When asked about the latest trends in distressed real estateinvestment, Wayne B. Heicklen tells about the back-and-forthnegotiations between a troubled bank and an eager private-equityinvestor over a few distressed assets.

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The firm had its eye on certain assets in a portfolio ofnon-peforming loans held by a financial institution on Long Island,recounts Heicklen, co-chair of the real estate group of New YorkCity-based law firm Pryor Cashman. It quickly found, though, thatthe bank's price expectations were too stringent, so it gaveup.

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Then the bank merged with another, so Heicklen's client triedagain and found the new ownerships more amendable to a sale. Butthe private equity company's original idea of acquiring just thegroup's best assets? Nice try, but no cigar. And no sale. "Theprivate-equity company started out bidding on the particular assetsit wanted but was quickly pushed into the direction of buying thewhole portfolio," Heicklen says.

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In many ways this failed deal is telling about current trends inthe industry, starting with the power that holders of distressedassets still wield in the market. That equation, though, can changeas more troubled banks seek out acquiring partners to keep themsolvent. However, the most recent and interesting change isillustrated by Heicklen's client's original desire: to buy just afew assets from the bank.

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It is a trend that is gaining traction in a number of marketssuch as Georgia, according to Maxine Hicks, a member of EpsteinBecker Green in Atlanta. "We are seeing this more and more," shesays. "Companies trying to cherry-pick certain branches ofdistressed regional banks."

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The FDIC is still seen as the main, or a main, channel throughwhich to acquire distressed assets, she says. But a mindset isdeveloping among some real estate investors, such as private equityfunds, that the best way to get the highest value in distressinvesting is to cherry pick, rather than take the entireportfolio.

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The approach certainly makes sense from a pricing standpoint.Distressed assets are viewed by many as overpriced and investorsare not being adequately rewarded for the risk they are taking.

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Spencer Garfield, managing director at Hudson Realty Capital, areal estate fund manager headquartered in New York City, has optedto shun distressed debt investing for this reason. Given the pricesat which they are trading, especially in auctions, he says, it isdifficult to see how some funds are meeting their IRRs. "Eighteenpercent to 20% is what the opportunistic funds are targeting, but Iam not sure how they are getting it based on what they arebidding," Garfield says.

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Some of this may change if Treasuries start to rise. Right nowthey are priced so low that the spread is very compelling. "But onan absolute basis returns are very low," says Bill Lindsay, apartner in the Los Angeles office of PCCP LLC, a balance sheet debtand equity provider. "It is hard to tell an opportunistic investor'well, I got you a good relative return at 10%: " At such prices,the risk of acquiring just a few distressed assets is lower than anentire portfolio.

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But putting this practice into affect is not easy, starting withthe fact that banks and the government are well aware of what theinvestor is trying to do as it cherry-picks the best loans,Heicklen says. "Many of these loans are losers, with only a coupleof diamonds in the rough. Believe me, both banks and private equityhave a feel for that." The environment is still skewed to theholder of the distressed loans, he says. Buyers, in other words, donot have that much negotiating power. In some cases, the investormay be better off taking the entire load. Or put another way, itmay be that the investor doesn't have a choice if it wants reallywants those assets.

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None of this is to say that banks are in iron-fisted control ofthe market or the negotiations. Depending on the scenario, theprocess of acquiring assets from a failed or failing bank is eithera complete mess or a methodical process, says Matthew C. Sullivan,managing director of the Investment Services Group at Lee &Associates in Los Angeles.

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"Oftentimes a community bank can't do much until it is sold orseized because it can't absorb the loss," he explains. "They arestuck until another acquiring bank comes along. Once the bank hasbeen acquired there is a loss-sharing agreement that isimplemented." In such cases the system works pretty much asintended, providing transparency and new opportunities to would-beinvestors.

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In other cases, prior to the bank being acquired or seized bythe FDIC, Sullivan says, it might not even have its loansclassified properly because it is afraid of being shut down sooner.Here, too, opportunities exist for a private-equity investor butonly for those with steely nerves. "You don't really know what youmay be getting and you often don't have time to conduct thenecessary due diligence," Sullivan says.

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Banks and private-equity investors have been reaching dealsthrough one of two ways. One has been for the bank to sell theportfolio in bulk and clean up its balance sheet. The other hasbeen a recapitalization by another institution. "A private-equitycompany will buy a small healthy bank, capitalize it and use it tobuy the troubled institutions," Sullivan explains.

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But some equity players attempting to become cherry pickers aremeeting with only limited success, Sullivan says. He is also seeingsome entities trying to buy banks and separate them into a goodoperating bank and one holding the bad loans. "There are a lot ofchallenges to doing that, however. As far as I know it hasn'thappened yet," he states.

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Buyers' tactics have also hindered deals, says Matthew Zifrony,a director with Tripp Scott in Fort Lauderdale, FL. In some casesbuyers are waiting for the bank to fail because they believe theycan get a better deal from the FDIC.

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"I am seeing a lot of frustration by community banks over thistactic," he says.

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A year ago, even six months ago, he says, private-equity playerswere negotiating with struggling banks in better faith. "Now it isclear there is another element in play: their calculations aboutwhat a property could be worth after the bank is taken over." Thisstrategy is not necessarily a slam dunk and much depends on theassets in question. The FDIC will try to unload certain assetsright away, he says. Nevertheless, there is logic to this approach,says Louis Archambault, a partner with Pathman Lewis, a real estatelaw firm in South Florida.

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"The advantage of buying an asset after the FDIC has shepherdedthe transaction is that the buyer has an agreement with the bank toguarantee a certain amount of loss," he says. "It allows for thevehicles of the failing bank to be transferred to the purchaser andplaces the assets back on the market in an attractive package forthe buyer."

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Archambault has a number of clients currently trying to buyindividual assets from banks in distressed situations, many of themforeign. They are not finding the process easy and some are waitingfor the assets to move to FDIC control. Still, though, waiting forthe FDIC to step in can be frustrating, considering the potentialof a private trade.

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There are some good deals available on banks' books, says PryorCashman's Heicklen. "Properties that used to trade at $400 persquare foot now can be had at $200 per square foot via a banknote."

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Also, banks are becoming more concerned about mark-to-marketrules, which show every indication of becoming tighter. So far ithas been easier on their books to sit back and wait, Heicklen says,but they know they can't do that forever. A more fluid, transparentmarket for distressed assets would be a welcome alternative tobanks when they are finally forced to push troubled assets offtheir balance sheet. "The banks have to realize that they need tomove forward, he says. "I do see that happening more than it hadbeen but it is still a major problem in recognizing losses."


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