As printed in Barrons
Distressful
Opportunities
By STEVE BERGSMAN
GELT
FINANCIAL, A SMALL REAL-ESTATE LENDER based in Southampton,
Pa., recently bought the $190,000 mortgage
on a five-unit Trenton, N.J., apartment building for $175,000. The
property had an estimated value of $475,000, but the borrower was slow making
payments and the lender decided it would prefer to sell the mortgage, rather
than badger the owner, month after month.
The
new note-holder offered the owner a deal: If he made regular payments for the
36 months and refinanced for 36 months, he would pay zero interest. What's
the catch? Gelt already had locked in a profit by buying the $190,000 note at
about an 8% discount. And if the borrower, despite the easier terms,
nonetheless defaulted, Gelt could take control of a property worth almost a
half-million dollars.
Gelt
is one of many firms that have found a lucrative niche in the property
market, investing in distressed debt on commercial real estate -- office
buildings, shopping centers, industrial structures and apartment buildings.
It's an approach that has considerable advantages over direct purchases of
equity interests in problem real estate. And Gelt has steadfastly stayed in
this market even through the 1990s and after the turn of the millennium, when
there were scant opportunities, thanks to low interest rates and rapid
property appreciation.
Now,
however, restless investment money is expecting a rise in troubled commercial
mortgages. Years of easy loan underwriting, including high ratios of debt to
equity, combined with higher interest rates suggest that a day of reckoning
for marginal properties may be nearing.
![[illo]](file:///C:/Users/VALUED~1/AppData/Local/Temp/msohtml1/01/clip_image001.jpg) For example, New
York-based Hudson Realty, a real-estate "opportunity" investor --
one that seeks out troubled properties -- has put together three funds that
include purchases of distressed debt. In the past two years, Hudson has bought $120 million of troubled
real-estate loans. The thinking, explains Spencer Garfield, a Hudson managing
director, is that over the next few years loans will come due that were
originated in 1996-1997, when Wall Street issuers of commercial
mortgage-backed securities were particularly aggressive. "The market
fundamentals are not so good now," says Garfield, "so some borrowers are going
to have trouble getting out of these loans. We expect them to sell at a
slight discount."
Palisades
Financial, based in Englewood Cliffs, N.J., is launching a $200 million fund
that will include distressed real-estate debt. Says David McLain, Palisades' chief investment officer, "When you see
lenders putting more than 90% loan-to-cost on projects, you realize there is
no downside protection. In the past, lenders built downside protection into
funding, but that went out the window the last couple of years."
Hedge
funds have entered the market with enthusiasm. One is GoldenTree Asset
Management, which has formed a joint venture, called GoldenTree InSite
Partners, with Tom Shapiro, a former managing director at Tishman Speyer
Properties. InSite will look for total returns in the mid-20% range on its
investments.
To
be sure, opportunistic investors may be salivating too, soon. Right now,
there is scant evidence of widespread weakening in income-producing real
estate. According to the Federal Reserve, charge-off and delinquency rates on
property loans hit all-time lows in 2005. Realpoint Research, an arm of GMAC,
shows delinquent balances on commercial-mortgage-backed securities declining
from January through September 2005, with an October uptick due mostly to
Hurricane Katrina damage. Similarly, Fitch Ratings' CMBS delinquency index
dropped to 1.19% in October, from 1.57% in January.
Patty
Bach, Fitch's senior director in the firm's CMBS group, is near-term
optimistic for commercial-mortgage-backed securities, but her company's 2006
Outlook expresses concern: "In existing floating-rate transactions, as
interest rates rise, loans exercising extension options will be at greater
risk, and borrowers will have more difficulty refinancing fully leveraged
loans."
The Bottom Line:
Investing
in distressed-property loans can offer more options for a generous payday
than directly purchasing underperforming properties. But too much money could
be chasing too few deals.
Apartment complexes may be especially
vulnerable. Heading into the end of 2005, loans on multifamily dwellings
accounted for 31.3% of Fitch's delinquency index, way ahead of the
second-place office sector's 18.9%. Realpoint attributed 38.9% of October
2005 CMBS delinquencies to multifamily loans, more than double second- place
office at 17.3%. The troubled condominium market could add to
apartment-owners' troubles as speculators are forced to put condos on the
market as rentals, giving multifamily projects unwelcome competition.
INVESTORS
LIKE DISTRESSED REAL-ESTATE DEBT because it is a way to gain control of
properties at a discount. And debt offers more flexibility than direct
purchases of properties.
"When
you buy distressed real estate, you have one exit: Fix it up and sell at a
profit," says Hudson's Garfield. "When you buy distressed
debt, you have more options: Make a new loan to the borrower and allow him or
her to perpetuate the existing business plan; go through the foreclosure
process to get control of the property; or allow the borrower to make a
discounted payoff." Traditional lenders like banks are particularly
loath to pursue the last option because of the precedent it tends to set.
One
of Palisades Financial's early distressed-debt deals were two loans it bought
from a Japanese lender that had spent four years in court fighting with a defaulting
borrower. As an entrepreneurial investor, says Palisades'
David McLain, the firm was able to change tactics and "monetize the
investments in nine months."
According
to Scott Tross, a Newark-based partner with the New York law firm Herrick Feinstein and an
expert on foreclosure law, the big money for distressed real estate debt is
coming from hedge funds. "They are the largest buyers and have an
insatiable appetite for the product," he observes. "Investors in
hedge funds demand handsome returns and distressed debt is one vehicle that
has the potential to deliver such returns."
That,
in itself, could pose a problem for investors. Jack Miller, Gelt Financial's
president and founder, frets that the field has become crowded: "Paper
is much harder to come by and prices are expensive. There are more buyers,
and now hedge funds have gotten into it."
STEVE
BERGSMAN is a free-lance writer, specializing in real-estate coverage.
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