The US real estate distressed debt market is deeper and more established than its European counterpart. Michael Lester looks at the latest developments

On 11 September 2009, Corus Bank, based in Chicago, Illinois, went belly up, and its 11 branches closed their doors for the last time. The Federal Deposit Insurance Corporation (FDIC) was named receiver. No advance notice was given to the public, but to protect the depositors the FDIC entered into a purchase and assumption agreement with MB Financial Bank for about $3bn (€2.3bn) of the $7bn of Corus' assets, mostly cash and marketable securities. Depositors of Corus automatically became depositors of MB Financial, so they did not complain - much. But what happened to the non-performing loans and foreclosed properties the bank had on its books?

On 6 October 2009, the FDIC sold a 40% equity interest in Corus' performing and non-performing construction and real estate assets - with an unpaid balance of approximately $4.5bn - to Northwest Investments, a consortium managed by Starwood Capital Group. The FDIC still holds the remaining 60% equity interest.

"Our first distressed loan portfolio of this current downturn was the Corus deal," recalls Chris Graham, head of acquisitions for Starwood for the Eastern region of the US. "We put in about $225m cash and our partners, including TPG Capital, Perry Capital and WLR LeFrak, put in about $320m."

The portfolio consists of more than 100 loans backed by 8m sq.ft. of property and 102 properties, including 79 condominium buildings, 14 multi-family complexes, eight office buildings and one land development project. Properties are located in a number of markets, including Atlanta, Chicago, Los Angeles, Miami, New York and Washington DC.

Back in 2009, this transaction, valued at $2.8bn, was one of the largest acquisitions of distressed commercial real estate assets. But Corus was the 90th US bank to fail in 2009, and another 50 followed the same year. There were 157 bank failures in 2010 and more than 90 in 2011.

And the banks - especially the smaller, regional banks - still have plenty of non-performing loans they would like to unload.

The situation that led to the collapse of the real estate and financial markets in the US was complex but, to put it simply, lending standards were ignored and underwriting terms were loosened. By the time property values peaked in 2008, mortgage instruments had become ridiculously complex and non-transparent, and the speed of transactions had accelerated rapidly. Add to that the proliferation of easy-to-get adjustable-rate mortgages (at the heart of the sub-prime debacle) and, voila, you have a crisis.

According to Jeffrey Citrin, managing principal of Square Mile Capital Management, "close to $2trn in commercial real estate loans were originated during the four to five years before the peak. They will mature over the next few years and need to be resolved before the banking system has cleared."

The debt market climbed after the 2001 recession. The Federal Reserves Flow of Funds Account has calculated that commercial and multi-family outstanding mortgages rose to a peak of $3.4trn in mid-2008. According to a white paper, ‘The Case for Debt Investment', by the Rosen Consulting Group of Berkeley, California, this debt still exceeds $3trn, most of it held by private institutions. In December 2010, banks accounted for the largest share of total holdings - about 42%; other private holders, such as life insurance companies, accounted for 10%, and savings institutions held 6%. However, the mortgage holders are changing, as opportunistic real estate funds are buying up this distressed debt from the banks.

The riskiest mortgages, according to Andrea Lepcio, co-author of the white paper, have been construction and development loans. By property type, according to Real Capital Analytics, multi-family and office lead distressed assets; industrial properties have the lowest delinquency rate.

Enter the grave-dancers
The biggest buyers in the distressed debt marketplace include Blackstone Group, Colony Capital, Lone Star, Oaktree, Square Mile Capital and Starwood Capital.
Blackstone, based in New York and London, is a notoriously tight-lipped opportunity fund. Its Blackstone Real Estate Special Situations II recently raised $2.2bn.

Colony, based in Los Angeles, California, is the third-largest private equity real estate fund in the world (behind Blackstone and Morgan Stanley Real Estate). Since the spring of 2009, Colony has purchased seven portfolios of bank loans that were taken over by the FDIC. "For the most part, we are buying senior-level debt, so we are first in line," says Kevin Traenkle, a principal at the firm. "If you don't apply too much leverage, it is hard to get hurt."

Lone Star, a Dallas-based opportunity fund, actively bids on just about every deal of $100mn and more that it hears about. Perhaps its name should be changed to Loan Star. Its Lone Star Real Estate Fund II recently raised $5.5bn.

Oaktree, based in Los Angeles, California, has $29bn (38% of its total assets under management) dedicated to distressed debt strategies. About 37% of its clients are public pension funds.

Square Mile, based in New York, has raised more than $1.5bn in discretionary capital since the establishment of its first fund in 2006. Its institutional clients include public and private pension funds, university endowments, foundations and foreign investors.

Starwood, based in Greenwich, Connecticut, founded and took public Starwood Hotels & Resorts (one of the largest hotel companies in the world) and iStar Financial (a specialty finance company focused on real estate). It runs several opportunity funds with equity investments worth several billions of dollars. Its investors include pension funds, endowments and high-net-worth individuals.

"Over the last three years, Starwood has purchased loans from 17 different banks, including several very large portfolios of loans," says Graham. "We have purchased loan pools from six different banks, including the FDIC. Our investments ranged from $20m to $170m.

"We see the opportunity to buy an asset for $2m-3m today that was worth $5m three or four years ago," continues Graham. "It affords us the opportunity to make money over time, with very little chance of a downside. We are not borrowing any money to do these deals; we're buying them on an all-cash basis."

The George W Bush administration invested directly in banks rather than purchase real estate that was underwater. But the Obama administration is partnering with private firms to purchase toxic assets and distressed mortgages. As part of its Public Private Investment Program (PPIP), the US Treasury partnered at the end of 2009 with AllianceBernstein, Blackrock, Wellington Management, Invesco and TCW Group, matching the equity firms' investments dollar for dollar, as well as providing debt financing. All together, the participating private investment funds have more than $12bn purchasing power under the PPIP program.

The federal government also strong-armed ‘bulge bracket' banks (Bank of America, Barclays Capital, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, Merrill Lynch, Morgan Stanley, UBS and Wells Fargo) as well as regional banks to pool and unload their distressed real estate debt. "Bulge-bracket banks weren't as bad off but, like the regional banks, they also had a large percentage of their balance sheets in commercial real estate lending. That was the result of the run-up in value and people thinking that there was never going to be a downturn," recalls Graham. "Then the music stopped."

Therefore, the large banks, starting in 2009 and 2010, began to work out and dispose of their loans. By and large, they have now worked through most of their problems and are fairly rid of their distressed commercial real estate loans. "Many of them have received TARP money; they're healthier now; they can afford to sell," says Graham. "Some are still in trouble and they're selling to raise cash, but many of them are in decent shape and they're being encouraged to get rid of these problems and move forward."

In September 2011, Bank of America sold a commercial real estate loan portfolio worth nearly $1bn to a group of investors for $880m - a discount of 20-25% from face value. The discount applies across the board, even to non-distressed loans, an indication of the bank's inclination to unload some of its $44bn commercial real estate portfolio. The venture that acquired the portfolio comprised funds managed by Square Mile, Invesco and Canyon Capital Realty Advisors. It includes current and delinquent loans tied to 32 properties of various types, including warehouses, office properties and senior housing. Bank of America has declined to comment.

While the big banks have largely cut their losses and restored their balance sheets, "the weaker lending institutions, including local banks and the special servicers on behalf of CMBS trusts, continue to be active sellers," says Citrin of Square Mile, "and will likely be more active during the next couple of years."

And, of course, there is the European market. While distressed debt of commercial properties is largely resolved among the big banks in the US, the regional banks and Europe are ripe for plucking.

The Corus deal is typical of how the FDIC has handled bank foreclosures.
When a bank or similar lending institution fails, the FDIC receives some of its assets and liquidates them, on average, in about three to five years. The FDIC's asset pools are created by the Division of Resolutions and Receiverships, putting together the bank's outstanding loans and selling this bundle to the highest bidder. Not all of the loans are non-performing but these days, many of them, unfortunately, are.

An acquiring bank often purchases all the assets of the failed institution. Whatever it does not want is assumed by the FDIC receivership. The FDIC enters into transactions with acquiring banks where losses from the assets are shared, typically in an 80/20 split. The FDIC assumes the larger portion of any potential losses. According to Greg Hernandez, spokesman for the FDIC, this helps to keep the assets in the private sector.

In early 2008, the FDIC, drawing on its past success with joint ventures, turned to the partnership model to sell large numbers of distressed assets (primarily non-performing single-family and commercial real estate loans and related real property) held by recently failed financial institutions. Since then, the FDIC has entered into structured transactions with private sector investors using limited liability companies. As of August 2011, the FDIC had closed 28 structured transactions covering more than 40,300 assets and $24.5bn in unpaid principal balance.

As in the case with the Corus bankruptcy, the FDIC keeps an equity stake in the loans in the receivership - usually around 60%. The structured transactions allow the FDIC to retain an interest in the assets while transferring day-to-day management responsibility to private sector professionals who also have a financial interest in the assets and share in the costs and risks associated with ownership. "The private investors are responsible for servicing the loans and the assets, and so they try to make sure the loans perform well," Hernandez says.

The FDIC sold about 3,500 commercial real estate loans with a book value of more than $6bn in 2009; that compares with commercial real estate loans sales in 2008 of just $153m.

The role of pension funds
Pension funds are buying distressed debt actively but not directly. They are investing in an indirect basis through real estate private equity firms. "Many of our institutional investors are public and corporate pension plans," Says Citrin. "They get material exposure to this attractive and highly specialised sector through Square Mile and our brethren. We are unaware of pension funds buying distressed whole loans directly except occasionally as co-investors with their managers in discrete transactions."

"Even the best of the pension funds, because of the current economic downturn, have a problem or two in their real estate portfolios. But they are buying many of these distressed debts," agrees Graham of Starwood. "And they are profiting from them."

The big banks in the US have sold off most of their underperforming and non-performing loans. The regional banks in the US are in a similar lifecycle to the European banks; they ramped up their selling in early 2011, and that accelerated throughout the year and is likely to continue through 2012.

Regional banks, as a group, had a higher percentage of their loans in commercial real estate than the big banks. "A lot of these regional banks invest in smaller, non-institutional assets, like $3m downtown office buildings and small warehouses," says Graham. "Unfortunately for them, demand for those kinds of assets hasn't been as great as for the larger, institutional-quality properties in major markets. But the regulators have come in and encouraged them to sell."

The buyers, representing pension funds, endowments and high-net-worth individuals, have been hedge funds, opportunity funds, private equity funds and real estate investment trusts (REITs). Like Citrin of Square Mile, they believe that obtaining commercial real estate debt at a discount is "a superb risk-adjusted opportunity" as long as the purchase is "not just lower than the loan's face amount but lower than the intrinsic value of the underlying real estate."

"Of course," adds Graham of Starwood, "if you're looking at a portfolio of 50 loans, there will be some losers where it could be 10 or 20 years before these properties recover the value they had three or four years ago. We're not going to buy a portfolio full of that stuff. We want to buy properties that will become winners, if they're properly capitalised, over the next two to five years. We believe our average hold period will be two-and-a-half to three years."

Time, of course, will tell. Right now, however, the private equity funds and their pension fund clients believe that opportunities abound.