Distressed assets

Distressed Asset Joint Ventures: A Winning Trifecta?

Chicago-based Corus Bank was once a prominent lender in the world of condominium development. But in 2009, Corus became just another failed bank, with one notable difference: Corus' assets were transferred to a unique joint venture between the Federal Deposit Insurance Corp. and an investor group led by Starwood Capital.

Although unconventional, the terms and evolution of this FDIC-Starwood venture potentially could be adapted as a private-sector model to help banks maximize the return on their growing inventory of real estate-owned and troubled loans. (See “FDIC-Starwood Joint Venture.”)

Managing and/or developing real estate remains largely outside of a banker's area of expertise as banks by their very nature do not wish to be actively involved in the real estate business. And with fewer new projects and a general lack of available financing, many qualified real estate professionals remain sidelined in a recovering economy.

Although recent years have seen substantial capital accumulated in funds created for the specific purpose of investing in distressed real estate assets, relatively little investment has actually occurred. Why then, when there is sufficient supply and adequate demand, have bankers, developers, and investors not partnered to profit from anticipated longer-term economic recovery of real estate markets?

Considering Private Options

Regardless of their relative strength or weakness, banks have focused primarily on managing risk and maintaining or increasing capital. Many have invested significantly in the enhancement of their internal processes and procedures to minimize risk and satisfy regulators.

Attempts to raise additional capital remain time-consuming and challenging, particularly for smaller community banks. Significant resources have been allocated to managing day-to-day REO operations, minimizing write-downs, and preserving capital. Shifts in personnel needs have required additional training time for new employees and former loan officers that have been transformed into distressed asset managers. All of these factors have contributed to an absence of focus on maximizing revenue.

For real estate professionals and investors, there are concerns about losing entrepreneurial independence since a joint venture would be subject to a regulatory environment and greater oversight. Moreover, some strong real estate professionals that would be optimal joint venture partners continue to find attractive, more traditional opportunities even in the current market.

Economic considerations are paramount in any transaction. The feasibility of completing and bringing to market partially developed property will vary widely depending on specific markets. Ultimately, asset values must be agreed upon, and the bid/ask gap continues to play a significant role in the joint venture context.

Growing regulation of financial institutions predisposes a “just say no” attitude toward new or creative transaction structures. Though weaker banks could probably benefit most, they have absolutely no chance of gaining regulatory approval for joint ventures. The strongest bank would find the approval process much easier. But some expect regulatory resistance to fade as the current administration increases its efforts to encourage private investment in the economy.

What Would a Private Joint Venture Look Like?

A viable model requires advance planning and a focus on the following components:

  • development of a business plan;
  • identification of qualified and financially stable real estate professionals and investors;
  • packaging of asset portfolio, recognizing the impact of the asset mix on pricing;
  • evaluation of upside and downside risk; and
  • allocation of management roles and control.

The economic terms of the joint venture are likely to dominate negotiations. Asset valuation for joint venture purposes is much like valuation in an outright sale but may provide additional flexibility because of the bank’s ongoing investment and upside potential. All parties should prepare financial pro forma analyses under various assumptions regarding asset sales, property absorption, loan performance, and exit strategies.

Parties must negotiate appropriate profit and loss sharing ratios for each partner, including priority returns and distributions. Residual interests of the parties must be determined, whether it be the bank receiving an equity kicker similar to the FDIC-Starwood model or another mechanism for allocating upside potential to the bank.

In addition to the various accounting issues that will arise, there are numerous tax issues associated with the formation and operation of a joint venture. The initial transfer of assets to a joint venture is generally not a taxable transaction, although any differences between asset valuations and tax basis may require special allocations of income or loss to the bank. While the terms of the agreement will generally control the allocation of tax profits and losses, statutory and regulatory restrictions may take precedence to assure compliance with the substantial economic effect doctrine.

Partners must individually evaluate their ability to utilize any tax losses generated, taking into account net operating loss positions of many banks, investor passive activity loss limitations, and developer basis limitations. The joint venture may provide an opportunity for favorable capital gains taxation on disposition of assets for certain investors and real estate professionals.

Regulatory concerns also will be a major factor in the joint venture transaction. Without regulatory authorization, banks cannot participate in joint ventures and that authorization, at least currently, is not based solely on a venture’s economic viability.

The complexities of accounting, tax, and regulatory issues associated with a joint venture vary based on the facts of each transaction and must be evaluated by skilled accountants, attorneys, and real estate advisers. A successful joint venture requires qualified professionals with the experience to structure the venture, minimize risk, and maximize return for all venture partners.

Looking Ahead

It's impossible to predict whether or not distressed asset joint ventures can revitalize real estate markets. But such ventures would relieve banks of real estate management responsibilities, could bolster banks’ upside income potential and long-term viability, and possibly facilitate more traditional asset sales by establishing valuations for comparable properties.

By employing idle capital and real estate expertise, joint ventures would likely produce a higher return than what lenders are currently recognizing from fire sale liquidations. But to make this happen, the FDIC needs to abandon its negative approach to private sector joint ventures. Regulatory restrictions also will need to be modified to give willing buyers and willing sellers the freedom to enter into economically viable transaction.

In addition to minimizing asset write-downs and searching for new capital, banks must expand their focus to maximize revenue to increase profitability and achieve acceptable levels of capital. At the same time, real estate professionals and investors may need to lower expectations for high returns by compromising on asset valuations.

With the right combination of lender, real estate professional, and equity investor, the distressed asset joint venture can be a win/win/win strategy. With the appropriate changes in regulatory policy, it’s a trifecta worth betting on.

Anita M. Pittman, CPA, is a partner with Cherry, Bekaert & Holland, LLP.

Anita M. Pittman, CPA

FDIC-Starwood Joint Venture After reviewing various options, the FDIC opted for a deal in which it would retain the upside potential while leveraging private equity and the industry expertise of successful real estate professionals to manage and optimize future value of the troubled assets. The basic terms of the joint venture are summarized as follows: face value of assets of $4.5 billion discounted by 40 percent to $2.8 billion;FDIC zero-coupon term loan of $1.4 billion with flexible repayment terms;equity of $1.4 billion consisting of $550 million Starwood cash (40 percent) and approximately $850 million FDIC assets (60 percent);Starwood held a managing 40 percent interest and received a 1 percent management fee;additional FDIC advance facility loan (up to $1 billion) at LIBOR plus 3 percent to fund completion of building construction, operating property deficits, carrying costs, and working capital requirements;distribution priorities: repayment of advance facility loan, repayment of term loan, and Starwood preferred return equal to twice the initial investment plus a 25 percent internal rate of return; and FDIC equity percentage to increase to 70 percent upon payout of Starwood’s preferred return.Pros and ConsSome have criticized the FDIC-Starwood joint venture, arguing that the zero-coupon term loan backed by unlimited guarantees of the U.S. government created unfair competition. However, this criticism fails to acknowledge the interest rate implicit in the initial pricing and loan structure that effectively results in an advance interest payment. Some developers have complained that offers to pay off loans now held by the joint venture are discouraged, and others have been vocal about the venture’s decisions to stop funding some projects. This could increase the likelihood of foreclosure and loss of developer profit while permitting the venture to profit when markets recover by claiming and holding titles to property. Utilization of private investment in the joint venture scenario, however, can provide an avenue for accelerating asset valuation. While banks have had limited success in packaging and selling certain distressed assets, it is far more common that banks and buyers have not yet been able to agree on asset pricing.


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