And while this strategy isn't new by any means, it is picking up steam.

John Strockis, executive managing director of asset services for Newport Beach, CA-based Voit Real Estate Services, has noticed a comeback of the loan-to-own strategy over the past 12 months. The volume of such deals is increasing for two primary reasons, according to Strockis and others familiar with the market.

First, Strockis points out that there are specific buyers who want to purchase notes and who understand the risks. "They have asset management platforms, and they have the platforms to service the loans, which are hopefully performing," he says. "At the end of the day, they want to get to the fee-simple real estate and foreclose."

Many of those buyers are venture capital firms that specifically raise funds in order to buy troubled loans through diverse strategies with the goal of owning the underlying property, explains Dawn Coulson, a partner at Epps Yong & Coulson LLP in Los Angeles. While she represents many traditional financial institutions, Coulson also represents various funds that she says not only specify the goal of ownership, but also have the infrastructure or strategic partners to turn the property around. The second primary reason for the uptick in loan-to-own transactions is that banks can now afford to sell the notes because "they understand that they could get better values for the underlying collateral than they did 12 months ago," says Strockis. Nonetheless, demand for the defaulted loans still outstrips the supply, pushing up prices. "There is a lot of distressed real estate out there, but not a lot of distressed real estate sellers and that gap increases pricing."

With the opportunity there, the key then for potential buyers is to determine how to account for the costs and risks accurately and to understand what they are buying. While it might seem straightforward to evaluate a market before buying, it isn't the market that you are buying, it is the loan to acquire a unique asset, says Clayton Gantz, a partner in the San Francisco office of Manatt Phelps & Phillips LLP. Gantz cautions that not all distressed assets are created equaL They can have environmental contamination, leases with kick-out clauses, TI requirements or structural problems resulting from deferred maintenance, to name just a few pitfalls.

If the asset has construction in progress, for example, Gantz says that the downtime from initial default to the investor's acquisition may have allowed weather to damage the site. "If you're buying a mezzanine loan, so the collateral is a company rather than real estate, you will inherit all of the liabilities of that company, not just those that show up on a title report," he adds. Unfortunately, unless the borrower in possession is cooperative, which Gantz says isn't likely, "it will be difficult to do due diligence on the property or the company." In that case, he says, the investor will have to make some insufficiently educated guesses about the property's condition and discount accordingly. He also says to beware the ongoing lender obligations that the buyer will assume, such as funding additional construction draws and accounting for cash collateral.

Coulson encourages investors to do their due diligence just as they would when buying the property outright or making the original loan. "The credit file for the lender usually includes an environmental report phase I, and maybe even a phase II in-depth environmental report," she explains. "If there isn't one, the buyer should consider including a put-back clause in the purchase if there is any contamination or anything in the loan that was not disclosed by the seller bank."

Oftentimes, borrowers who go into default not only stop making payments of principal and interest on their loan but they also stop sending the bank financial statements and become nonresponsive to the bank's requests. So says Shlomi Ronen, managing director of Lucent Capital, a newly formed real estate finance advisory firm in Los Angeles. "This can make it very difficult for a loan buyer to understand fully the physical and financial condition of the asset," says Ronen. "In these circumstances, local buyers with indepth knowledge of the market and the product type have an advantage."

Buying a pool of notes increases the risk factor, according to Richard Hill Adams, chairman and CEO of Laguna Hills, CA-based American Realty Capital Advisors Inc., simply because, "You really don't know everything that is in that pool," he says. "And you know that the expectation is that some of the notes you will wind up keeping, some of them will get refinanced and some will get sold. But all in all, you are buying them at such a discount-possibly 30 cents on the dollar-that you should make a profit at the end of the day"

Hill Adams points to one of his clients-which he wasn't at liberty to name-that recently acquired a portfolio of notes from the FDIC that was in excess of $700 million. "Some of them are in foreclosure," he says. "In some cases, they are working out the loan or are willing to modify it. And in some cases the properties are performing and the loans are getting paid off."

But the investor who bought the huge portfolio, he adds, had the expectation that some of the notes were going to be loans to own. "And because they have a development company as part of the financial company, they made that acquisition with the ability to develop out the property and the land that they are acquiring through these note foreclosures," he explains.

The risk of bankruptcy hangs over all transactions in the distressed-asset arena. It can tie up the property for a long time and result in substantial legal fees, basically throwing a monkey wrench into any deal. Since the possibility of bankruptcy is unavoidable, Tom Muller, a real estate and land use partner in Manatt Phelps & Phillips' L.A. office, says that note buyers should evaluate carefully the likelihood that the borrower will file for bankruptcy protection. "If the property is worth much less than the face amount of the loan the note buyers are buying, it may not be worth the borrower's time or energy to file for bankruptcy protection," he explains.

Muller has firsthand experience in this arena, where his client wanted to buy a not-very-well-tenanted commercial property, so the client bought the note for 60% or so off its face value, which is a bit lower than the property's value. "The client, the investor, assumed that the owner wouldn't do anything to resist when they came to foreclose because it seemed that the owner was so far underwater that bankruptcy just wasn't likely," Muller explains. "But when the owner found out that the investor had bought the note, they filed for bankruptcy, and although it wasn't fatal, it was an unhappy surprise."

Probably the most important change in bankruptcy law for real estate lenders since the recession of the 1990s was a provision making it much more difficult to tie up real property held in a singleasset company in bankruptcy, Muller says. "Difficult, but not impossible, and the benefit of this change, at best, is to allow a foreclosure to proceed after 90 days if the borrower has not come up with a plan of reorganization."

Coulson says that one of the keys is to use the bankruptcy code offensively. "Have the court immediately declare the case a single-asset bankruptcy which is usually the case with the special-purpose entity borrowers-and put the time pressure on the borrower to reorganize fast through making a deal with the senior lender or get out of bankruptcy," she says. "There may be times when the court will not agree about the single asset or cut the debtor slack and give more time, but at least the pressure is on."

According to Muller, bankruptcy can also thwart an investor's ownership intentions, since the property can be sold out of the bankruptcy case by order of the court without the investor's consent. This is true even though the investor's claim under the loan documents-to the extent the property was worth enough to secure it-should be protected, Muller points out. But the investor's idea of "protected" may differ from the court's, especially if the borrower is able to come up with new money to help finance a recovery plan. In that case, the investor could be crammed down-forced to remain as a lender with a stretched-out loan at an interest rate the court deems fair.

Given the amount of uncertainty associated with obtaining title, Lucent Capital's Ronen says it is crucial for an investor not only to anticipate all the risks, but also to budget for

all the scenarios that could unfold post-acquisition. For example, Ronen explains that a buyer may purchase a loan with the intent to obtain title, but after initial negotiations with the borrower, it may be mutually beneficial to work out the loan. He adds that a buyer of a non-performing loan should have a back-up plan in place.

The "situations" that Ronen refers to could include an abnormally long foreclosure process; incomplete or dated information available to a nonperforming loan buyer, leading to many uncertainties about the physical and financial condition of the property; and bankruptcy. This last, Ronen says, could slow title down as long as two years, considering the backlog in some court systems. The most successful purchases of non-performing loans that Ronen has seen are situations in which the purchaser has unique knowledge of the property, the market or the financial condition of the borrower." As always, access to this type of information provides a significant competitive advantage," Ronen says.

Most investors in nonperforming loans are valuing the assets using the same basic methodology, arriving at a market value for the collateral and then discounting it by the carrying costs associated with obtaining title, says Ronen." The key here is to anticipate all unforeseen circumstances that could arise post-close and what effects these circumstances could have on your basis in the asset."

One question to keep in mind, says Manatts Muller, is whether the seller of the loan actually has the original signed promissory note. "If not," he says, "you may not be able to foreclose at all:

He explains that the law deems the current holder of the original note to be the owner of the loan, regardless of who holds or has been assigned the mortgage or other

loan documents. "When the loan has traded hands several times, the original note and other loan documents may be difficult to find," he says. "Many borrowers have avoided foreclosure by demanding that the note-holder produce the original note, which it could not do."

Muller adds that "foreclosing on the loan does not necessarily mean that you will end up with the property" Foreclosure is done by public auction, he says," which means that others can show up at the sale and outbid you if you are not willing and able to put up your own cash beyond the face amount of the note." The good news, Muller explains," is that you can credit bid up to the face amount of the note, but this can be disappointing if you've spent the time and duediligence money to get the property" Ronen has seen situations in which the intent was to obtain title, but after initial conversations with the borrower after close, the note purchaser proceeded with a discounted payoff above the price for which they purchased the loan." This ended up being a mutually beneficial and quick solution for the note buyer and the borrower," Ronen says. This unexpected solution illustrates one of the guiding principles of buying distressed loans-that every deal holds the potential for unexpected problems and unexpected solutions. In other words, when buying troubled loans, expect the unexpected."

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