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Troubled residential real estate loans have received a great deal of media exposure, and now banks and the government are recognizing that commercial real estate loans are a serious cause of concern for the continued viability of banks. Credit problems resulting from commercial real estate have been escalating. There is roughly $3.5 trillion in commercial real estate loans held by banks, commercial mortgage-backed securities (CMBS), or other institutions in the United States. More than $2 trillion in loans are maturing by 2013. However, the combination of tightened underwriting standards for new loans and falling real estate values will result in many property owners not qualifying for re-financing. This will lead to many owners looking to sell, resulting in substantial supply of available properties in the market and a further decrease in property values.

According to the Federal Reserve, banks hold $1.8 trillion of the $3.5 trillion in loans. In the first quarter of 2007, 1.4 percent of these loans were delinquent. More than 2 years later, that figure is approaching 8 percent and rising. These delinquencies are causing bankers to be overwhelmed with a myriad of issues and a wave of foreclosures, which has contributed to the dramatic increase in bank failures this year. As a result of these rising problems, banks are focusing on analyzing the performance of their existing loan portfolios. In many cases, banks are deciding that disposing of unproductive assets is their best option for reducing risk and stabilizing capital. These “real estate owned” or REO assets can be complicated to manage and sell. Many banks’ special assets groups are working at capacity and are not equipped to manage and process the loans and associated properties in their pipelines.

Banks with a portfolio of distressed assets should consider the following guidelines when working with an outside firm to manage the commercial REO disposition process.

Prior experience with distressed assets matters greatly. It is important to partner with a broker that can foresee and handle the complex issues that can slow or kill a transaction (bankruptcy, property deterioration, remaining M&M liens and other title issues). Understanding a bank’s regulatory situation and options is crucial, as is being attuned to the bank’s strategy and goals regarding REO assets. Familiarity with various disposition strategies and an understanding of which to use for a particular asset can maximize the asset’s sale price.

Advisory role
To mitigate exposure, banks need to partner with a group that understands both real estate fundamentals and the current economy. This partner should also be willing to offer frank opinions on individual assets. For instance, would it benefit the bank to reposition the asset prior to marketing it for sale? Should the bank complete any outstanding construction, or market the property in its current state? Work with a broker who approaches clients in an advisory role — giving feedback that others withhold, setting realistic expectations, hosting an open dialogue — rather than brokers who purely focus on the individual transaction.

Sell, sell, sell
Some banks have decided to hold on to REO assets and wait for the market to return to previous pricing levels. This thinking is flawed, since real estate values are based purely on supply/demand and assessment of risk. The recent decrease in values is expected to continue during the next few years. Furthermore, vacant improved properties can carry additional costs, liabilities and time commitments to banks due to deterioration of the improvements from age, weather, vandalism, etc.

Optimal pricing
It is imperative that banks avoid pricing errors and effectively market their REO assets. Property values and the number of completed transactions are declining across all property types. Once a bank decides to sell an REO property, the property should be marketed with a sale price reflective of local market conditions. Banks need a broker that understands how to accurately price property in the current environment. Many REO assets have asking prices of more than the current market value. Oftentimes, the price is determined by the outstanding loan balance or an appraisal using dated market value indicators. This can significantly increase the amount of time a property sits on the market and on the bank’s books.

Banks are being besieged by aggressive buyers who sometimes negatively exaggerate an asset’s value. The bank’s best interests in the outcome of the disposition should be protected; that sometimes means not selling an REO asset to the first buyer that comes along. The bank’s broker needs to have the market knowledge to counter such arguments and quickly expose the asset to a wide array of prospective buyers.

Missing documents
With REO properties, it is common for the bank’s detailed knowledge of the property and its history to be sparse. This sometimes includes missing documents that are important to provide additional background on the property and are factors in determining the property’s current value. Items such as leases, construction plans and entitlement approvals need to be scrutinized prior to marketing an REO property.

Banks can reduce their risk by aligning themselves with the right partner and following these guidelines. These rules will help banks work through the difficulties of managing and disposing of REO in this economic environment.

— Maury Bronstein, director, and Randall Tuller, principal, work in The Situs Companies' Houston office.

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