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COVER STORY, AUGUST 2010
CRE EBBS & FLOWS
Opportunities and setbacks continue to shape the commercial real estate market.
Tony Wood
So many headlines these days appear to offer good news for the commercial real estate markets, yet read on and it’s just more of the same. A “The Commercial Real Estate Tsunami Averted?” article ends up to be nothing more than a report on how CMBS tranches are being sold at 50 cents on the dollar and the relief of sellers that there are actually buyers for them.
Everyone knows the first commercial real estate “tsunami” has already hit. Commercial real estate values are down 30 to 40 to even 50 percent and the same with rents; generally, activity in most markets is down to a trickle. Banks are continuing to extend and pretend, creating what are called “zombie loans.” It is important to draw the distinction between how the commercial real estate banking industry is managing its debt crisis versus the ongoing crisis in the actual commercial real estate markets that secure these loans.
Tim Echemann, principal at Industrial Properties Brokers in west central Ohio, says activity is “spotty. Brokers must make due with a lot less. There are fewer deals and not as many brokers in the business. Values are off 30 percent from 2008 highs. However, high-tech, aerospace and nuclear industries are growing. There are fewer deals being done right now, but entrepreneurs are entering into the market.”
Yes, $1.5 trillion in commercial real estate debt will mature in the next few years — nearly half of the entire nation’s commercial real estate debt. Yes, more than half of the properties tied to those loans are under water, and, yes, this has never happened before. And, yes, the “recovery” is still trying to get off the ground. So what? So the pathways of opportunity are finally beginning to rise above the de-leveraging quagmire.
Foreclosures & Note Sales
First, the long-awaited wave of commercial real estate foreclosures is in sight. In the July 8, 2010, Dow Jones Newswires article, “Commercial Real Estate Bargain-Hunting Makes Bargains Scarce,” Prabha Natarajan reports, “some hope of a flood of troubled assets coming to market, and these are expected to trade at more reasonable prices,” referencing the managing director and head of Prudential Real Estate Investors’ global debt group and other sources that believe “overleveraged properties and distressed sellers are likely to emerge in the next few months and peak next year as banks and lenders start looking to clean up their books.”
Investors are now purchasing portfolios of bad debt secured by properties they want to own, then pushing those loans through foreclosure and ultimately taking possession of the underlying real estate. This is a powerful testament to the new commercial real estate marketplace and the retooling and retraining required to take advantage of the opportunities that lie ahead. The fundamentals of commercial real estate investment are being rewritten, at least temporarily.
There are very few actual property sales being recorded these days with note sales transacted under the radar in the back room of a banker; a buyer of debt and an attorney constitute the primary activity in many markets. There are no records of note sales reflecting what was actually paid in these types of transactions. Brokers and appraisers are challenged to provide opinions of value without the information necessary for accurate determination of value. This is going to be a problem for some time to come and the industry needs to develop systematic ways to track these transactions and make that information available to the participants in the marketplace.
Training and Innovation
The Commercial Real Estate-Owned Brokers Association (CREOBA), an organization which exemplifies the effort to fill a void in this new distress-oriented marketplace, has the goal of providing top-notch training on property valuation and the selling of commercial REO assets. CREOBA has 15 different training programs including “Broker Opinion of Value” and note sales.
“Banks want property managers first, months before the foreclosure sales take place,” says Ray McLane, president of CREOBA, which now has 600 brokers in a nationwide, 45-state network that has expanded to include other distressed-asset specialists such as attorneys, consultants and property managers. “What’s different this time is that it’s so bad the government is doing what it can to slow things down. It is like a slow-motion wreck. While there is a foreclosure REO deal flow now, it has been a long time coming.”
There is tremendous interest in note sales these days for a variety of reasons. Brokers want to know how they can become a part of this emerging market sector and get paid a fee for their efforts.
“It’s all about relationships,” says David Fong, CREOBA’s note sales course instructor, attorney and managing director of Asia Pacific Capital from his Los Angeles office while in the middle of closing a $60 million note purchase with a face value of $100 million. “When banks have big portfolios to liquidate, they go to their relationships first. Jones Lang LaSalle and other firms have created auction arms to sell large portfolios for lenders they already had relationships with.”
Many commercial real estate loan portfolios often sell at 50 cents on the dollar, according to Fong; some may include the asset dogs and dolls, so to speak, to offset investor risk, and due diligence is critical. Typically, these deals involve the bank, attorneys and investors. Brokers can earn their place at the table by initiating a note sale. Bringing a qualified investor to the table for a distressed asset held by a bank is the best way to develop relationships on both sides of the table. Fong indicated brokers’ fees are negotiable but it depends on the deal. “If a broker brings me a $30 million note that I want to buy I could see paying as much as $300,000 in a brokerage fee for the right deal.”
Discounted Pay-Offs
Some companies have evolved to specialize in the bulk sales of distressed debt or providing funding for discounted pay-offs (DPOs) to owners. Carrolton and DebtX are companies that sell notes on behalf of the FDIC and private assignments from the banks.
Chris Miller, president of First Capital Mortgage and Trust Deed Investments in Roseville, California, has created DPO Funding, a service of his mortgage company dedicated to assisting owners of commercial real estate negotiating and funding discounted pay-offs on properties that are over leveraged. “Some lenders are willing to take a 50 percent discount for an immediate cash pay-off,” he says. “With this program, we work with owners to restructure their debt and obtain a release from their personal guarantees in some cases. We pay brokers a fee for referring their clients our way.”
These are a few of the opportunities rising to the surface as the commercial real estate market begins to stabilize and reinvent itself, but there are still many who are struggling with how to survive this difficult time. Commercial real estate brokers in particular see a market where their standardize services are no longer in demand and finding their way to profitability may be a daunting task.
“A large portion of seasoned brokers and many newer brokers are facing substantially empty pipelines,” says Rebecca Young of Shirlaws business coaching. “If the market stays slow until 2011 or longer, it means that those brokers that want to stay viable during this time will need to change the way they do business. Some will need to design a new approach and reinvent themselves to be more relevant in their current specialty. Many will need to migrate to new service lines that have access to industries and situations where transactions will continue to happen.”
Tony Wood is a senior vice president with TRI Commercial/CORFAC International and author of the new book, “The Commercial Real Estate Tsunami - A Survival Guide For Lenders, Owners, Buyers and Brokers.”
Bargaining with Distressed Landlords
Many property owners have been weakened by the lingering recession. Falling rental values, declining occupancy rates and maturing loans with no readily available replacement financing are all impacting landlords’ bottom lines and eroding their equities. For strong tenants or those with short remaining lease terms, this may create a leverage opportunity. Tenants should consider the following factors when negotiating lease concessions:
1. Protect against landlord insolvency. How will the landlord pay for, or finance, promised tenant improvements? Tenants may need to examine a landlord’s financial statements; generally, unheard of until recently. Many landlords are limited liability entities, whose only asset is the building in question. Add to that, the likelihood that the building’s equity is probably eroded, and tenants probably have little recourse if a landlord fails to complete tenant improvements (TIs). Depending on the strength of the landlord, the tenant might demand proof of a loan commitment to fund TIs, or that TI dollars be deposited in advance into an escrow account, or be backed by a letter of credit naming the tenant as beneficiary. The parties could also establish a right of offset against rent if the landlord fails to complete the improvements.
2. Protect against declining building maintenance. A landlord’s failing financial strength may lead to deterioration of building and common area maintenance. Tenants concerned about a landlord’s ability to maintain should demand a right of self-help, and to offset costs against rent to cover expenses incurred.
3. Make the deal a win-win situation. Tenants who demand lower rent should offer something of value in return. For example, it will be far easier for a landlord to justify a rental reduction in the short term, if the tenant offers to extend the lease term. Also, consider escalating the rent over time, perhaps even back to or above pre-concession levels. Consider shifting responsibility for some or all operating expenses to the tenant. Some landlords may need the added certainty that operating expenses will not increase; therefore, changing a gross lease to triple net may give a landlord confidence that it won’t be hurt on the back-end by operating expense inflation. Consider offering a personal or affiliate guaranty, or a so-called good-guy guaranty, where the guaranty is only effective upon a tenant default if the tenant fails to immediately surrender possession of the leased premises to the landlord.
4. Beware of the rights of mortgagees. Loan documents may prohibit a landlord from amending leases (especially for a rental concession), so tenants should determine whether lease modifications require lender consent. Since leases are generally “subordinate” to the lien of a mortgage, tenants should require a non-disturbance agreement from the landlord’s mortgagee to assure that tenant’s possession will not be interfered with, even if the lender forecloses its mortgage. In select circumstances, tenants should also ask the lender to provide it with a duplicate notice of mortgage default; perhaps even a right to cure such default and offset the costs of such cure against rent.
5. Special considerations for single-tenant buildings. Tenants negotiating new leases or amendments to existing leases for single tenant buildings should also consider requiring an option to purchase. However, some lenders believe such options impede their foreclosure rights, so they may withhold their consent to purchase options within a lease, unless the option specifically provides that it cannot be exercised against a successor landlord such as a lender after foreclosure or, at a minimum, that the option price first payoff the mortgage.
As with any negotiation, leverage points can be anticipated by being prepared. Whether the landlord or the tenant, plan out a strategy for success in advance. Identify all of the players involved and the obstacles to success ahead of time. Be creative, and above all, make the deal a win-win situation; otherwise the effort is doomed to fail.
Steven D. Sallen is president and CEO of Maddin, Hauser, Wartell, Roth & Heller PC. |
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