Thursday, May 14, 2009

Why Are Performing CRE Loans Selling for 50 Cents on the Dollar?

Zero Hedge and Real Property Alpha have picked up on the results of recent FDIC auctions of CRE loans (Zero Hedge posts here and here, Real Property Alpha posts here and here). A graph from Real Property Alpha shows performing CRE loans are being sold at roughly 50% discounts:

You might think the sales price on the performing loans indicates the collateral backing the loan is worth only half the loan amount, but that’s not the case. This is about a change in investor yield requirements, not CRE fundamentals.

Let’s say you have a well secured, performing $10,000,000 CRE loan paying a 6% interest rate:


Now, let’s say you are taken over by the FDIC, and the FDIC wants to sell the loan. You might think that since the loan is well secured you could sell it for the full principal amount, but you would be wrong; note buyers want a 12% yield on their investment (actually, they want more – I get two or three calls a day from people wanting to buy notes, and return requirements are 12% to 25%). To get a 12% yield on a loan paying 6% interest, you need to buy it at a 50% discount:


You might question why the FDIC would sell – 6% is not a bad yield when 5 year Treasuries are at 2%. If the answer is the same as when I worked there in the late 1980’s, it’s because their job is to liquidate assets at the best price they can get for them. But, most banks would be content to collect 6%, and that explains why you don’t see many banks selling performing CRE notes.