It’s The Law
By Lewis G. Feldman
In Turbulent Market, Savvy Investors
Can Profit From the Clean Up Effort
ON WALL STREET AND MAIN STREET, GREED HAS
changed to fear, and euphoria to despair. The broad
economic decline in the fourth quarter of 2007 is well
known. So are the negative implications for the real
estate credit markets, leveraged loans, non-subprime
borrowers and the high-yield markets. Despite the easing of interest rates by the Federal Reserve Bank, capital
flows declined, creating debt and equity dysfunction.
Recognizing the threat of a collapse of the global capital
markets, Congress and the Bush Administration pushed
to give the Secretary of the Treasury broad authority to
purchase up to $700 billion of “troubled” securities, including billions in real estate debt. So what are some of the
strategies to profit when the real estate capital markets are
creating more turbulence than since the 1920s?
Locating assets to purchase before a bank
failure may offer a more efficient trade for
both the bank and the investor.
One tactic is called “loan to own.” Under this approach,
an investor purchases a troubled project or makes a loan
secured with a mortgage or pledge of equity to the current
property owner. On default, the borrower exits the deal
and the lender gets the asset.
The investor’s goal in deploying the loan to own strategy is to purchase or make the loan at a risk-adjusted
discount or interest rate significant enough to overcome
the potential issues inherent in the deal. The investor must
underwrite valuation risk on the entry, the potential cost of
restructuring the asset, litigation against the borrower and
secured and unsecured parties, managing the property
and the disposition of the real estate. Active participation in
the management of a distressed asset can result in reclas-sifying a lender as a controlling party subject to liability as a
principal predicated upon breach of fiduciary duties or the
covenant of good faith and fair dealing.
Another strategy for acquiring distressed real estate
is to buy the bank holding the assets. Depending on
the target—a bank holding company or savings and
loan holding company—different regulatory approvals
are required. Rules are changing quickly to allow equity
participants to capitalize banks and thrifts without running
afoul of controlling interest rules that can invoke regulatory
supervision and operational or investment limitations.
Acquiring a troubled bank’s holdings can be cheaper
and bear less risk. The FDIC will typically sell the bank’s
untainted assets and retain the troubled ones. An investor can compete in a portfolio auction and pay whatever
the market dictates. Locating assets to purchase before
a bank failure may offer a more efficient trade for both
the bank and the investor. Faster liquidation and lower
transaction costs are just a few of the benefits.
To find potentially available product, one must understand which institutions are indeed troubled. Banking
regulators do not identify troubled institutions, only the
number under credit watch. An investor must interpret a
bank’s financial statement, including capital ratios, loan
loss reserves and regulatory operational directives.
A savvy investor may also acquire structured secured
debt. The well-publicized collapse of the market for
CMBS provides potential opportunities. Investors can
buy loan assets of the troubled CMBS tranche from a
special servicer, or a controlling class of CMBS obligations at a discount in the secondary market and duke it
out with investors in other tranches. And although new
CDO issuances today are rare, discounted CDOs are
increasingly present in the secondary market due to rating downgrades. Particular challenges in the purchase
of a CDO include the lack of transparency, litigation risks
attendant to CDO issuance and portfolio management,
the inheritance of prior legal claims and restrictions
imposed by the original tax structure of the CDO.
In the early ’90s, those with the courage and capital
to purchase assets and loans at discounts and restructure them prospered handsomely. For those savvy
enough to understand the financial prospects present
today and in the future, cleaning up the capital mess will
lead to huge opportunities.
The views expressed in this article are those of the
author and not REAL ESTATE FORUM.
Lewis G. Feldman is a partner and head of the public/private
development group for Goodwin Procter LLP in Los Angeles.
He may be contacted at lfeldman@goodwinprocter.com.
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