It's no great secret that even as distress continues toaccumulate, foreclosures are slow in coming. The leeway banks havebeen given in modifying loans is one factor, and the lengthy timeframe entailed by the process in judicial-

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foreclosure states such as New York,

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Florida and New Jersey is another. This is giving rise to notesales as distressed asset holders look to cut their losses bygetting rid of those assets as quickly as possible. In the shortterm at least, we can expect to see more such sales, expertssay.

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"There are still a lot more modifications and foreclosures goingon than actual note sales," points out Kingsley Greenland, CEO ofBoston based DebtX. He adds, however, that note sales are "growingin usage very quickly" and he expects to see more such investmentopportunities coming to market over the next six to 12 months.

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Kevin Welsh, a senior vice president with the New Yorkinstitutional group at CB Richard Ellis, would agree. "I like touse the expression 'debt is the new equity, " he says, adding thatthe notes are "typically being acquired by relatively sophisticatedinvestors." Some buyers acquire the notes with the goal ofeventually gaining control of the property (see "Loan to Own?Expect the Unexpected," beginning on page 14) while others are lessconcerned with real estate than with maximizing yield.

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The current holders of the note have plenty of motivation forselling them, experts say. Many lenders, whether banks or lifecompanies, have had distressed assets on their books

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for a long time and are becoming increasingly frustrated withthe amount of time it takes to foreclose on properties. Moreover,due partly to the Federal Reserve's accommodative monetary policy,lenders have been enjoying substantial profits over the pastseveral quarters, and so they are in a position to withstandselling at a loss while cleaning up their balance sheets.

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To Michael Fay, Southeast regional head of the asset resolutionsteam at Colliers International, selling notes represents "a way forthese groups to get the problems off their books. What they'reeffectively doing is shoving the problem onto another group, andthat other group is going to have to foreclose as well. So it's notthat foreclosures or REO sales are going to go away, they're justmoving paper from one group to another group for specific reasons,such as reserve issues and cleaning up balance sheets."

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Adds Fay, "It's also a great tool for dealing with a problematicborrower. The lender says, 'You can sit here and work this out withus, or we're going to sell your note to someone else who ultimatelyeither wants to own the property or will sell the note offagain:

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It's a little bit of a carrot-and-stick method."

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Selling notes is also a way to help bridge the yawning gapbetween supply and demand. In late June, for example, Invest corpReal Estate sold Talos Capital Ltd. a $100-million mortgage loan ona Washington, DC office property that the US Coast Guard uses forheadquarters space, for an undisclosed sum. "We saw an opportunityto sell this mortgage at a strong profit given investors' renewedinterest in commercial real estate loans and the dearth of qualityassets changing hands these days," commented Jon Dracos, co-head ofInvestcorps real estate business.

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The proliferation of note sales is very much a function of themost recent cycle, say commercial real estate veterans who rememberthe days of the Resolution Trust Corp. "This is so different fromthe '90s, it's incredible," says Welsh. "If you looked at thecapital structures that were in existence then, it was mostlysenior lenders. Everything was so much clearer in terms of whoowned the real estate and where the risk lay. You weren't dealingwith the complex capital structures." Therefore, REO sales camethicker and faster than is the case in 2010.

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Given the time-consuming slog that the foreclosure process oftenrepresents today, lenders see note sales as a quicker route. Butthere is a tradeoff. "Absolutely you're not going to get as muchthrough a note sale as if you take the property through foreclosureand sell it yourself," says Greenland.

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Proceeding from that assumption, the question becomes why thebank would willingly lower its return through a note sale."Undeniably it is because there's a race right now to prove thatyou have a healthy balance sheet," Greenland says. "To do that isto show stabilized or reduced non-performing assets or REO. ThatlS-to-24-month

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lag it takes to foreclose hurts you in a market where netconsolidation is starting. So it's all about getting your balancesheet healthy, and the quickest way to do it is to sell the assets.But that presumes that you have the capital adequacy to do it."

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Many banks are now in a better position to do this than theywere a year ago, Greenland says. "One, they've had time to increasetheir reserves," he notes, "and two, there's more pricetransparency now, so there's less concern about where the terminalasset values are going in the next year or two."

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That means prices on the buy side have firmed up a little, sothe bid/ask spread is narrower. A report from Jones Lang LaSalle'sretail investment sales group points out that notes typically sellfor between $0.55 and $0.75 on the dollar of outstanding balance."Though the lender or special servicer takes a loss, the loanholder is able to avoid what are often lengthy and costlyforeclosure processes that can be fraught with legal risk,"according to the JLL report, which cites a Credit Suisse creditupdate that advocates resolving specially serviced loans "theearlier the better" via discounted payoffs or note sales to shortentiming in serving and exhibit lower loss severity "The longer anasset sits in special servicing, the higher the loss rate thatspecial servicer takes," says Kris Cooper, managing director ofJLLs retail investment sales group. "Distress holders need to movequickly to execute an exit strategy to clear their balance sheetsof assets and notes to mitigate losses efficiently."

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For buyers, the discounted purchase price on notes compared toREO helps offset one of the pitfalls, namely, that the investor maynot actually get to the real estate. On a grand scale, Welsh pointsout, that's one of the risks faced by the joint venture of PershingSquare Capital and Winthrop Realty Trust in its recent discountedpurchase of the $300-million senior mezzanine debt on the1l,227-unit Peter Cooper Village/Stuyvesant Town apartment complexin New York City. No sooner than the JV bought the debt than itfaced an injunction by the senior lenders, who were planning aforeclosure of their own on the $3-billion first mortgage.

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Welsh says he's confident that the JV is "eventually going toget to a point where they sell co-ops, condos or whatever" at Stuy-Town. "But rest assured, that's a tough row to hoe," he says."You've got to feel pretty good about maneuvering through thevarious headwinds that will definitely exist through theprocess."

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Other buyers, Greenland points out, "may be restricted by theirinvestment criteria to buy only distressed debt, not distressedassets. If I'm a fund that's raised money to buy distressed debt,I'm limited in the universe" of buying opportunities. "Conversely,I may get a better opportunity by going in and not trying to get tothe asset but restructuring the debt, yet having a fallback in caseI get the asset."

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Note sales may take two forms. Banks or special servicers maysell portfolios that pool loans from across a wide geographic area.Each of the loans will come under scrutiny by the investors,looking at what stage of the foreclosure process it has reached,how the note's value can be enhanced and how to optimize the loan'svalue for resale.

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That was the approach behind last month's joint-ventureacquisition of a portfolio of 38 non-performing loans by Ram andSquare Mile Capital Management. Backed by 39 shopping centersacross nine Southern states, the portfolio carried a total parvalue of $150 million, the purchase price was not disclosed,although a release notes that the loans were acquired at "asignificant discount" to par.

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"The recent transaction with Square Mile was the first largeportfolio that we seriously considered purchasing," says CaseyCumming, president of Palm Beach Gardens, FL-based Ram. "In thepast 18 months, distressed debt investing has represented anoverwhelming majority of our new transactions. The acquisition ofcommercial mortgages on a selected basis will continue to be apositive addition to our traditional acquisition and redevelopmentprograms."

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Similarly, Milwaukee-based M&I Bank recently tapped MissionCapital Advisors to market $273.9 million worth of loans in variousstages of distress. The 55-loan portfolio is being divided into sixregional pools, with final bids due Sept. 15. "Our credit qualitytrends continued to benefit from our aggressive approach tononperforming loan identification and resolution," Greg Smith,M&I's CFO, said on a recent earnings call.

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Funds and other large-scale investors may find advantages inbuying a portfolio "because they're limiting the amount ofcompetition," says Greenland. "When you limit competition, youreduce price. For some people, there are certain types oftransactions where price does not matter or is not as significant adriving force, where a portfolio transaction could make sense. Butfrom a proceeds standpoint, it's never advantageous."

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Alternately, a distressed debt holder may sell a single note,collateralized by a property or a portfolio of properties. Thistype of buyer is pursuing the loan-to-own strategy, and it's thekind of customer DebtX is looking for. "We believe in selling atthe asset level to increase proceeds," says Greenland.

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Whether it's one-off or portfolio sales, the potential buyingpool for notes is arguably unprecedented. Fay says he's never seenso much capital in the market as there is now, and particularly ascompared to the RTC era.

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Just as lenders may differ on whether to sell portfolios orwhole notes, so investors have a variety of reasons for buying inone or the other format. Fay says that although investors may shareseveral characteristics, including the dollar ranges of theinvestments they're prepared to make, it's difficult to generalizeabout their note strategies.

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"There are so many different investment groups with differentplays," he says. "I will tell you that there is a buyer foreverything out there."

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Would-be buyers need to look very carefully before diving intothe notesale waters. "You always want a good idea of exactly wherethe lender stands in the foreclosure process, what the status ofthe litigation is and what the defenses are that had been raised bythe borrower," says one expert. "You want to know the exactstructure of the capital stack so that you understand fully who isinvolved and to what extent they're involved. And you really needto be very good on what the documents are. If there is more thanone lender, you want to make sure you understand what theintercreditor agreement says."

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Industry observers predict that, while note sales will rise asmore distress comes to market, it won't be a permanent increase.Fay says there are REO portfolios coming to market where the wholeforeclosure process has already been gone through. "That is goingto have a trickling effect over the next five years," he says."We're going to have a lot more note sales over the next two tothree years, and then they will start to pull back and REO willreally speed up."


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