Buying distressed commercial mortgage debt is not for the faint of heart. Nor is it for the inexperienced, the risk-averse, or those with shallow pockets. At the same time, the current economic disturbances have created a treasure trove of potential investment opportunities.
Distressed commercial mortgage debt is a more descriptive way of saying that commercial mortgage loans are non-performing, that is, they are in default or about to be in default. Either the borrowers are not making monthly payments or the loans are not being paid by the borrowers when they come due and there is no way for the borrowers to refinance the loans.
Sometimes the source of distressed debt is just a bad market. The developers of renovated Gold Coast condos in Hoboken are unable to keep up with their loans because people have been walking away from $50,000 deposits in order to avoid paying $750,000 for a condo that has seen its value slip significantly. Similarly, new or redone office buildings or industrial sites must be leased at rentals that are high enough for the developer to repay loans.
As difficult as distressed debt is for the borrower and the banks, it might offer an opportunity to buy assets at a good price. “The price paid for distressed debt is always at a substantial discount from the face value of the obligation,” says Russ Bershad, co-chair of the real property and environmental department at Gibbons, a 230-attorney law firm with offices in Newark, Trenton, New York, and Philadelphia.
To offer a loan of $10 million, says Bershad, the original lender had to believe the property was worth about $12.5 million, or would be worth that when it was developed or improved. If the loan is distressed and a purchaser acquires it for $7 million, the property likely will go through foreclosure, and the purchaser will likely end up owning a piece of real estate worth substantially more than the purchaser paid to acquire the loan.
Bershad will speak on “Financing and Buying Distressed Debt” at the New Jersey Institute for Continuing Legal Education on Wednesday, October 21, at 9 a.m. at the Renaissance Woodbridge Hotel. Bershad’s presentation is part of a day-long forum on commercial real estate. Other topics covered include “Common Interest Ownership” by Christine Li; “Construction and Site Development” by Charles Kenny; “Bankruptcy and Foreclosure” by Ira Levee; “Land Use” by Steven Tripp, and “Environmental and Select Solar Panel Issues” by Jack Fersko. Cost: $249. Visit www.njicle.com
Vast quantities of bad commercial mortgage debt still exist on the books of banks, Bershad says, but the banks have not been very willing to sell over the past year, even as his firm has begun to see clients and service providers looking to buy distressed debt.
Bershad understands banks’ reluctance.The primary problem for them is, had they sold these properties they would have had to take a hit immediately on their books.
If, after all, a loan for $10 million were sold for $7 million, there would be a $3 million loss on their books.
However, with a change in accounting rules this year that lifted the rules that require banks to value assets at prices reflecting current market conditions, the banks can hold on and wait for the market to rebound. Additionally, says Bershad, “there has been a lot of hope that if things were really bad, there would be a government program that would take debt off their hands at a minor discount or close to par.”
But banks are beginning to sell some of their bad debt. “The reason is that they have a ton of these assets and have to do something,” says Bershad. “They can’t hold on to them indefinitely, and banks are in much better shape so they can handle more of a gradual release of debt into the marketplace.”
Despite the investment potential that this distressed debt represents, Bershad warns interested parties about what it takes to succeed with this type of investment:
Possess sufficient know how. Banks that sell distressed loans proceed very quickly — usually they prefer that less than a month between the time they decide to sell to when they get paid. “Banks offer a loan or portfolio to a select, capable purchaser or to bidding among several bidders,” says Bershad. “They are expected to evaluate a portfolio, make bids, make a decision, enter into a contract, and close very quickly.”
Although potential buyers may do some due diligence before making a bid, they are usually given greater access to information in the bank’s files during and after the bidding process, says Bershad. Most lenders require buyers to enter into a confidentiality agreement restricting the buyer from speaking to the borrower or third parties about the loan or the mortgaged property.
Understand potential risks. One potential risk is of litigation that might be in process. “If the bank is in a suit with the borrower, that’s a whole other level of involvement if you are the loan purchaser — because you’ll step into the bank’s shoes and have to continue the litigation,” says Bershad. Although the borrower will often assert some defenses, for example, wrongful conduct on the part of the lender, these rarely succeed, he adds.
Another risk is that the borrower will file for bankruptcy — his last defense when a mortgage foreclosure sale is imminent. Although the lender can usually complete the foreclosure, it inevitably takes longer.
Following a bankruptcy filing, an automatic stay goes into effect, and can only be lifted by the bankruptcy court. Bankruptcy proceedings may also wrest control of the assets from the lender. “If the property has equity,” says Bershad, “then there is a chance that the bankruptcy court will appoint a trustee whose job is to take over the property and find a way to sell it and repay all the debt.”
If you’re lender, he explains, you would prefer not to have trustee, who will slow things down. Rather, you would prefer to complete foreclosure and sell the property quickly instead.
Possess skills in commercial real estate. Because one of the ways a purchaser of distressed commercial mortgage debt can make money is by acquiring property in foreclosure, you have to know how to deal with the distressed asset if you end up owning it, says Bershad. “If it is being built, you have to complete construction; if it is raw land, it needs approvals; if it a condo and only half sold, you have to know you can revitalize a project that has a stigma attached to it.”
Other problems that might accompany distressed real estate are environmental issues or structural problems with a building.
Be credible. A potential buyer will need to have credibility with the bank and have access to the hefty sum necessary to buy the distressed debt. “They don’t want people who will waste their time,” says Bershad.
Bershad graduated in 1973 from the University of Pennsylvania with a bachelor’s in history, and from Rutgers law school in 1977.
He was a clerk in the appellate division, then worked for a couple of years in a small firm in Cherry Hill. He moved to Gibbons in 1982, where his expertise is in the buying, selling, financing, leasing, and redevelopment of commercial real estate. He has served as an adjunct professor at Seton Hall University Law School, teaching real estate financing.
Bershad’s wife, Sharon Wynn, practices commercial real estate law at Stark and Stark. They are long time residents of Hopewell Township.
The bottom line for investors in distressed commercial mortgage debt is that buyers need to be people who have built and sold similar projects in the past. “This isn’t a game to be played by an amateur,” says Bershad. “There’s a reason why the original developers of the project went into a default. There are a lot of profits to be made, but only by those who are capable.”