Kearny Real Estate Co. of Los Angeles and its joint venturepartner, TriGate Capital of Dallas, recently acquired a vacant74,000-square-foot flex! research and development building in theRancho Bernardo submarket of San Diego. That purchase is a primeexample of why commercial real estate observers say that shortsales in a growing number of cases represent the preferred way outof a distressed asset for buyers, borrowers and lenders. Kearnypaid $6.8 million for the 74,000-squarefoot R&D building,according to partner John Bragg, who notes that the building soldfor $11 million in 2006. The purchase price represented 68% of theoutstanding loan balance, and the new owners plan to invest $1.8million immediately to renovate and reposition the property, withreserves set aside for future tenant improvements.

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To Kearny, the deal represented "an opportunity to acquire awell-located, quality asset at a very attractive price ," accordingto company vice president Jason Rosin. He says the property is in asubmarket that "has bottomed out and should be one of the first torecover when the economy begins to improve."

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For both the borrower and the lender, the short sale representeda way out of what could have been a much more protracted solutionif the asset went into foreclosure. That, according to experts ondistressed assets, is one reason that short sales are gainingpopularity and the pace of such deals is accelerating. If thelender and the borrower can come to an agreement on who is coveringthe deficiency on a short sale, "then the short sale can be prettyquick ," says Hampton Beebe, senior vice president of BocaRaton-based ARA Florida. ARA recently represented Prestige BuildersGroup, the former owner of272 condo units in the Olivine at theTownship Condominiums in Coconut Creek, FL when Forest PropertiesManagement of Newton, MA bought the condos in a short sale.

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Forest paid $22.5 million, or just under $83,000 per unit,compared with the average sales price of $227,415 per unit that theprevious owner garnered before discontinuing condo sales in late2007. The Massachusetts company bought the units from a consortiumof lenders led by KeyBank, which had filed a foreclosure lawsuitagainst the legal entity that owned the complex. Beebe says hedoesn't know the exact amount that Prestige owed, but he believesit was not more than $30 million.

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In the cases of both Kearny and Forest Properties, the buyerswere able to acquire the assets because the lender agreed to ashort sale. That mutual agreement is no small point because, asmanaging director Daniel Lisser of the New York City office ofJohnson Capital points out, "Once the borrower has agreed to giveup the property, it is the lender who is controlling thetransaction" and determines whether to work out the distressedproperty via short sale, foreclosure or other means. Yet Lissersays that on the workouts with which he has been involved, theshort sale has never been an option that was considered by eitherparty. He adds: "I would expect that they would become more commonbecause a short sale is almost a free option for the lender, sincethey can put in a reserve price to test the market."

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He explains that a lender who goes the short-sale route anddoesn't like the bids still has the option of foreclosure. He alsosees short sales as "probably more likely to occur in markets wherelenders can estimate the sales price on a fairly reliable basis."Secondary and tertiary markets, where there are few sales toestablish values, are problematic, he says.

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In addition, Lisser points out that lenders are more inclinedtoward short sales of properties that are well tenanted. "If thebuilding is empty or under-occupied, it makes sense for the lenderto take title, lease it up and then sell it versus trying to sellan empty building ," he says.

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Another potential benefit for a short sale transaction, at leastfor the lender, is that the property may be sold for a higher priceif it is not viewed as a distressed asset, says Steve Lurie, apartner with Los Angeles-based law firm Greenberg Glusker.Additionally, he points out that a short sale avoids the time andexpense involved in a foreclosure. A non-judicial foreclosure takesat least four months to complete, he says. "A benefit to theborrower of a short-sale transaction is that the borrower will nothave a foreclosure

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or deed-in-lieu transaction as part of its credit history, whichshould make

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it easier to borrow in the future." Short sales raise income taxissues regarding cancellation of indebtedness, but so doforeclosures because both are taxed under the same rules.

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Whether a lender is more inclined to pursue a short sale or aforeclosure depends on a list of pros and cons that can varyaccording to the specific property. An important issue from thelender's point of view is that completing a foreclosure saleextinguishes any liens on the property, whereas a short sale or adeed-in-lieu will not, Lisser points out.

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Beebe notes that the negotiations for the Olivine condominiumsinvolved three different lenders, the former owners and the buyer.With many borrowers facing the real threat of foreclosure, manymore like the borrowers and lenders in the Kearny and ForestProperties deals are looking for ways to avoid it. And althoughthere are still negative ramifications associated with theshort-sale option, for distressed borrowers, they are less damagingthan the foreclosure or bankruptcy alternative.

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"Short sales are typically preferred when all parties arecooperating with each other ," says Beebe. "If a lender has acooperating borrower, then a short sale can be a faster and lessexpensive than filing foreclosure and going through the courtsystem." Beebe points out that foreclosures can take a year ormore, but a short sale could take just a few months or less if allparties agree to the sale. He adds that legal fees and court costscan really add up in foreclosure.

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The difference in many cases, according to Beebe, is whether theloan is recourse or non-recourse. If the loan is recourse, theborrower and the lender have to agree on how to handle thedifference between the purchase price and the loan amount, known asthe deficiency, he says. The deficiency on a recourse loan is benegotiated between both parties.

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"They have to come to agreement on what percentage of thedeficiency each will be responsible for ," Beebe explains. "If theycan agree on who is covering the deficiency, the short sale can bepretty quick. If the loan is non- recourse then the borrower canjust walk away." He adds that foreclosure is typically necessarywhen the borrower and lender disagree on the best course ofaction.

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This level of agreement, according to Lisser, means that, "Froman image point of view, a short sale appears to be a morecontrolled and friendlier transaction to the public." On the otherhand, a foreclosure, even a friendly one, "just sends a bad messageout to the market ," he says. Short sales appear less negativebecause the borrower is more visible and seems more in control.However, from the lender's point of view, "A big concern on theshort sale is that the property is selling at market price and theborrower is not working with a buyer to sell it below market ,"Lisser says. The lender usually insists on hiring the sales broker,who then has a fiduciary responsibility to the lender.

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For the distressed borrower, the biggest benefit of a short saleis the borrower's release of the debt obligation, according toMarty Higgins, a senior investment advisor at Hendricks &Partners' San Francisco office. "They also avoid a foreclosure ontheir credit report and retain some aspect of control in a shortsale ," Higgins says.

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The short sales that Higgins has done have actually been drivenby the lender. He points out that for a number of reasons, a lendermay not want to foreclose primarily to avoid exposure in owning anasset post-foreclosure. Lenders are also cooperating more on theshort-sale process. According to Higgins, the reason for anincrease in cooperation is that "the inventory is increasing andlenders may be under greater scrutiny from the FDIC to unload toxicassets from the balance sheets faster." He adds that "Banks arealso realizing that they can avoid liability with a short sale and,in a lot of cases, may end up receiving the same net figure as ifthey took the asset and sold it on the open market."

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Two recent short sales that Higgins closed took place fordifferent reasons. One was related to a conduit loan that thelender originated. He explains that it made more sense for theirinvestors to short the property and essentially re-write theconditions of their existing note with a new borrower. The othersituation involved an asset that was acquired from a failed bank."The acquiring bank had approval for a short sale from the FDIC,allowing it to exit much quicker than going through the foreclosureprocess."

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Such quick exits are a chief concern of lenders, according toLisser. "The key issues are speed and getting control of theproperty as fast as possible," he says. "Lenders fear that thelonger a borrower with no equity is in control of a property, theworse condition it will be in once they obtain control, as theborrower has no incentive to spend money on maintenance and tenantretention." In addition, a property with a weak owner/ borrowerwill be unattractive to potential tenants and leasing brokersbecause tenants are leery of leasing space at a property that couldbe taken over by the lender, Lisser adds.

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Except for the fact that short sales occur as a result ofdistress, typical transaction details closely resemble those ofquality, market-rate deals.

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In a transaction in Burbank, CA, for example, the locally basedCusumano Real Estate Group acquired the 145-unit Jefferson atToluca Lake apartment complex on an all-cash

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basis from developer JPI of Irving, TX in a lender-facilitatedshort sale. The price was undisclosed, but the property was beingmarketed at an asking rate of $31 million by listing agents DeanZander and Vince Norris of Hendricks & Partners, an ask pricethat represents a considerable discount from the $43 million thatthe complex fetched in 2007 before a renovation program by JPI.

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Although the complex was technically in distress, it is aquality asset that generated more than 25 qualified offers fromboth private and institutional investors, according to Zander andNorris. They point out that the bidders were attracted to thelocation and excellent condition of the property, as well as growthassumptions for the submarket. In addition, the complex was 99%occupied at the time of the sale.

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The number and dollar volume of commercial real estate shortsales shouldn't be difficult to calculate, according to Lurie, butin fact they are because the existence of a short sale is notapparent from the public records, and because the industry does notappear to be reporting the figures. However, New York City-basedReal Capital Analytics does track the total dollar volume of alltypes of resolutions of troubled assets, which would include shortsales. According to the latest RCA figures, resolutions of troubledassets skyrocketed to $14.6 billion in volume for the first half ofthis year, up from $3.8 billion in the first half of 2009. RCApoints out, although "the volume of sales resolving distress isstill only a fraction of investor demand ," the current trendsuggests that sales will continue to increase.


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