NYT: Loans on Distressed Properties Become a Burden and an Opportunity

By JULIE SATOW
Published: December 23, 2008

When the New York developer Harry B. Macklowe acquired the Drake Hotel almost three years ago and began buying up surrounding properties, market specialists expected him to include the site in a mammoth luxury office development.

Robert L. Freedman’s firm in Manhattan is forming a group to handle loan sales. “We are expecting a flurry of deals,” he said.

After the downturn in credit markets, however, Mr. Macklowe defaulted on his loans, and bidders are now vying for the Park Avenue site at fire-sale prices.

But the Drake site is not for sale directly. What is available is a $200 million mortgage for the swath of land, which covers a third of a city block between Park and Madison Avenues and 56th and 57th Streets. The buyer of this note will own a majority of the most senior piece of the debt, and so will most likely be paid back first should Mr. Macklowe have enough funds. If he defaults, the owner of the note will be in the best position to take ownership of the underlying property through a foreclosure.

This deal highlights a shift in the commercial real estate market, away from brick-and-mortar properties and toward the buying and selling of debt. “We are expecting a flurry of deals like the Drake Hotel site, where it is the loan that is for sale, not the actual real estate,” said Robert L. Freedman, the executive chairman of Williams Real Estate, a New York firm. The company is now creating a distressed-property group to handle such transactions.

During the real estate boom of recent years, developers increasingly used debt to finance their acquisitions. Now, with the market cooling, some of these borrowers are beginning to default. This is leaving lenders — including banks, private equity firms and hedge funds — in the position of owning the real estate.

Many lenders are looking to offload these loans because they need to cash out quickly, or because they are not in the business of selling real estate and lack the necessary resources and expertise. This means that commercial brokers, who regularly negotiated the acquisition and sale of properties, are now marketing mortgages and other loans.

“I am being inundated with calls from banks who want to sell their loans,” said David Schechtman, a senior director at the commercial brokerage firm Eastern Consolidated. “In just the last few weeks, I have also collected a list of about 30 clients — primarily high-net-worth individuals, long-established real estate families and small opportunity funds — who want to buy up these loans.”

As the market tumbles, the delinquency rate for bonds backed by commercial properties has surged. It measured 0.71 percent as of Dec. 5, compared with 0.26 percent a year earlier, according to the research firm Trepp L.L.C. While the actual number of defaults is still quite low, it is expected to increase.

“Loans don’t typically go into default immediately when there is a downturn in the market,” said Robert Knakal, the chairman of the brokerage firm Massey Knakal. “In the beginning, owners continue to make payments on their loans, hoping things will turn around, or if the loan is relatively new, it may have a significant interest reserve that is still carrying the note. So defaults on mortgages are a lagging indicator of market conditions.”

Despite this delay, there are early indications of an increase in loan sales. “Clearly, there has been a pickup in sales volume,” said David F. Dorros, a managing director at CB Richard Ellis.

To handle this uptick, brokerage firms like Eastern Consolidated are expanding their distressed-debt teams. Some firms are also requiring that their real estate brokers get broker-dealer licenses, which allows them to sell financial instruments.

Cash-rich developers and wealthy individuals are maneuvering to take advantage of the shift. Some are buying performing loans, where the borrower is continuing to pay interest on the debt. In this case, the buyer acquires the loan at a discount, but continues to receive interest payments. Then, when the loan comes due, the buyer is paid back the full face value.

Others are snatching up nonperforming loans, where the borrower has defaulted on the payments. In this case, patient buyers, including developers and private equity firms, may acquire the debt at a discount and eventually take ownership of the underlying real estate — usually after court action.

This is the strategy that the New York developer Time Equities Inc. is pursuing. “Rather than buying properties from conventional owners, we are looking to buy discounted debt on nonperforming properties,” said Francis J. Greenburger, the founder of the firm.

Time Equities is establishing a joint venture with the KOR Companies of Jersey City to buy nonperforming loans on land in the New York area, with an emphasis on New Jersey. It hopes to take ownership of the vacant sites at a discount, and develop them.

While there is a noticeable increase in this type of vulture investing, the buying and selling of commercial real estate loans is not a new strategy. CB Richard Ellis, for example, began a national loan sale advisory group five years ago.

“The business has become more visible now, but lenders have always understood it as a viable option to proactively manage their loan portfolios,” Mr. Dorros said.

In the current environment, however, the volume and complexity of deals are expected to be much greater than in the past because so many of the loans were grouped together and converted into bonds.

“The cash bind that many lenders are in is much more acute today than in the early 1990s,” when the previous major downturn in commercial real estate occurred, Mr. Knakal said.

As the market grows accustomed to the sale of loans, many eyes will be trained on the Drake Hotel site.

“It will set a floor price, establishing new benchmark metrics for the new economic realities,” Mr. Freedman said. “The Drake is just the tip of the iceberg; stay tuned, there is more to come.”

Copyright 2008 The New York Times Company. All rights reserved.