Private equity firms are increasingly acquiring lender-owned properties through small transactions that the public doesn’t always see. These under-the-radar sales allow owners of distressed properties to stay on after buyouts and continue to manage assets.
These so-called “white knight” deals, in which private equity firms find troubled loans and negotiate discounted payoffs on behalf of the borrowers with banks or special servicers are done quietly because note sales don’t garner the same attention that equity sales do. Moreover, in some cases there is not always a transfer of title that takes place.
Most commercial real estate investors prefer to acquire real estate assets outright instead of acquiring a real estate loan, says Sandy Monaghan, managing director of Cushman & Wakefield’s New York capital markets group and national practice leader of their resolution group. However, given the low amount of REO assets for sale so far in this cycle, he says, many investors have either purchased non-performing loans as a means of eventually owning the real estate outright or have elected to recapitalize existing borrowers to deploy capital.
Another reason these deals remain hidden is because distressed commercial properties tend to be smaller and more geographically dispersed than is typically appropriate for institutional investors according to Dr. Sam Chandan, president and chief economist of Chandan Economics, a commercial real estate and economic analysis firm, and an adjunct professor at the Wharton School of the University of Pennsylvania.
“Even large banks disposing of visible assets are not at liberty to divulge confidential details of the transaction,” Chandan says. “But in these cases, information comes to the market through other channels.”
How the deals work
Here’s how the transactions work: Say a property fetched $40 million at the peak of the market and was leveraged with $25 million in debt. Today, that same property may be worth just $20 million and the borrower is underwater and may have defaulted. Banks are faced with two options: they can sell the property at a loss or they can work out a deal with a new investor that includes new financing. The “white knight” in this case, may come along, pay $20 million in cash for the property and then put a new loan on it for $13 million, bringing new money to the table. This strategy, in effect, limits the loss a bank would take by selling the property on the market.
“The borrower says, ‘If you foreclose on me, you’d have to take title, and if you sold it, in fact after net of transaction costs, etc., you’d only receive $19 million,’” explains Russ Appel, co-founding principal of The Praedium Group LLC, a New York-based national real estate investment firm. Instead, the old loan is retired and the bank gets cash. For its part, Praedium is active in such deals and sees it as part of the market’s overall recovery. “This is a consistent place where people are recapitalizing assets that are under the radar screen and is something that will help the market.”
In addition, the sales leave assets in the hands of more capable operators than if the lender took direct control. And, in many cases, the deals keep a spot at the table for the former owners.
In those cases, the investor works with the borrower by offering terms or a discounted payoff so that the borrower can pay off the property at a rate that’s less than what’s outstanding but higher than what the investor paid for the note. “Usually the highest value is with the guy who has [the property] because he wants to keep his real estate or he doesn’t want to blemish his credit report,” says George E. Mozer, principal of George Smith Partners Inc. in Los Angeles.
George Smith Partners has worked on dozens of such transactions in the past few years, and has closed on eight to 10 of them within the past six months. He says dealing with existing management avoids the friction of costs and the difficulty of working with a “big institution that’s just a financial engineer;” instead, involving the borrower can be an asset.
There is some downside risk in the current commercial real estate market however, Monaghan says, due to a large amount of capital waiting to buy a relatively low supply of REO and loan assets. This supply/demand imbalance could cause asset values to get bid up beyond levels that are supported by the market fundamentals of occupancy and rental growth. Market fundamentals continue to lag in most markets. However, with 10-year Treasury rates currently around 2% and with the recent stock market volatility, commercial real estate represents an opportunity for many investors to gain higher yields, he says.
Experts agree that the trend will continue, but how long remains unclear.
Appel says he noticed the trend developing this year as banks became better positioned financially to complete these transactions, and expects such deals to be a consistent part of deal flow for the next five years. “In 2008 and 2009, [the banks] were so distracted with their homebuilding portfolios, they just didn’t have the processes in place,” he says. “Now they know how to do it, they can do it. They’re working with borrowers. They’re trying to find solutions.”
Spencer Levy, executive managing director for CB Richard Ellis in New York, also believes that the distressed market should stay active due to the large number of rollovers and extensions that occurred for banks and special servicers. Loans that were originally slated to come due in 2009 and 2010 were extended, but now the new expirations will begin hitting in 2012 and 2013.
Also, Levy notes, some of the most distressed deals are contained in banks that otherwise might have failed and were purchased as law share agreements insured by the FDIC, which won’t trade for another three years. “You’re going to see pretty significant volume then,” he says. “There’s going to be a steady stream of volume of deals where private equity firms work with distressed borrowers.”