Monday, June 22, 2009

Valuing Note Purchases

There is a common misconception that lenders know the value of their CRE loans. For example, here’s an excerpt from a Naked Capitalism post (Yves is talking about the PPIP Legacy Loan program):

The problem isn't, contrary to PR designed to mislead the public, that the assets are hard to value. That holds only for an itty bitty percentage of the total. The real problem is that the banks are carrying them at above market values, and above any reasonable long term value too (their protests to the contrary). The problem is not the saleabilty of said assets, it's that they don't like the prices.

I can tell you with absolute certainty that lenders do not know the value of the CRE debt they are holding – there is just too much uncertainty around the key variables. Here are some of the problems:

Uncertainty around the current value of the underlying collateral. CRE is always a thinly traded market, and that is especially true now (more on this topic at Why There Are Very Few CRE Sales). To state the obvious, when there are few sales it’s difficult to establish values.

Uncertainty around the future value of the underlying collateral. Legacy debt service is a big component of the cost structure of existing CRE. When CRE is foreclosed and sold, the debt burden of the new owner will be much lighter, enabling them to cut rents and attract the best tenants (think Detroit automakers with huge pension obligations trying to compete with manufacturers that don’t have this burden). When this happens more of the old deals default and are sold as REO, which creates additional rent reductions, and so on in a vicious spiral down (more on this at CRE Loans and the Death Spiral of Doom). Even if you think you have a good handle on the current collateral value, there is no way to predict how far down this spiral will drive values.

Uncertainty over borrower actions. Apart from the collateral value issues, there is the fact that until you own the real estate the current borrower is still a factor to be dealt with. Depending on the jurisdiction, it can literally take years to get control of a property. And, given today’s low interest rate environment there is unprecedented risk that the debt will be restructured in bankruptcy at a very low interest rate (more on that at Getting Tilled: How a $6,425 Truck Loan May Decide the Fate of General Growth Properties).

All these are uncertainties affecting the current lender. Now imagine the position of the note buyer. REIT Wrecks describes the note purchase due diligence process in “What Hypocrisy? FDIC Loan Sales are a Total Black Hole”. An excerpt:

So what happens when you bid on one of these loans? The FDIC does not allow property inspections of any sort. Buyers are afforded the opportunity to review the original loan files, which contain such helpful information as the original, hopelessly out of date appraisal. Assuming you have enough local market knowledge to formulate a bid and "win", you'll have just 7 days to close. There is no futzing around with surveys, title reports and good standing opinions - we're talking an all-cash close on a 7-day fuse.

Arguably non-FDIC note sales afford better due diligence opportunities. However, I can tell you from experience it is very difficult to pick up an unfamiliar loan file and figure out the deal and it’s current status in the best of circumstances. Imagine trying to do that for a pool of deals, with limited due diligence time, no access to the borrower, and probably only partial access to the files.

It’s no wonder there are few note sales going on given the difficulties of establishing value.