Starting Commercial Real Estate Note Buying Fund Business Model

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Distressed Funds Lining Up for Prime Assets
Investors wait for wave of properties and note packages to hit market
BY JULIE NAKASHIMA                                       erties, according to Lundin.                             created an even larger decline in values, which          lanche of distressed assets is barely a snowball.
CREJ Staff Writer                                            “We would be buying debt for things we               frankly has eaten all the way through in many               Louis Tomaselli, an executive vice president

                                                         wouldn’t mind owning,” Lundin said.                      cases the owner’s equity and is into the debt.”          with Voit Real Estate Services’ Commercial
             einforcing the entrepreneurial nature           She said LBG is concentrating on retail because         The fund is targeting assets in the $3 million to     Brokerage division, said he thinks there’s going to
             of the finance community, distressed        it’s the historic strength of the principals of the      $30 million range for properties in California, Ari-     be some inventory next year, but the majority op-
             asset funds have been on the rise since     company, which beside herself also includes              zona and Nevada. Sheward said the focus will be          portunity is going to be in buying note packages,
             the economy entered a downswing.            Doug Beiswenger and David Goldman.                       property types the company has done historically,        either from the Federal Deposit Insurance Corp.
                At least a couple of times a week,           According to Lundin, things are going to get         including industrial, low-rise office and medical        or lenders.
Scott D. Lamontagne, western director of the             “ugly” on the retail side.                               office.                                                     “I think there will be some hard assets available,
Special Assets Services division at Marcus &                 “People say it’s never going to come back, but          Turner’s fund is $100 million, which is quite a       but I don’t think it’s going to be as large an oppor-
Millichap Real Estate Investment Services,               it always does,” she said. “We believe you can get       bit smaller than some of the other funds targeting       tunity as many believe it will be,” Tomaselli said.
gets a request from a large owner or new fund that       these prime properties right now and not pay for         distressed assets. Sheward said Turner Opportu-             But if someone is willing to buy a pool that could
is looking for distressed assets.                        vacant space and then ride the market up.”               nity Fund will be supplemented with other funds          potentially have four different product types and
   “There’s a tremendous amount of demand right                                                                   and that the company has the ability to use lever-       multiple-state geographics, he said, that’s where
now,” Lamontagne, who also is regional manager           Keeping the Dogs — or Cats                               age, if there’s debt available.                          the opportunity is.
of Marcus & Millichap’s Encino headquarters,                While LBG’s fund is just getting under way,              “We plan to be very active participants in the ac-       “The FDIC can sell that entire portfolio and
said. “Unfortunately, there’s not a lot of distressed    Newport Beach-based Turner Development                   quisition of distressed loan portfolios or distressed    not have to deal with the one-offs, and the buyer
inventory to supply those funds.”                        Corp. recently closed its first fund. Sean Sheward,      properties, as much as we can acquire profitably         can create value through one-off sales.” Tomaselli
   He said the business models of yesteryear,            chief investment officer for the Turner Opportu-         and intelligently,” he said.                             said.
where you had a private or quasi-institutional           nity Fund I LP, said the fund is fully subscribed:          The loan portfolios it would be buying, especial-        Lamontagne seems to have no doubt more dis-
syndicator that was looking for hard assets, have        closed and ready to invest.                              ly portfolios of nonperforming or subperforming          tress is coming. He said Marcus & Millichap has
shifted in many cases to more of a vulture-fund             “We’re being patient but opportunistically look-      loans, are illiquid, messy and management-in-            158 REO properties listed on the market.
scenario where they’re syndicating the equity            ing for properties or, more likely in the near term,     tensive, so they fit well into an opportunity fund          “That number seems to be growing steadily,” he
sources that want distressed assets.                     distressed loan portfolios,” Sheward said.               construction, he observed. They also require high        said. “Less than 60 days ago we were at 100.”
   Lamontagne said the funds come in                        The fund’s investors are high-net-worth in-           returns.                                                    Moreover, Lamontagne said, there’s in excess
“two flavors”: Some, he said, are looking to ac-         dividual, with no institutions for the most part.           “We’re cognizant of that and prepared to jump         of $250 billion in commercial loans that will be roll-
quire good underlying real estate assets by way          That’s pretty much how Turner has capitalized            into that arena knowingly,” Sheward said.                ing over and coming to term over the next year.
of foreclosure,                                          its development projects, by creating single-asset          On the loan side, however, the company will              “We simply do not have the liquidity to replace
   “The other model is they’ll do an arbitrage play,     entities with high-net-worth private investors.          need to be more flexible because the portfolios          that,” he said. “The indications are that we will
where they’ll acquire a pool of notes at 40 or 50           Sheward said many of its stalwart investors           consist of varied collateral types.                      have a fairly lengthy return to liquidity in the
cents on the dollar, then turn around and sell the       have agreed to go into the new fund, in many cas-           “In addition to our focus on industrial, low-rise     capital markets, and I think what most of the
notes individually to other private investors,” he       es bringing in their friends or business associates.     office and medical, we’ll see some retail, some          funds that are raising capital right now believe is
said.                                                    But he said part of the evolution of the fund is that    hotels that failed, self-storage,” he said.              that because of that pressure in the capital mar-
   In one of the newer funds to be launched, Los         a year ago when Turner first spoke to potential             Sheward said it’s like buying a portfolio com-        kets, it’s going to force a lot of owners to hand the
Angeles-based LBG Realty Advisors is seeking             investors about the upcoming distress, many of           posed of both dogs and cats, when you’re focused         keys over.”
to raise $250 million for a high-yield real estate       them didn’t know what he was talking about.              on one type of animal.                                      Lundin notes that the amount of distressed
opportunity fund focusing on retail, debt and joint-        Now the discussion centers on how much dis-              “We’ll keep the dogs and find someone else to         property to hit the market on the retail side has
venture equity investments.                              tress there will be and the right time to jump back      buy the cats,” he said.                                  been just a trickle, unlike the gush on the land and
   According to Leslie Lundin, the newly formed          into the investment market.                                                                                       residential side. But she expects that to change as
company’s managing partner and president, LBG               “We have counseled our investors and our              Preparing for a Snowball or Avalanche?                   property owners run out of money.
primarily is focusing on existing California retail      investors have counseled back to us that patience           It can seem as though everyone is looking at             “At some point, the lenders just won’t be able
properties that are distressed in some way, such         is a virtue and one that we’ll be employing to the       distressed asset funds these days. Even Eliot            to extend any longer. There’ll be more pressure
as overleveraged ownership or loss of tenancy, in        best of our ability.                                     Spitzer, the ex-governor of New York and son of          to bear on them, and they’ll just have to move the
prime infill and primary and secondary markets.             He called this the first foray into the discretion-   a Manhattan real estate mogul, entertained the           assets,” she said.
   She said there are lots of properties to be had       ary fund world for Turner. Sheward said that 12 to       idea of starting a vulture fund to buy distressed           Sheward agreed, although he’s not sure when
at a significant discount to replacement cost that       18 months ago, the company recognized that the           real estate after being forced out of office by a        the wave will hit.
have lost tenants but are well-located.                  commercial real estate market would be entering          prostitution scandal.                                       “But we’re starting to see some signs of dis-
   “The only reason they’re so beat down is              a period of distress and started to put into motion         In July, Information Co. Inc., a business informa-    tressed properties trading hands, more notices
because we’re in this blip where tenants are drop-       an opportunity fund where it would have full dis-        tion provider based in Katonah, N.Y., released an        of default, more foreclosures and more portfolios
ping like flies,” Lundin said.                           cretion over the funds.                                  electronic database of 200 distressed asset funds        that are becoming available for sale,” he said. “All
   She said LBG plans to get its hands on these             “We expected at the time a significant decline        that invest in distressed and undervalued assets         of those factors leads us to believe we’re moving
properties either through direct acquisition or          in valuation and the opportunity to buy distressed       — up from 150 distressed asset funds in the data-        quickly toward a resolution and we ought to see
distressed debt purchase, buying debt with the           property from property owners whose loans ma-            base it released a year ago.                             some activity by the end of the year if not early
intention of potentially foreclosing. The com-           tured,” Sheward said. “But as it turned out, the            But while distressed funds continue to take           2010.”
pany also plans to buy distressed debt secured           combination of the capital markets dislocation           shape, one question that comes to mind is: Where
by retail, multifamily, office and industrial prop-      and weakness in real estate fundamentals have            are the distressed properties? The anticipated ava-         — E-mail


                                                        Hard Money Lenders Making It Easy
  BY CHARLES HERSHSON                                     to lend. The money is provided by pension                 � Conversely, if for some reason a loan isn’t           Banks got into trouble by over-leveraging the
                                                          funds, high-net-worth individuals and individual        possible, prospective borrowers can be told             values of the properties they were encumber-

              ith all the news about California’s cli-    retirement accounts. While some companies               immediately as there is no two- to three-month          ing. When the value of the property is less
              mate being bad for business it is easy      specialize in commercial real estate, there are         waiting period for the bank loan committee to           than the loan balance and the borrower can no
              to forget that the Golden State is the      independent mortgage companies that focus on            make a decision on whether to offer funding or          longer service the debt, defaults and foreclo-
  seventh largest economy in the world. Even fac-         the residential side of the market.                     reject an application.                                  sures are the natural result. It happened in the
  toring in Sacramento’s budget troubles and the                                                                                                                          subprime meltdown and soon the commercial
  stalled credit situation in the financial market,       Apples and Oranges                                      The Strategy                                            arena will be hit too.
  economic indicators are leaning more toward               Though both lend money, banks and inde-                  In order to execute this type of streamlined
  vibrant rather than dormant — particularly in           pendents differ in many aspects. These include          loan process, independents currently may limit          Secrets of Success
  commercial real estate.                                 the following:                                          the loan amount, derived from an equation                  The key to success in the lending business
     It is true that banks and traditional institu-         � Independents take a kinder and gentler              tied to the value on the property. The loan sum         is evaluating the property to be secured. While
  tional lenders have all but shut off the flow           approach, lending on the credibility of the real        amount figures to be roughly between 40 and             the mantra used to be “location, location, loca-
  of money to borrowers, regardless of their              estate and not solely on the credit-worthiness of       50 percent (at maximum) of the property’s               tion” and sales comparables, the independent’s,
  qualifications or credit rating. The independent        the borrower.                                           worth. This conservative approach has kept              or hard money mantra is “equity, equity, equity”
  mortgage companies, however, the hard money               � Independents require less paperwork                 this financially independent niche in business.         and income stream. Additionally, and perhaps
  lenders, are busier than ever closing deals.            which often allows the turnaround for funding a         It also limits exposure to investors in down
     Unlike the banks, independents have money            loan to happen in seven to 10 business days.            markets — like in today’s present environment.                                See HERSHSON, page 15

PAGE 14    SEPT. 8, 2009    CALIFORNIA REAL ESTATE JOURNAL                                                                                                                                   WWW.CAREALESTATEJOURNAL.COM

REICHWALD                                              that this revised ratio is the minimum and could
                                                       well be higher under selected circumstances, at
                                                       the FDIC’s discretion. A failure to maintain the
                                                                                                                that if only a transfer to an affiliate was involved,
                                                                                                                it would not unreasonably withhold approval.
                                                                                                                                                                         pressed concerns that the SOP would be applied
                                                                                                                                                                         in a highly subjective and uneven manner.
                                                                                                                                                                            At the instance of Director Dugan of the OCC,
Continued from page 1                                  required level of capital at the outset, or well-capi-   “Silo” Structures                                        the SOP contains a requirement that it be re-
                                                       talized status after three years, would trigger an          Complex structures in which the actual ben-           viewed by the Board within six months to judge
as the institution in question has maintained an       “undercapitalized” designation, thereby implicat-        eficial ownership and decision-making authority          its effectiveness and impact.
overall CAMEL rating of one or two continuously        ing the restrictions on operations contained in the      is difficult to determine and actual ownership              The day after the release of the SOP the FDIC
for seven years.                                       Federal Deposit Insurance Act.                           and control is separated will not be approved to         announced that its list of very-troubled banks
                                                                                                                acquire a failed institution under the SOP.              had increased to 416. At the same time, the CEO
Capital                                                Cross Support                                               In addition, the SOP contains limitations on          of BankUnited stated that over the next two
    While the FDIC retreated from its original            The original FDIC proposal included require-          transactions with affiliates, the application of         years some 1,000 banks will be lost. Notwith-
proposal that a failed institution acquired by         ments about cross support among commonly                 foreign secrecy laws and the disclosure of confi-        standing these very troubling numbers, the
private equity maintain a Tier 1 capital leverage      held companies, which caused a great deal of             dential information contained in any application.        Chair of the FDIC stated that the Board majority
ratio of 15 percent for three years and be deemed      negative comment. The FDIC has scaled that                                                                        felt that the SOP truly extends a significant and
to be well capitalized thereafter, the SOP adopts      back. Under the SOP, a cross-support obligation          FDIC Board Action                                        realistic invitation to private-equity to participate
a different requirement. The recapitalized bank        would only be required if the same investors own            The SOP was adopted by a 4-1 vote, with               in the necessary recapitalization of the banking
or thrift has to maintain a ratio of Tier 1 common     80 percent or more of two or more depository             the only negative vote coming from Director              industry in the United States. The private-equity
equity to total assets of at least 10 percent for      institutions. The SOP contemplates that the stock        Bowman of the OTS. He spoke against the SOP              community will have to decide if this invitation
a three-year period. The FDIC recognizes that          of these commonly held institutions would be             because he believes that far more flexibility on         comes with too many strings attached. �
this requirement may result in less-than-opti-         pledged to the FDIC, to be exercised to recoup           the part of the FDIC is required since, generally
mum pricing for the failed institution; however,       any losses incurred by the deposit insurance fund        speaking, the banking industry needs substantial
it reflects the FDIC’s choice to force private         in the event of the failure of the bank or thrift.       capital and private equity can be an important              Harold P. Reichwald is co-chair of the Banking
                                                                                                                                                                            and Specialty Finance Practice Group at law
equity to manage the institution for long-term                                                                  source of that capital. Bowman suggested that
                                                                                                                                                                            firm Manatt, Phelps & Phillips LLP. Reprinted
prudential growth, not short-term profitability.       Continuity of Ownership                                  all potential bidders should be treated equally,            with permission from the Manatt Banking Law
Thereafter, the institution would have to maintain       The FDIC kept the three-year ownership                 even though private equity presents a different             newsletter.
a “well-capitalized” status. It is important to note   requirement of the original proposal but added           risk profile from other potential acquirers. He ex-

  HERSHSON                                              retirement income funds greatly diminish are
                                                        now looking to real estate to recoup and rebuild
                                                        wealth. It is certainly a good time for it.
                                                                                                                “blood on the streets” in the residential lending
                                                                                                                area because of the overly aggressive refinanc-
                                                                                                                ing frenzy in single-family homes. Nostradamus I
                                                                                                                                                                        continue to grow and prosper.
                                                                                                                                                                          The media need to take a wider look at the
                                                                                                                                                                        lending industry. There’s a lot of good news to
  Continued from page 14                                   This adage still holds true: Money is made           am not, but I and many other professionals in my        share. �
                                                        in real estate on the purchase, not on the sale.        field can read the economic signs. And let me
  more importantly, determining whether or not          With independent lenders still lending and              tell you a little secret: I am not optimistic about
  a debt can be serviced in a down market is a          sellers often willing to give a loan in second          the immediate future.                                     Charles Hershson is founder
  major factor in the decision-making process.          position to help close the sale, opportunities are         I do not think we will have stability in the           and president of Southern
                                                                                                                                                                          California-based Fidelity
                                                        out there for the knowledgeable investor.               commercial market until the last quarter of
                                                                                                                                                                          Mortgage Lenders Inc., which
  Real Estate, Not Stocks                                                                                       2010. In the meantime, banks will be forced               has been funding real estate
    Investors who have pulled out of the stock          Uglier Before Better                                    to change their traditional business models               loans since 1971.
  market and have seen their portfolios and               Two years ago I predicted there would be              and independent mortgage lenders will

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