Navigating the Challenges Of Loan-to-Own 

Current market conditions present unprecedented opportunities for apartment investors to pursue “loan-to-own” transactions. With the supply of available, high-quality apartment communities limited, many institutional buyers are considering non-conventional ways to invest capital. “Loan-to-own” transactions generally involve the purchase of debt secured by real property at potentially significant discounts toward the ultimate goal of owning the underlying real estate.

It’s evident within the apartment industry that many newly constructed properties cannot be sold or refinanced at their current carrying values. Following are sobering facts that underscore the scale of this exceptional market opportunity:

• More than $1.4 trillion in commercial real estate-secured loans will come due by 2013, and approximately 65 percent of those loans will have trouble getting refinanced.
• The volume of nonperforming real estate loans is anticipated to increase to a staggering $165 billion in 2010 from a 2009 record high of $135.7 billion.
• The process of writing off troubled loans is only in the early stages. To date, the impacted financial institutions have been unwilling to “face the music” by booking these losses and have worked out only a minimal amount of the defaulted loan volume by selling loans at a loss or foreclosing on the property.

Banks and other financial institutions facing these economic stresses will increasingly be incentivized to dispose of non-performing loans at significant discounts over their face values. Several regional banks already have become very active in selling their notes.

Buying notes on properties sounds alluring and appears to be quite compelling on a spreadsheet. However, there are pitfalls, both tangible and intangible, that buyers must fully understand before they pursue a “loan-to-own” transaction.

Here are the reasons why banks and investors might consider this strategy—and the potential legal and business pitfalls that investors should understand.

Benefits to Banks

1. The foreclosure process takes a large amount of time and money. In some situations, banks can escape from foreclosure with small losses, but it takes different talent within the bank to actively manage these assets and successfully execute a loss mitigation strategy. Loan originators often have a different skill set from asset managers or workout specialists. Selling the loan allows the bank to avoid an expensive foreclosure process as well as the potential risk of the borrower putting the deal into bankruptcy.
2. The demand for notes on high-quality newly built products is strong.
3. Apartment loans are much more liquid, and the percentage discount on these loans are less than other product types, so it is easier for banks to sell apartment community loans, and those loans won’t need to be discounted as much as other commercial loans.
4. The quicker a non-performing loan is moved, the less scrutiny the bank’s real estate portfolio will come under from regulators. There is no benefit to the bank to have problems linger.

Benefits to Investors

1. Investors believe they can buy a note at a large discount, foreclose and then be left with a property at a discounted price-per-unit.
2. Investors are not forced to compete against others in the customary brokerage sales process.
3. Investors can have their cash go to work immediately.

Potential Pitfalls

1. Virtually every loan needs to be purchased with an all-cash transaction. Additionally, third-party financing of loan acquisitions is non-existent. If sellers provide financing, it will most likely be a very low loan-to-value and will have a recourse component.
2. The current cash flow is very low. Most loans on the market are London Inter-Bank Offered Rate (LIBOR)-based. Because LIBOR has fallen to virtually nothing, the current monthly payment, in general, is below 3.5 percent. Even buying the note with a significant discount, the cash flow on the loan is lower than 5 percent. Thus there is generally a negative arbitrage to the investor’s equity.
3. Buyers, in general, are required to accept the existing loan documents that generally have very achievable extension rights. Many loans had soft thresholds for the borrower to gain one- or two-year extensions, and the note-holder must honor those agreements.
4. Foreclosing current borrowers or developers could be challenging. In many situations, the note-holder must be willing to forgive some guarantees and make payments to facilitate an orderly transfer of the asset in a deed-in-lieu. Additionally, bankruptcy by the borrower is always a risk if negotiations become contentious and take longer than expected.
5. If the property has a mezzanine lender, the inter-creditor agreements will result in more detailed and difficult negotiations. This is very common in condo construction and large project construction.
6. REITS, when using this strategy, face generally accepted accounting principles (GAAP) that force any discount to be amortized over the life of the outstanding loan.
7. Note-buyers must remember they are lenders with little active say in the day-to-day operations of the property.
8. Note-buyers need to be fully committed to this business model. If mezzanine pieces are purchased, they need to step up into an equity position and work with the senior lender(s).
9. Note-buyers must remember that they are lenders. If the apartment fundamentals turn up, or cap rates continue to turn down, the existing borrowers might be able to pay off the loan under the existing terms. If that happens, the note-buyer must be content with the cash internal rate of return.

Managing the Legal Risks
Investors interested in capitalizing on loan-to-own market opportunities should become educated about the legal risks associated with debt-purchase transactions and develop a precise action plan to manage them.

Debt-purchase transactions differ from real estate acquisitions and present additional requirements and risks. Carefully consider these differences and the numerous associated issues that may impact the return of and on any investment made when purchasing real estate secured debt.

Becoming a Lender. Debt purchasers, in essence, become lenders. Become educated about the legal requirements and the custom and practices governing lenders in the state where the property is located and, if different, the state whose laws govern the loan documents.

At all times, owners must conduct themselves as lenders and not just as real estate investors whose sole objective is to ultimately own the real estate securing the debt. This is particularly relevant when servicing the debt and exercising remedies in the face of a borrower default.

When becoming a lender, risks of lender liability are assumed. While lender liability can be alleged based on numerous legal theories, the most common claims involve the implied covenant of good faith and fair dealing imposed on every party to a contract. This covenant requires that neither party to a contract take any action that deprives the other party of the benefits of the agreement. This means that, as a lender, care must be taken to not gain opportunistic advantage of the borrower in a way that suggests the lender is not acting in good faith. To mitigate risks of lender liability, fully evaluate the selling lender, its reputation, including any history of lender liability claims it may have faced. Analyze how the debt was serviced by the selling lender and any other relevant facts concerning the course of conduct between the borrower and the selling lender.

Dual-Track Due Diligence. Debt purchases require two separate comprehensive and concurrent due diligence efforts. The first is the customary due diligence that would be conducted on the underlying real estate securing the debt (as if only the apartment community was being purchased). The second is the extensive due diligence that must be performed on the debt itself. Each debt purchase transaction will present its unique set of facts and circumstances. It is critically important to identify all material facts, documentation and information concerning the debt that may impair a purchasing lender’s rights and increase their risks. This evaluation should include, among many other things, an assessment of the type and status of all secured and unsecured financing for the property and the material facts that can be uncovered about the selling lender, the borrower, any guarantors and the property. Be sure to confirm that the selling lender actually owns the debt being purchased.

The investigation should also encompass full-blown due diligence about the documentation evidencing and securing the debt. This involves obtaining copies of, and conducting a full legal evaluation about, all of the material loan documents. During this process, map out a path that would most likely follow in exercising remedies under the loan documents in light of applicable law and local custom and practice. Specifically, develop a timeline for the pursuit of these remedies (i.e., would you exercise the assignment of leases and rents, seek a receivership, proceed immediately to a foreclosure or pursue a deed-in-lieu, and how long might it take in the specific jurisdiction to successfully pursue the remedies elected?). Finally, obtain and confirm the effectiveness of any existing mortgagee title insurance policy insuring the lien securing the debt.

Loan-Purchase Documentation. Typically, a debt-purchase transaction involves a loan purchase agreement and other documentation that transfers title to the loan documents and associated mortgagee title insurance policy to the debt purchaser. The documents should include an assignment of the deed of trust or mortgage that is recorded among the appropriate land records. Be sure to carefully document the debt purchase transaction, including obtaining customary representations and warranties from the selling lender and addressing any unique circumstances impacting the purchasing lender’s risks. As part of the documentation, you must receive an assignment of the selling lender’s mortgagee title insurance policy and purchase an updating endorsement to that title policy. The endorsement should change the name of the insured to the debt-purchasing entity and add the recorded assignment of the deed of trust or mortgage as part of the description of the “insured mortgage.”

Pricing the Debt. As a first step, establish an estimated price for the debt based on the lower of the market value of the property or the maximum amount that would be paid for the loan to achieve the minimum acceptable yield, assuming the borrower fully performs and pays off the loan at its scheduled maturity. Taking the results of that determination, apply a discount to the estimated purchase price that takes into consideration the following factors:

• the general risks and uncertainties of loan enforcement;
• the likely absence of an opportunity to conduct thorough due diligence on the underlying apartment community;
• and the unique risks based on the specific facts the transaction presents concerning the property, the borrower, the guarantor(s) and the state where the property is located. Factor in both the estimated dollar amount of these risks and their probability of happening in order to quantify the discount and ultimately arrive at a final purchase price.

The uncertainties of loan enforcement are numerous and include the following risks:

• delays or failure in effectuating the assignment of rents or obtaining a receiver;
• delays or failure in completing foreclosure;
• purchase of the property by a junior creditor or assignee of the borrower by statutory redemption;
• limitations on recovery from guarantor(s) due to any number of factors, including the guarantors’ shrinking assets and other liabilities;
• lender liability claims;
• and delays or losses in recovery due to borrower’s bankruptcy.

Seek guidance from professional advisors (i.e., loan work out specialists, appraisers, accountants and attorneys) who can assist with determining these risks and assigning a probability to each.

Conclusion
Real estate investors can play the loan-to-own game and likely achieve a return of their investment if they become properly educated about and carefully manage the associated legal risks.

Before pursuing a debt purchase transaction, develop and commit to following a set of best practices guidelines. These should be customized to address your specific risk-tolerance profile, take into account applicable state laws, customs and practices and be designed to help identify and minimize the unique risks presented by each debt purchase opportunity.

Mike Kelly is President, Caldera Asset Management. He can be reached at mkelly@calderaassetmanagement.com.

Pamela V. Rothenberg is a real estate attorney in the Washington, D.C., office of Womble Carlyle Sandridge & Rice. She leads the firm’s multifamily real estate industry team and is a member of the firm’s real estate solutions group. She can be reached at prothenberg@wcsr.com.

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