anderson says that most "higher-quality," large-cap loans are syndicated. "Therefore, there is generally a lead, agent bank and six or more participant banks," he says. "The sponsor is generally institutional with significant capital and expertise. For the aforementioned reasons, we are not going to see that many trophy assets go to foreclosure."

Generally, Anderson adds, loans fall into three basic categories: syndicated (usually with balances at or greater than $30 million); securitized; or on-balance sheet. Most foreclosed assets will be on-balance sheet loans, the majority of which are multifamily and small commercial.

Mitch Siegler, senior managing director at San Diego-based Pathfinder Partners LLC, has observed a noticeable increase in bank foreclosures during the past six months. "We believe this is largely because the six-to-12-month loan modifications entered into last year have not produced the desired results-generally because the project still couldn't be refinanced without a significant new equity contribution from the sponsor," he says. "And, of course, the sponsor wasn't a seller at market prices since his equity would have been wiped out."

Foreclosure Factors

Another factor leading to more foreclosure activity, according to Siegler, is that banks have now had 10 to 12 quarters of healthy earnings-net interest margins are strong because of the extraordinarily low cost of funds relative to spreads they can earn from buying Treasury securities or making new loans. "This has enabled them to add dramatically to their loan-loss reserves, the effect being that assets have now been impaired down to levels much closer to their actual market values," he says. "Banks don't want to foreclose and hold a property in REO for very long. A year or two ago, banks couldn't foreclose on the loan and sell the property because their carrying value was so much higher than market value-and they couldn't take such a huge hit. Now, carrying values more closely approximate market values for many assets-so banks can foreclose and sell without such a large loss."

Also, Siegler continues, regulators have been scrutinizing loan files much more carefully and encouraging banks to move forward to resolution of troubled assets. "Loans that were modified over the past couple of years are not great candidates for further restructuring. That is likely to drive foreclosures."

In addition, the FDIC has seized nearly 150 banks in the first 10 months of 2010 as compared with 140 for all of 2009, Siegler points out. Many analysts believe hundreds or thousands of banks could fail over the next few years, he adds. "During the past few years, the assets of these seized institutions have been absorbed by successor financial firms. This has generally been done subject to a loss-sharing arrangement with the FDIC. Usually, the successor bank cannot sell the loan. So, the successor bank's options are to work out or modify the loan; sell it, (unlikely because of FDIC constraints); or foreclose. We expect increasing bank failures to lead to more foreclosures."

Preserving NOI?

Banks generally have not been able to increase the net operating income unless the asset is located in an infill location and is a class A property, says G&E's Anderson. "Since vacancies are still double-digit in most submarkets and rents are soft , most new tenancy comes from class B tenants moving to better space," he says. "There are other methods that banks use to mitigate losses, including utilizing the receivership process on securitized loans, keeping existing debt in place and allowing for new sponsorship and recapitalization." There is no magic bullet to increase NOI, says Trigild's Hoff man. "The quality of the property, the competitive market and the management and marketing skills, as well as the integrity and past actions of the borrower will affect how much the bank, or its receiver/management company can improve NOI," he says.

Generally, banks preserving or increasing NOI through the holding period are case-by-case, but according to Goodman, lenders are usually not as organized as they need to be in order to maximize the NOI of these troubled assets. "The people involved-whether they are the lenders or the vendors that deal with the property-know that their tenure associated with the asset is short term," he says. "They do not have the incentive to maximize the operations of the assets that an investor has."

Some well-capitalized financial institutions will choose to foreclose and create value in their REO assets before selling the property, says Voit's Strockis. Typically, these financial institutions have a well-trained REO department and often will hire a third-party asset manager to assess what capital is needed to preserve or increase NOI, he says. "These firms will have to be convinced that the investment in capital expenditures, tenant improvements and leasing commissions provides a market return when the property is ultimately sold."

If given the choice, a lender will stretch to restructure a quality asset if the NOI can support a one- or two-year extension, Strockis says. Alternatively, "A lender may choose an orchestrated short-sale if the gap between the loan balance and market value is ‘reasonably' small for a class A property," he adds.

Looking ahead, Strockis expects some, but not all, market fundamentals to turn from negative absorption and negative rent growth to minimal absorption and fl at rent growth. "This fundamental market recovery will further stir investor interest and increase the demand to acquire higher-quality bank owned assets," Strockis says. Next Month Part II: REO: Pricing, Pros and Cons, and more.

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