AMERICAS NEWS: Weight lifting – FDIC structured sales

Do you fancy acquiring a portfolio of 1,200 performing and non-performing commercial real estate loans for 40 cents on the dollar? Would you like to buy that portfolio of loans from US banks with zero-coupon debt? Would you also be interested in getting a credit line to service that loan portfolio at rates of LIBOR-plus 3 percent? Yes? If so, the US banking regulator, the Federal Deposit Insurance Corporation, would be interested in talking to you.

The structured loan sales currently being run by the FDIC, led by chairman Sheila Bair, have become a prominent fixture of the US real estate transaction landscape. At times, you could be mistaken for thinking that this is the only game in town.

FDIC

Despite the fact that private investors have to partner with the government, competition to buy stakes in these pools of mortgages from failed banking institutions has often been intense. In one deal in June, a portfolio of 62 construction and hospitality loans originated by Atlanta’s failed Silverton Bank attracted 214 bids from 37 different groups, according to the FDIC. The winner, New York-based Square Mile Capital, secured a 40 percent stake in the portfolio paying $68 million in equity, equivalent to 82 cents on the dollar.

However, not everybody can play the structured sale game. Designed by the government as a means of quickly moving the assets of failed banks off the FDIC’s books and into the workout hands of private investors – but retaining a majority stake to share in the upside – the sales typically involve large portfolios of sometimes small to mid-size loan balances on thousands of residential and commercial assets. The underlying real estate can be spread across more than 20 US states, and be in varying degrees of performance, or non-performance. The auction winner will also be expected to write a cheque for their share of the equity within a couple of weeks.

Taking down an FDIC structured sale, therefore, is not just about having the most real estate skill or aptitude; it’s about having a bit of muscle as well.

In January, for instance, Colony Capital took down a portfolio of 1,184 loans, primarily secured against assets in Georgia, California, Nevada and Florida and with a $1 billion face value, for $91 million of equity or 44.7 cents on the dollar. Six months later, Colony was back for seconds acquiring a portfolio of 1,660 loans with a face value of $1.85 billion. This time working with junior equity partner New York-based The Cogsville Group, Colony paid $218 million for a 40 percent stake in the deal.

Colony and Square Mile are not alone in this arena though. Rialto Capital Management, founded by former LNR Property Corporation chief executive Jeffrey Krasnoff in 2007, acquired the largest portfolio to date in February paying $244 million for a 40 percent stake in two portfolios – one comprising 5,166 residential acquisition, construction and development (ADC) loans, the other holding 345 commercial ADC loans. The loans were from 22 failed banks in 10 states, including Georgia, Florida, California and Texas.

Last October, Starwood acquired perhaps the most high-profile portfolio of the FDIC auctions so far, buying a 40 percent stake in 101 commercial construction loans from the failed Chicago bank, Corus. Working with TPG Capital Group, Perry Capital and WLR Lefrak, Starwood paid $551 million for the loans, which had a face value of $4.45 billion.

Yet for all the competition and interest in structured sales, just 15 firms have won in FDIC auctions since they first began in June 2008.

“Portfolio purchases are really a game for the big guys,” said Frank Tardif, founder of Basking Ridge, New Jersey-based consulting firm Integrated Real Estate and Regulatory Insights and a former FDIC senior liquidator. “The large funds, the large capital raisers, the large private equity guys are the only firms that have the manpower to conduct and pay for the due diligence on these portfolios. By teaming with special servicers, they can also marshal the armies of people to work out the loans after they’ve won a portfolio.”

Digging deep

Even before firms have won an auction though, they must first conduct due diligence on the loans in question. With portfolio sizes ranging anywhere from 62 loans to upwards of 5,475 mortgages, digging into loan specifics can be a labour intensive, and time consuming, job. The FDIC, however, typically gives firms just four to seven weeks to conduct the analysis they need to make a bid.

There’s no short cut to the due diligence.

Colony principal Paul Fuhrman

For Colony’s second FDIC portfolio, a team of 30 underwriters was employed almost round-the-clock to help the firm make a bottom up assessment of the $1.85 billion portfolio of loans from 22 banks, according to principal Paul Fuhrman. “There’s no short cut to the due diligence,” he said.

Starting with the failed bank’s original loan files, underwriters will organise the portfolio by sector and geography, looking at appraisal reports, asset and loan summary reports, site inspection reports, as well as using comparable sales information from real estate data providers and their own loan portfolios (if they have any), to determine what the underlying collateral is really worth. For some of the larger assets, site visits will also be made.

Fuhrman accepts it’s an intense process, particularly considering the size of the loans often involved in the portfolios. Focused on the smaller balance commercial real estate loans from regional US banks, Colony’s average loan  balance among its FDIC portfolios is just $1 million. The firm currently has loans across all real estate sectors, located in approximately 45 states.

Underwriting starts with an asset-level, bottoms-up underwriting to determine the value of the underlying collateral. We also look at the loan level metrics and whether the loan is performing, sub-performing or non-performing.

Fuhrman

“Generally, our underwriting starts with an asset-level, bottoms-up underwriting to determine the value of the underlying collateral. We also look at the loan level metrics and whether the loan is performing, sub-performing or non-performing. If it’s non-performing, can we convert it to a performing loan through a mutually acceptable modification. Sponsor recourse and creditworthiness is also a factor, but difficult to underwrite,” Fuhrman said.

Underwriting such deals, however, is not a cheap exercise. Industry professionals PERE has spoken to suggest due diligence costs can range anywhere from $500,000 to $1 million a time, especially when much of it is outsourced to underwriters and asset managers.

Fuhrman said Colony spends a “fraction” of that figure, using mostly in-house investment professionals to underwrite the loan pools. But he noted: “You cannot underwrite these deals without spending a significant amount of time and money.”

As such, the herd of buyers targeting FDIC structured sales is starting to thin. In July, Colony faced down competition from just three other bidders, compared to the 20 it faced during its first auction in January. At the latest FDIC auction in September, there were just five bidders for a $762 million portfolio of 1,062 residential and commercial ADC loans, according to the FDIC. Leawood, Kansas-based Mariner Real Estate Management ultimately acquired a 40 percent stake for $52 million, in partnership with servicer Cohen Financial.

Raining cats and dogs

Of course, buying the portfolio is only part of the story.

Nick Moore, president of Peracon, a real estate risk and transaction management software firm, says one of the first challenges is determining which loans are strategic (those that will benefit from any real estate recovery and are worth holding onto) and which are not and should be disposed of as quickly as possible. “These deals are about maximising recovery value, for the private investor as well as the US taxpayer,” he added.

It’s not a loan-to-own mentality. It’s about maximising the value of a position in the short-term, and taking a different strategy, a risk management strategy, for the long term.

Nick Moore, president of Peracon

As such it’s not just a matter of servicing performing loans and working out non-performing mortgages, it’s also about determining where the most value lies for the public-private joint venture. “If you have a condo hotel development loan that is half finished, you need to understand your obligations as to how much more working capital it will take to complete, whether you have the right sponsor behind it, will it achieve the IRR requirements of the FDIC and investment partners and what’s the process for draw downs if you decide to continue funding the project,” he said. “It’s not a loan-to-own mentality. It’s about maximising the value of a position in the short-term, and taking a different strategy, a risk management strategy, for the long term.”

In trying to maximise value though, investors have to have a desire to get their hands dirty.

“This is about blocking and tackling. It’s hand-to-hand combat on a daily basis,” Fuhrman explained. He said firms have to accept that the portfolios being acquired will be a mixed bag. They are, after all, a compilation of various commercial loans from failed banks across the US. They will therefore include a vast array of assets from gas stations in Utah, to churches in Georgia, car washes in Florida, multifamily in California and land in Nevada. “You get all kinds of cats and dogs,” Fuhrman added, “but if you do the due diligence right there shouldn’t be any material surprises. This is what these banks were doing. You just have to value the assets appropriately.”

The quality of the underlying real estate has surprised some industry professionals though. Kevin Higgins, founder of workout and portfolio consulting firm Crossroads Advisors and former head of Swiss Re’s American real estate private equity investment arm, said he had been “taken aback” by some of the deals on the failed banks’ balance sheets. Having recently worked on some bank and FDIC deals, Higgins said some assets, particularly residential, were just “too far from the growth path and growing economies” to benefit from any future recovery.

“Time will help take care of the land and assets in the path of growing economies or at least close to it. But some of this stuff could be very problematic and I just don’t know how much real value there is to be recovered in many cases,” he added.

Zeroing in on the deal

For the FDIC auction winners, at least, time is on their side. With zero percent financing with a seven-year term, the FDIC has attempted to offset the problems inherent in the loan portfolios against the possibility of attractive returns for all sides.

“The leverage is one piece of why these deals are attractive, but it’s not just the zero percent,” said Terry Anderson, co-president and partner of Mariner Real Estate. “The maturity of the [financing] means we can hold our investments as well. We don’t have interest clicking away.”

The maturity of the [financing] means we can hold our investments as well. We don’t have interest clicking away.

Terry Anderson, co-president and partner of Mariner Real Estate

Fuhrman agreed that the government-backed financing deal allows FDIC auction winners to take their time over working out the loans. “Your initial focus in dealing with these portfolios is understanding why some of the loans are not performing,” he said. In many cases it could be because of a loan maturity default, or simply because they don’t know where to send the payment after their bank closed down. “You are trying to convert non-paying customers into paying ones.” Loan extensions and modifications are one way of trying to achieve this. As Fuhrman explained: “With the FDIC structure, you are not encouraged to immediately foreclose and liquidate the assets.”

For some, though, the financing provided by the FDIC puts auction winners at an unfair competitive advantage, not just in relation to borrowers but other creditors as well. One mezzanine lender, who declined to be named, said such terms could allow auction winners to be “more aggressive in their servicing and more aggressive owners of real estate”.

There may be troubles ahead

With the US’ banking system struggling to come to grips with significant property valuation declines across much of their assets, one thing is clear in the debate about FDIC structured sale auctions: they will remain a reality of the US real estate transaction market for years to come.

The value destruction across the entire real estate industry has been huge.

Frank Tardif, founder of Integrated Real Estate and Regulatory Insights and a former FDIC senior liquidator

The FDIC has closed or resolved 118 banks in the year to date (as of 20 August). That number comes on top of the 140 banks that were resolved in 2009. However, the corporation’s list of troubled banks, those institutions it deems most likely to fail next, rose to 829 during the second quarter, its highest level since 1993. Tardif, who worked at the FDIC Division of Supervision and was a senior liquidator at the FDIC Division of Liquidations in the 1990s, said, based on his experiences, the list could be much higher in the near future.

“The value destruction across the entire real estate industry has been huge, as documented in FDIC portfolio sales records and the CMBS performance data. Amongst the smaller regional and most community banks, these losses will become debilitating due to their over-exposure to the asset class,” Tardif said.

Even if the losses are not recognised by the financial institutions in question, or discovered by the FDIC, he said “that most, if not all of this group’s capital has effectively been wiped out. All one has to do is compare portfolio and loan sale pricing data against an existing bank’s real estate loan exposure and their capital base. Sophisticated bank buyers are doing exactly this as they search for acquisitions.”