Distressed Real Estate Acquisitions: Mitigating the Risks
A recent report in the WSJ details the FDIC's efforts to sell off real-estate loans acquired from failed banks. This describes on a larger scale transactions which have become quite common in the Southeast as community banks and regional lenders unload unwanted assets.
In fact, most CRE trading today involves distressed assets-either REO properties or note sales. This trend will likely grow in 2010 as more lenders work through problem assets. These transactions create opportunities for investors as properties trade at a fraction of the prices seen at peak levels, oftentimes at discounts up to 40 or even 60%.
But these opportunities come with increased legal risks. Because of the fire-sale prices, the sellers are demanding (and receiving) quick closings with very short due-diligence periods and few if any representations or warranties which survive closing. As a result, buyers should take several steps to mitigate the increased risks:
- First, insist on certain basic reps and warranties: disclosure of borrower defaults, loan balances, and at the most basic level, that the seller owns the note and has the authority to sell. (See this Bryan Cave report for more detail on seller reps in a note sale.)
- Second, be prepared to move quickly on due diligence. Buyers should make best efforts to perform the same level of due diligence as in a non-distressed transaction. One potential advantage is access to the lender's due diligence files. Insist on this access as early as possible. But do not agree to a due diligence period that is unrealistically short.
- Third, due to the distressed nature of the asset, pay particular attention to the possibility of past-due taxes and utility bills. These liabilities will become the responsibility of the buyer after closing.
- Fourth, review the lender's documents and files critically. The stress in RE markets is revealing that many lenders were often sloppy in their underwriting and due diligence. Do not assume that the documents are correct, enforceable, or free of defect. Also, look for correspondence or documentation that could allow the borrower to claim that the loan terms have been modified.
From the seller's perspective, the timing with oftentimes be the primary motivation. The lenders will generally want non-performing assets off the books by the end of a month or fiscal quarter. In exchange for meeting these deadlines, a seller may make other concessions.
Buyers with an understanding of the increased risks, along with the ability to mitigate these risks and close quickly, will find incredible opportunities to profit from the current downturn in CRE.
