Friday, May 15, 2009

Investor Returns on FDIC Discounted Note Purchases

John Reeder over at Real Property Alpha and I have a discussion going on the implications of the FDIC selling performing CRE loans at 50 cents on the dollar (see John’s posts here, here and here, and mine here). One of John’s commenters asks about cap rates on these transactions, which I’m taking as an opportunity to show how these deals can be such a home run for the note buyer.

I’ve expanded my previous example to show net operating income, cap rate, and collateral value. There’s not enough information in the FDIC sales info to use an actual example, so I’ll show a couple of hypotheticals. The first example is a marginally performing loan where the property generates just enough income to cover the interest payment:


I’ve picked an 8% cap rate – the real life non-distressed transactions I’m seeing have cap rates in the 7%s for multifamily on up to the 9%s for retail. At this cap rate the property has negative equity, so at maturity the borrower will presumably be unable to pay off the loan and the note holder will foreclose. Here are the numbers for a note buyer who bought at a 50% discount:


Even though there’s a $2,500,000 loss on the $10,000,000 loan, since the note buyer only paid $5,000,000 for the note they are up $2,500,000 on their position.

Let’s say the original loan is performing well and the NOI is more than the interest payments:


In this example, the borrower has equity and will be able to pay the loan off by selling the collateral. That works out even better for the discounted note buyer, because even though they only paid $5,000,000 to buy the note they get repaid the whole $10,000,000 (100% return).

This kind of apparent no lose proposition is what gets people very excited about buying notes at a discount. There are risks, of course; property income might deteriorate, cap rates might continue to increase, or the borrower might file bankruptcy and get the loan restructured on terms less favorable to the note holder. That’s why note investors are looking for a relatively high yield and a big discount going into the transaction; a 50% discount gives a lot of room for things to go wrong and still get an acceptable return. However, selling at a 50% discount is a huge hit for a bank to take (I’ve posted about the impact on the bank’s balance sheet here), so as far as I know the FDIC is the only active seller that is discounting to this extent.