North Carolina CCIM State Gathering
Presentation by: Jay Rollins
September 24, 2010
1.
Commercial Real Estate Market Outlook
2.
Distressed Assets: What you Need to Know
3.
Loan Workouts and Recovery Primer
4.
Adapting to the New Market Environment: Making Money
5.
The New Underwriting: How Lenders are Analyzing Deals
6.
Questions & Wrap Up
2
There is $1.4 trillion of commercial real estate debt that is coming due over the next few years.
This represents 40% of all commercial real estate debt. With values down 30-40%, most of these
loans cannot be refinanced at par.
5
Banks
Community Banks: They are holding onto their assets because they cannot afford to
sell at market prices. If they do so, they risk being insolvent. The FDIC is not
aggressively closing banks. They are aggressively putting banks under operating
agreements. It is hard to do business with community banks.
Large Regional Banks: These banks are overburdened with legacy loans and REO.
They have been able to raise equity or have received TARP funds, so failure is unlikely.
They are shedding real estate assets because they are profitable in other areas.
LARGE REGIONAL BANKS ARE THE BEST TO DO BUSINESS WITH.
Money Center Banks: They typically hold larger assets, and will primarily
extend/pretend because they can. Money center banks hire bulk advisors.
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Other Lenders
Private Lenders: In the “go-go” credit years, private lenders were forced to
do the most risky deals as securitization took away their traditional
transaction base. They are now in workout mode, and they will restructure.
CMBS: The flood gates are opening and CMBS defaults are rising quickly.
Special servicers have more problems than people to deal with them. This is
a significant opportunity. CMBS LOANS ARE FORECLOSING, CREATING REO
OPPORTUNITIES.
Life Companies: There is not a lot of distress in these portfolios. They will
typically cure their own problems on a situational basis. THERE IS NOT MUCH
OPPORTUNITY WITH LIFE COMPANIES.
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What will the commercial real estate finance landscape look like?
We are back to balance sheet (hold the risk) versus syndication (sell the risk).
Less capital available: Less capital in the market going forward, as a record amount of
legacy debt is maturing.
 CMBS: The highly reliable CMBS market of $150-200 billion of annual liquidity is
gone!
 Wall Street: The Wall Street lending machine (investment banks and hedge funds) is
gone and/or shrinking.
 Banks: The banking system is burdened by toxic legacy assets.
More equity required by lenders in the market:
 Old model: 10-20% equity. New model: 40-50% equity.
Tougher underwriting by lenders in the market: Tougher standards for securitizationthe lenders will hold some risk.
 Tougher analysis on future occupancy assumptions
 Tougher analysis on future rent assumptions
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1.
2.
3.
Public Non-Traded REITs: This is a new market player to watch.
Its very expensive to launch these vehicles ($10 million). They
typically have to return 8-9% to their investors, so expect loan
rates in the 10% range.
CMBS, take two: CMBS will be back, but it will look very similar to
how it started in 1999. Very conservative, and only for core assets
with good rent rolls.
Private capital: Expect to see a rebirth of private capital. This will
come from a variety of small funds/asset managers across the
country. SEE JCR CAPITAL.
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SubPerforming
Loan
NonPerforming
Loan
Lender has
Filed for
Foreclosure
Bankruptcy
Period
Foreclosure
Sale
Final
REO
Notice &
cure period
Note Sale
• Lender gets
out early
Note Sale
• Most note
sales in this
stage
• Most risk in
life cycle at
this stage,
as borrower
can still file
bankruptcy
Note Sale
•
•
•
Deepest
discount
Buyer inherits
the good, the
bad, & the ugly
from the lender
Lender reps &
warranties
important at
this stage
Risk Period
Redemption
Period
• Borrower’s last
• Borrower can
chance
buy back the
• Lender risks
note – this
time delays and
does not
possible “cram
typically
downs”
happen
Asset Sale
• Clean Title
• Least Risk
• Highest
purchase
price in the
distress life
cycle, as
the asset
is “clean”
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1.
2.
3.
4.
5.
6.
Bad sponsors: Incompetence, lack of experience, weak people in
bad market.
Too much time: Time kills all deals.
Costs were under estimated: Increase costs without increase in
revenues.
Key leasing or sales did not occur: Did not generate pro forma
revenues.
Property overleveraged: What percent of the business plan is
needed to be achieved to pay off debt. See key leasing bullet
points.
Market conditions change: Demand weakens or credit terms
tighten.
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


The senior debt: In the best position. Will seek a foreclosure or
note sale quickly.
The senior bank lender will typically avoid REO.
The CMBS lender will typically want REO:

More value

More fees
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The mezzanine lender: In the worst position.
The three options are:
1.
2.
3.
Pay off senior lender – need capital
Assume the loan (if allowed by the Intercreditor
Agreement)
Try to have capital call on sponsor (unlikely)
18
The Limited Partner equity has very little recourse.
The options are:
1.
2.
Take over as General Partner
Write fresh checks to cure debt defaults
19
The sponsor:
• Behavior is key: Good guy vs. bad guy
• Cooperative vs. difficult
• Problem solver vs. deer in headlights
20
•
•
In some cases the first trust lender or the
mezzanine lender will seek to sell their note at
discount, take the loss and walk away.
Buying non-performing or sub-performing loans is
a business all to itself.
(Continues on next slide)
23
Key issues of Note Sales are as follows:
 Assignment of the note: The buyer “inherits” the existing
note “as is.” Thus, all of the terms are pre-set. The
buyer must be comfortable with the remedies, default
rate, recourse, etc.
(Continues on next slide)
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Reps & warranties: Typically only rep will be the validity of the
note
Note buyers worrying about previous bad actions, promises,
etc.
Note sales at discount give the new lender more flexibility to
work out an amicable solution (lower basis).
Pay special attention to default provisions, cure provisions,
and default interest rates.
(Continues on next slide)
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Foreclosure is an excellent way to “cleanse the asset.” It
extinguishes all claims and liens and is a great tool for
transferring assets.
The Process: Driven by state law. Know your state law before
lending or buying notes
Judicial vs. Non-Judicial Foreclosures:
 Judicial foreclosure: A full blown legal process with a judge,
a hearing, and a court date. Takes up to one year, very easy
to stall.
 Non-judicial foreclosure: Public notice, then sale at court.
Takes 30-60 days.
(Continues on next slide)
27
Mezzanine Foreclosures: A “UCC” process


This is an administrative judicial process
The lender “instantly” becomes the borrower
Unsecured liens: They are wiped out or “cleansed” at
the foreclosure process.
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Bankruptcy is a borrower option once the loan is
defaulted on, and prior to foreclosure. You can never
negotiate away the right of bankruptcy.
Bankruptcy law is a combination of federal law and
state law.

Bankruptcy outcomes are greatly influenced by the
bankruptcy judge and the leniency of a particular
court.

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Keys to Bankruptcy Analysis
1.
Special Purpose Entity: Also known as a single purpose entity.
Avoids the co-mingling problem.
2.
Real Project Equity: Can create a problem for the lender –
susceptible to a cram down plan.
3.
Bankruptcy Plan: Every bankruptcy has to have a plan submitted
by the borrower. The plan must show equity in the property and
how they can pay off creditors.
4.
Motion to Lift Stay: This is the lender asking the court to “throw
out” the bankruptcy filing due to lack of merit – this is rare.
5.
Debtor in Possession Financing (DIP): Lending to bankrupt entities as
part of a cram down plan – this is great business. The DIP lender is
paid first. (JCR Capital will provide the loans.)
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
An historic opportunity

Where were you in 1992?

Now is the best market for those with intellectual
capital
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•
•
•
•
•
•
•
Rev Par
?
NOI
?
Price per foot
?
Appraisals
?
Replacement Costs?
Markets
?
Revenue Streams ?
34
Answer: Leveraged Return on
Equity
35
All equity purchases
• Cap Rate = ROE
• Cash on cash return is unleveraged
• The return is the cap rate (unleveraged)
95% leveraged purchase
• Key go/no go “number is the leveraged ROE
• Leveraged ROE increases with debt
• As leveraged ROE increases, sellers will pay more
• Prices go up and cap rates go down
36
OLD
NEW
Price $10 Million
Price $10 Million
Interest Costs
First: $8MM @ 5% =
Mezz1: $1MM @ 9% =
Mezz2: $500K @ 13% =
Total Interest
Cash Flow
NOI
Cost
$400,000
$90,000
$65,000
NOI $650,000
NOI $650,000
Equity
96-100%
Equity
71-100%
$500,000
$3,000,000
Mezzanine 2
91-95%
First Trust
0-70%
$500,000
$7,000,000
Interest Costs
First: $7MM @ 6% = $420,000
$555,000
$ 650,000
($ 555,000)
Net Cash Flow
$
95,000
Mezzanine 1
81-90%
Leveraged ROE
$1,000,000
$95,000/$500,000 = 19%
First Trust
0-80%
$8,000,000
Cash Flow
NOI
Cost
$650,000
$420,000
Net Cash Flow
$230,000
Leveraged ROE
$230,000/$3,000,000 = 8%
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Summary
Old
Cap Stack
New
Cap Stack
Adjustments required for new
capital stack to meet old returns
Adjustments if cash
flow declines 15%
Price
$10MM
$10MM
$7MM (price decline: 30%)
$6 MM (40% decline)
NOI
$650K
(cap rate 6.5%)
$650K
(cap rate 6.5%)
$650K (cap rate 9.3%)
$550,000
(cap rate 9.2%)
Leverage
95%
70%
70%
70%
Leveraged ROE
19%
8%
17%
16.6%
Summary:
Change in leverage takes property value down 30%
Change in leverage and 15% cash flow decline takes property value down 40%
*Both changes are based on cap rates moving from 6.5 to 9.2%.
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
No more “golf and cigar” guys

No more Rolodex bonuses

The smarter guys will be the winners
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Understand the options at every level of the deal.
Think in terms of these three buckets:



Asset level issues
Debt issues
Equity issues
41
Asset Status:
What is the current state of:

The physical asset

Rent roll quality

Competitiveness: Price/function

NOI trends
42

What is the current status of the debt?

When is the debt due?

Are there any extension options?

Is the loan in default?

Is the loan in special servicing?

Has the lender taken a write down?
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
How much equity is currently in the deal?

Where did the equity come from?

Sponsor

Institutional

Limited Partners
◦ Do you anticipate future capital calls?
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1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Negotiate extension with lender
Negotiate a discounted payoff with lender:
• New debt
• New equity
Sell the asset
Sell the asset with carry back:
• Sponsor carry back
• Bank carry back
Refinance the senior debt
Refinance the junior debt
Restructure the senior debt
Restructure the junior debt
Bring in new equity partners
• Into the partnership
• Buy the note at a discount
Bankrupt the property: Restructure via the courts
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


It will be critical for you to manage the expectations of your client over the next
year. There is a gap today between buyer and seller perceived values. To help
bridge this gap, use your knowledge of capital markets and show the seller the
buyer’s pro forma.
If using the “new underwriting” metrics we discussed (80% LTV constraint / 1.25x
DSC constraint / 8% loan constant), and the buyer’s pro forma is not achieving a
mid-teens leveraged ROE, then your seller’s pricing may be too high. Other
points to consider:

◦
Rent Roll: Is it ready for sale, or should you spend some time cleaning it up?
◦
Owner’s current financial situation:
◦
◦
◦
◦
Why are they selling today?
Is the loan on the property due?
Can it be refinanced in today’s market?
What are the alternatives if the property does not sell?
◦
Current financing: Is it assumable? A conduit loan made in 2004-2007 with an assumption
option and good terms, could increase the value of the asset today.



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The market is changing. Values are dropping and deals require more equity. Make sure you are
working with knowledgeable, qualified buyers who can bring 20-25% equity to the deal. Other
things to focus on:

◦
NOI: Focus on the trailing-12 month NOI, not pro forma NOI.
◦
Rent Roll: Understand the tenant mix, and discount the revenue from tenants who may not
qualify for underwriting purposes (i.e. month to month tenants, those with escape clauses,
etc.) as this income will not be “counted” by the lenders.
◦
◦
Debt: Understand if the property will:
Need a bridge loan or will qualify for permanent financing
◦
Return thresholds: Have this conversation up front about buyer’s return expectations so
you can solve for the leveraged ROE, and make sure you have realistic return expectations
and sales price.
◦
Roll schedule: Should be staggered.
◦
Occupancy: The more the better.
◦
Tenant quality: Look at the income statement, balance sheet and sales per square foot.






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You may want to begin the pitch talking about the owner’s financial
positions in the building, before discussing space or vacancy. Understand
what the building financial situation is, as this may drive the type of tenants
the owner will seek. This “thinking like the owner technique” will
differentiate you from the competition. Good questions are:





◦ What are the owner’s long term objectives with the building?
◦ When is the loan on the building due?
◦ If the loan is due soon, have they run a refinance pro forma under
today’s new stricter credit guidelines?
◦ If the loan is due soon, can it be easily refinanced based on the
current roll, or is the leasing and current vacancy going to materially
impact the ability to refinance?
◦ Is the current loan a conduit, bank or life company loan?
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In these situations, you may have to “reverse engineer” the potential
building your client’s are looking at. You can help dive a better lease for the
client if you know the situation of each building’s owner. Things to think
about are:






◦ When is the loan on the building maturing?
◦ What type of financing is on the building (conduit, bank, life company,
etc.)?
◦ Does the building have secondary debt (mezzanine loan)?
◦ When was the loan made (look for when it was last sold)?
What you are trying to understand is how critical your lease may be to
the building’s short term
financial health of the current owner.
The more critical your deal is to the building’s overall financial health,
the better transaction you can negotiate for your tenant clients.
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



Investment basis: Investment basis will typically be measured on a
per foot or per door basis. JCR will seek to make investments at or
below replacement cost.
Cash flow to investment basis on income based investments (income
properties): JCR will seek transactions that can provide current or
near term cash flow of at least 8% return.
Stabilized cash flow to investment basis (income properties): JCR
will seek investments that can provide pro forma “stabilized” cash
flow to investment basis of at least 12%.
Net operating income analysis: JCR will thoroughly analyze each
potential investment and perform due diligence on the historical,
current and future project net operating income.
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



Quick sale value: For each investment, JCR shall determine the
asset’s “quick sale value.” JCR will seek to make all of its
investments below the asset’s quick sale value.
Ownable basis: In all investments, JCR will underwrite the
investment where it would be comfortable owning the asset.
Market recovery investments: In some cases, especially with nonincome producing assets, JCR will be relying on a sale at market
recovery for investment realization. In these cases, JCR will
underwrite submarket supply and demand, asset quality, and
location. JCR will also pro forma conservative exit values, which will
typically be less than 80% of prior peak values.
Sponsorship: JCR will also endeavor to make loan investments with
credit worthy sponsors and will underwrite approved sponsor's
ability to manage and operate the underlying assets.
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1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Flexible structures
Investments do not require current pay
Investments can be structured as debt or equity or a hybrid
Can close quickly
Can be short term: 6 months or mid-term 3 years
Non-recourse
Rate: Can be as low as 10%
All in return requirements: 15-20%, can be achieved via rate, fees, or
profit participation in various combinations.
We typically do not like to be subordinate to other debt
Preferred deal size $1-10 MM
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Course 1: Stabilized Commercial Properties
Buying, investing & financing stabilized properties
Course 2: Value Added Commercial Properties
Creating wealth through commercial real estate
Course 3: Mezzanine Debt & Joint Venture Equity
Joint venture equity & mezzanine debt
Course 4: Opportunistic Real Estate Investment:
Investing in distressed assets, land & condos
Course 5: How to Make Money in a Down Market
How to find and take advantage of opportunities in a down market
Course 6: Starting a Fund 101
Everything you need to know to start a real estate fund
How to buy: Contact Tara Eisler – taraeisler@jcrcapital.com
 DVD courses
 Online courses
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