Early in the recession, commercial real estate investors eagerlyawaited the flood of distressed properties expected to hit themarket. They sat, they waited and they wondered when the tricklewould turn into a flood so that they could expand their marketshare, enter new regions and pursue strategic and financialobjectives through investments in this growing sector. But whilethe number of assets underwater is huge, very few have come tomarket.

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Banks, the FDIC and CMBS servicers now hold more than $140billion in troubled loans. Instead of waiting around for propertyholders to sell those assets into a bad market, many investors areseeing that $ 140-billion problem as a real opportunity to buy thedefaulted loans at a deep discount in order to acquire theunderlying real estate.

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Ideally, not only can they acquire those assets, but they alsoget them at

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a discount because, regardless of the face amount of the note, abuyer of a defaulted loan is not going to pay more than the valueof the collateral securing the loan. And then the buyer will applya reduction to that lower value to take into account the variouscosts and risks in transitioning from note-holder to owner of thecollateraL

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And while this strategy isn't new by any means, it is picking upsteam.

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John Strockis, executive managing director of asset services forNewport Beach, CA-based Voit Real Estate Services, has noticed acomeback of the loan-to-own strategy over the past 12 months. Thevolume of such deals is increasing for two primary reasons,according to Strockis and others familiar with the market.

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First, Strockis points out that there are specific buyers whowant to purchase notes and who understand the risks. "They haveasset management platforms, and they have the platforms to servicethe loans, which are hopefully performing," he says. "At the end ofthe day, they want to get to the fee-simple real estate andforeclose."

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Many of those buyers are venture capital firms that specificallyraise funds in order to buy troubled loans through diversestrategies with the goal of owning the underlying property,explains Dawn Coulson, a partner at Epps Yong & Coulson LLP inLos Angeles. While she represents many traditional financialinstitutions, Coulson also represents various funds that she saysnot only specify the goal of ownership, but also have theinfrastructure or strategic partners to turn the property around.The second primary reason for the uptick in loan-to-owntransactions is that banks can now afford to sell the notes because"they understand that they could get better values for theunderlying collateral than they did 12 months ago," says Strockis.Nonetheless, demand for the defaulted loans still outstrips thesupply, pushing up prices. "There is a lot of distressed realestate out there, but not a lot of distressed real estate sellersand that gap increases pricing."

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With the opportunity there, the key then for potential buyers isto determine how to account for the costs and risks accurately andto understand what they are buying. While it might seemstraightforward to evaluate a market before buying, it isn't themarket that you are buying, it is the loan to acquire a uniqueasset, says Clayton Gantz, a partner in the San Francisco office ofManatt Phelps & Phillips LLP. Gantz cautions that not alldistressed assets are created equaL They can have environmentalcontamination, leases with kick-out clauses, TI requirements orstructural problems resulting from deferred maintenance, to namejust a few pitfalls.

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If the asset has construction in progress, for example, Gantzsays that the downtime from initial default to the investor'sacquisition may have allowed weather to damage the site. "If you'rebuying a mezzanine loan, so the collateral is a company rather thanreal estate, you will inherit all of the liabilities of thatcompany, not just those that show up on a title report," he adds.Unfortunately, unless the borrower in possession is cooperative,which Gantz says isn't likely, "it will be difficult to do duediligence on the property or the company." In that case, he says,the investor will have to make some insufficiently educated guessesabout the property's condition and discount accordingly. He alsosays to beware the ongoing lender obligations that the buyer willassume, such as funding additional construction draws andaccounting for cash collateral.

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Coulson encourages investors to do their due diligence just asthey would when buying the property outright or making the originalloan. "The credit file for the lender usually includes anenvironmental report phase I, and maybe even a phase II in-depthenvironmental report," she explains. "If there isn't one, the buyershould consider including a put-back clause in the purchase ifthere is any contamination or anything in the loan that was notdisclosed by the seller bank."

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Oftentimes, borrowers who go into default not only stop makingpayments of principal and interest on their loan but they also stopsending the bank financial statements and become nonresponsive tothe bank's requests. So says Shlomi Ronen, managing director ofLucent Capital, a newly formed real estate finance advisory firm inLos Angeles. "This can make it very difficult for a loan buyer tounderstand fully the physical and financial condition of theasset," says Ronen. "In these circumstances, local buyers withindepth knowledge of the market and the product type have anadvantage."

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Buying a pool of notes increases the risk factor, according toRichard Hill Adams, chairman and CEO of Laguna Hills, CA-basedAmerican Realty Capital Advisors Inc., simply because, "You reallydon't know everything that is in that pool," he says. "And you knowthat the expectation is that some of the notes you will wind upkeeping, some of them will get refinanced and some will get sold.But all in all, you are buying them at such a discount-possibly 30cents on the dollar-that you should make a profit at the end of theday"

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Hill Adams points to one of his clients-which he wasn't atliberty to name-that recently acquired a portfolio of notes fromthe FDIC that was in excess of $700 million. "Some of them are inforeclosure," he says. "In some cases, they are working out theloan or are willing to modify it. And in some cases the propertiesare performing and the loans are getting paid off."

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But the investor who bought the huge portfolio, he adds, had theexpectation that some of the notes were going to be loans to own."And because they have a development company as part of thefinancial company, they made that acquisition with the ability todevelop out the property and the land that they are acquiringthrough these note foreclosures," he explains.

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The risk of bankruptcy hangs over all transactions in thedistressed-asset arena. It can tie up the property for a long timeand result in substantial legal fees, basically throwing a monkeywrench into any deal. Since the possibility of bankruptcy isunavoidable, Tom Muller, a real estate and land use partner inManatt Phelps & Phillips' L.A. office, says that note buyersshould evaluate carefully the likelihood that the borrower willfile for bankruptcy protection. "If the property is worth much lessthan the face amount of the loan the note buyers are buying, it maynot be worth the borrower's time or energy to file for bankruptcyprotection," he explains.

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Muller has firsthand experience in this arena, where his clientwanted to buy a not-very-well-tenanted commercial property, so theclient bought the note for 60% or so off its face value, which is abit lower than the property's value. "The client, the investor,assumed that the owner wouldn't do anything to resist when theycame to foreclose because it seemed that the owner was so farunderwater that bankruptcy just wasn't likely," Muller explains."But when the owner found out that the investor had bought thenote, they filed for bankruptcy, and although it wasn't fatal, itwas an unhappy surprise."

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Probably the most important change in bankruptcy law for realestate lenders since the recession of the 1990s was a provisionmaking it much more difficult to tie up real property held in asingleasset company in bankruptcy, Muller says. "Difficult, but notimpossible, and the benefit of this change, at best, is to allow aforeclosure to proceed after 90 days if the borrower has not comeup with a plan of reorganization."

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Coulson says that one of the keys is to use the bankruptcy codeoffensively. "Have the court immediately declare the case asingle-asset bankruptcy which is usually the case with thespecial-purpose entity borrowers-and put the time pressure on theborrower to reorganize fast through making a deal with the seniorlender or get out of bankruptcy," she says. "There may be timeswhen the court will not agree about the single asset or cut thedebtor slack and give more time, but at least the pressure ison."

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According to Muller, bankruptcy can also thwart an investor'sownership intentions, since the property can be sold out of thebankruptcy case by order of the court without the investor'sconsent. This is true even though the investor's claim under theloan documents-to the extent the property was worth enough tosecure it-should be protected, Muller points out. But theinvestor's idea of "protected" may differ from the court's,especially if the borrower is able to come up with new money tohelp finance a recovery plan. In that case, the investor could becrammed down-forced to remain as a lender with a stretched-out loanat an interest rate the court deems fair.

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Given the amount of uncertainty associated with obtaining title,Lucent Capital's Ronen says it is crucial for an investor not onlyto anticipate all the risks, but also to budget for

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all the scenarios that could unfold post-acquisition. Forexample, Ronen explains that a buyer may purchase a loan with theintent to obtain title, but after initial negotiations with theborrower, it may be mutually beneficial to work out the loan. Headds that a buyer of a non-performing loan should have a back-upplan in place.

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The "situations" that Ronen refers to could include anabnormally long foreclosure process; incomplete or datedinformation available to a nonperforming loan buyer, leading tomany uncertainties about the physical and financial condition ofthe property; and bankruptcy. This last, Ronen says, could slowtitle down as long as two years, considering the backlog in somecourt systems. The most successful purchases of non-performingloans that Ronen has seen are situations in which the purchaser hasunique knowledge of the property, the market or the financialcondition of the borrower." As always, access to this type ofinformation provides a significant competitive advantage," Ronensays.

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Most investors in nonperforming loans are valuing the assetsusing the same basic methodology, arriving at a market value forthe collateral and then discounting it by the carrying costsassociated with obtaining title, says Ronen." The key here is toanticipate all unforeseen circumstances that could arise post-closeand what effects these circumstances could have on your basis inthe asset."

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One question to keep in mind, says Manatts Muller, is whetherthe seller of the loan actually has the original signed promissorynote. "If not," he says, "you may not be able to foreclose atall:

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He explains that the law deems the current holder of theoriginal note to be the owner of the loan, regardless of who holdsor has been assigned the mortgage or other

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loan documents. "When the loan has traded hands several times,the original note and other loan documents may be difficult tofind," he says. "Many borrowers have avoided foreclosure bydemanding that the note-holder produce the original note, which itcould not do."

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Muller adds that "foreclosing on the loan does not necessarilymean that you will end up with the property" Foreclosure is done bypublic auction, he says," which means that others can show up atthe sale and outbid you if you are not willing and able to put upyour own cash beyond the face amount of the note." The good news,Muller explains," is that you can credit bid up to the face amountof the note, but this can be disappointing if you've spent the timeand duediligence money to get the property" Ronen has seensituations in which the intent was to obtain title, but afterinitial conversations with the borrower after close, the notepurchaser proceeded with a discounted payoff above the price forwhich they purchased the loan." This ended up being a mutuallybeneficial and quick solution for the note buyer and the borrower,"Ronen says. This unexpected solution illustrates one of the guidingprinciples of buying distressed loans-that every deal holds thepotential for unexpected problems and unexpected solutions. Inother words, when buying troubled loans, expect theunexpected."


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