Distressed Asset Joint Ventures: A Winning Trifecta?
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.
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
Considering Private Options
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.
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
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?
viable model requires advance planning and a focus on the following components:
of a business plan;
of qualified and financially stable real estate professionals and investors;
of asset portfolio, recognizing the impact of the asset mix on pricing;
of upside and downside risk; and
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
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.
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
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.
M. Pittman, CPA, is a partner with
Cherry, Bekaert & Holland, LLP.