A 131-unit apartment building in Michigan was appraised for $7 million in the spring of 2010. At the time, the market was frozen in Michigan. Appraisal in the summer of 2011 came in at $10.4 million, based on increasing NOI.

For this particular Michigan property, the strategy was to hold the asset until the market showed signs of recovery in Michigan, and work on leasing up the non-stabilized occupancy. “NOI has been improving with higher occupancy rates and fewer lease concessions,” explains John Maute, a senior managing director at Houston-based Situs Cos. “Improving economy in the State of Michigan for the past 12 months is bringing back out-of-state buyers.”

That is just one of the many examples of an REO that has been analyzed by a special servicer over the past few years. According to Maute, “as a special servicer, we analyze the property to see if we can increase the value with immediate work to rebuild the operations and occupancy of the neglected property at a relatively low cost.”

The issue of whether more value-add can be achieved through leasing REO vs. selling it is a frequent question, Maute explains. “At its core, it is a ‘cost/benefit’ question.”

According to Jonathan Mayblum, co-founder of Arcturus Group, based in New York City, options for a special servicer are loan restructure/workout, note sale, quick asset sale at or after foreclosure, and value-add after foreclosure with subsequent sale. “In analyzing a given loan, a special servicer is obligated to evaluate viable alternatives and determine which strategy will maximize the recovery on a net present value basis,” he says. “In performing its analysis, the special servicer must consider the uncertainty of future cap rates and how they may be affected by larger economic and geopolitical trends.”

In order to take advantage of value-add opportunities, Mayblum says, special servicers must foreclose and assume management and operation of the assets. “Special servicers have to balance ultimate recovery amount, the timing of the recovery and the amount of trust money needed for asset improvement,” he says. “Spending cash flow on an asset further subordinates bond holders because that money comes out of the cash flow waterfall before any other payments to the debt holders, so the servicer has to be cautious and diligent in taking that step.”

There are numerous value-add opportunities in having special servicers work through a distressed asset, rather than simply sell the asset immediately, and any ability a servicer has to increase bankability of an asset’s future cash flow will be credited at the time of sale. So says Carolyn Leslie, asset manager for Orange County, CA-based Voit Real Estate services. “Value can certainly be created through a lease-up, and, in addition, working with tenants provides an added opportunity to increase value.” She adds that “restructuring current leases to increase term, resetting rental rates to market, and/or building in subsequent rent bumps will all have worthwhile effects on revision value.”

As long as the value-add process can be completed in a fairly short timeframe—less than nine months—the efforts will be rewarded at the time of sale, explains Leslie. “This is evident in the capital markets, as investors seek strong credit-worthy cash flow, and are willing to pay more for it, illustrated by the cap rate compression.”

For Jerry Anderson, who leads Sperry Van Ness’ asset recovery team, his experience with the REO departments of banks is that “stabilization” of the asset is more important than “trying to add value.” Anderson says that “Asset managers of banks do not have the time or funds to try to add value to distressed assets. They're anxious to sell the asset at a price that will minimize any aggregate losses of distressed assets that particular quarter.”

Anderson continues that REO departments of banks and asset managers constantly juggle losses to minimize the overall impact to the bank’s financing statement. “A sale over book value on one asset may enable the bank to take a loss on another,” he says. “Astute asset managers monitor the aggregate carefully quarter to quarter. And often with a loan in default on a difficult asset—market area, hotel operation, environmental liability—a bank will aggressively market the loan versus being faced with taking the asset back as REO.”

Mayblum explains that one viable value-add opportunity for special servicers is a situation where limited capital investment will likely lead to substantially increased performance within a short timeframe, but the current borrower is either unwilling or unable to provide that capital. “In this situation, the value-add proposition for the servicer is apparent because it has determined that a reasonable expenditure of capital—such as for tenant improvements and marketing—may quickly solve the problem.”

He adds that the special servicer must be able to make the case that its investment of trust dollars in a value-add strategy will yield greater recovery on a net present value basis. “This strategy is likely to be most successful in primary markets where the real estate market recovery is well documented.”

In secondary and tertiary markets, however, this strategy may be more difficult because of the amount of required capital relative to the potential increase in value, says Mayblum. “Unless there is an obvious marketing or operational failure of the borrower, small balance loan foreclosures are not strong candidates for value-add propositions, because they rely too much on a market recovery rather than an asset recovery.”

(Visit the Distressed Assets page on GlobeSt.com.)

Instant Insights /

Lenders&#146; Big Question: Sell or Lease REO?

Related Stories

Recommended For You

Lenders Big Question: Sell or Lease REO?