Investment Analysis

Back to Basics

Strong growth in the secondary markets is a hallmark of the new economy.

The landscape for commercial loans and bank-owned real estate sales has dramatically changed during the last two years. The era of bank failures and Federal Deposit Insurance Corporation takeovers is receding into the memories of the Great Recession. As domestic banks emerge from the downturn, new considerations face prospective buyers and sellers of distressed properties.

Since 2012, most variables have clearly trended upward in major markets. The FDIC's 2015 first quarter report of insured institutions shows a nearly 7 percent increase in aggregate net income from 2014. Likewise, nearly two-thirds of institutions reported year-over-year growth in quarterly earnings. These trends are attributable to several factors, including the influx of foreign capital, EB-5 investment, and evolving regulatory and reporting requirements. Formerly downtrodden markets, such as Miami, have embraced an infusion of both capital and population, resulting in a rebound in property values, rental rates, and new project development. 

Despite the outward signs of growth, uncertainties remain in our economic and political landscape. Many experts question whether the large and, in some cases, second-tier markets have become overzealous in their optimism.  

Trends in the New Economy

The upward economic momentum has shown dramatic effects on secondary market sales. The most obvious of these variables is the stabilization or escalation in major market property values and the lengths at which note buyers must go to find value.

With banks today being simultaneously stronger and less desperate to offer discounts and quick fixes, distressed note buyers simply are having to work harder, search longer, and price higher for deals than before. Commercial banks and third-party purchasers are continuing to adapt to these trends and seek stronger footing.

Beyond rising commercial property values and rents, subtler factors have strengthened our markets. First, the judicial system today is usually better equipped to resolve a diminishing caseload of distressed commercial loans. Disputes are resolving more quickly now, while increasing property values fuel opportunities for refinancing.

Second, the institutions that emerged from the financial crisis have greater capacity and experience to handle matters internally. The special asset teams have contracted, with greater attention being given to individual loan files.

Finally, domestic banks are no longer shedding vast volumes of loans to stay afloat or avoid regulatory scrutiny. Today's commercial paper sales are more likely to support a bank's positive initiatives than avoid substantial losses. As a result, lenders are simultaneously less likely to shed bad loans and more capable of resolving them internally. 

Commercial Debt Buyers and Sellers

The new economy is forcing distressed debt buyers to reevaluate pricing and develop more creative strategies to maximize returns. Choice deals in core markets have dwindled, so leading investors migrate toward tertiary markets to find greater margins.

Regardless of the market, buyers of distressed debt should remember that the same fundamental investment principles apply: capitalizing on operational advantages, building relationships, understanding the local economy, and getting creative.

Sam Zell was famously quoted in April 2016 for saying the U.S. economy is now “in the ninth inning.”

Lending institutions will continue evaluating their balance sheets for opportunities to diversify and improve. Likewise, borrowers will experience hardships in certain regions. If opportunistic buyers can intelligently discuss and anticipate these opportunities, deals will continue to flow, although the volume will decrease.

Particularly with respect to distressed loan sales, buyers should remain vigilant about due diligence and protective documentation. Significant competition and abbreviated due diligence periods often pose great challenges and breed mistakes.

Take, for example, the fractured sale scenario. Recently, it was common for note purchasers to buy only part of a particular lending relationship, leaving some of the relationship behind with the selling institution. This fractured sale scenario not only results in legal and business conflicts between buyer and seller, but also lost time, increased costs, and the potential loss of goodwill. These situations can be avoided through proper due diligence, as well as appropriate representations and warranties in the sale documents. 

Those concerns are not as prevalent for bank REO sales, which have presumably been run through an appropriate foreclosure process or deed-in-lieu documentation. As the secondary markets cool and price compression sets in, there will be less tolerance for surprises like unforeseen fees and expenses.

Prospective buyers are also wise to recognize that certain relationships between buyers and sellers have crystallized over the last few years. This familiarity may create a barrier to new entrants in regional markets.

Established relationships and a broker's reputation for competitive pricing, minimal re-trading, and quick closes remain critical in this new era of bank sales. When a bank needs to get a loan or a pool of loans off the books, decision-makers will continue to evaluate all of these factors in conjunction with pricing. Larger non-bank institutions with strong connections and a reputation for hassle-free closings will continue to win the day.

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Drew Demers

Drew Demers is a partner in the Banking and Real Estate Practice Group at Burr & Forman LLP in Fort Lauderdale, Fla. Contact him at ddemers@burr.com.

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