Managing risk in today’s volatile commercial real estate markets
Tuesday, July 20, 2010
The FDIC's Long Positions
Economics of FDIC's Structured Finance: Sale of Corus Loans Means Betting on the Recovery of Failed Condo Projects By James Sterngold and Jonathan Keehner - Jul 19, 2010 BLOOMBERG
Developer Norman Radow expected some thanks in April when he offered to repay a $35 million defaulted loan on a 32-story San Diego condominium project he had taken over, originally financed by failed Corus Bank. Instead, his new lender urged him to keep the money.
Even more striking to Radow was that the lender was a company majority-owned by the Federal Deposit Insurance Corp., an arm of the government swamped with bad debts, whose partners were private investors led by Starwood Capital Group LLC.
“They said they wanted to keep the principal outstanding longer because they had a zero-percent loan from the government, and it was worth more for them to keep our loan out,” said Radow, 52, chief executive officer of Radco Companies, an Atlanta-based distressed-property firm that has sold 85 percent of the 244 units in the Mark, overlooking San Diego’s Petco Park stadium. “The sooner you repay us, the worse it is for us.”
While Radow repaid the loan anyway, his experience shows how a new FDIC strategy for managing assets seized from failed banks has turned the agency into a long-term investor, making a multibillion-dollar bet on the recovery of some of the most distressed condominium markets in the country, from Miami to Las Vegas. Instead of selling the assets to maximize cash in hand, the agency is offering its private-sector partners zero-percent financing, management fees and new loans to complete construction of projects it can hold until markets recover.
Risk ‘Worth Taking’
While the strategy entails greater risk if real estate prices fall or don’t rise as much as hoped, agency officials say it offers a better chance to replenish their deposit insurance fund -- which was overdrawn by almost $21 billion as of the end of the first quarter -- than sales for cash. More than 260 banks have failed since 2007.
“While using LLCs to sell loans is not risk-free by any means, it is a calculated risk well worth taking,” said David Barr, a spokesman for the FDIC. “Alternatives would be either to hold the loans and work them out ourselves or sell them outright for cash, both of which have their own risks associated with them, as well.”
An LLC is a limited liability company. In the case of the Corus loans -- $4.5 billion in financing for 102 real estate developments across the U.S., including 79 condominium buildings -- the FDIC transferred the assets to an LLC in which it retained a 60 percent stake. It sold the remaining 40 percent to the Starwood-led group of private investors, offering it an interest-free loan for half of the purchase price.
‘Potentially Big Loss’
The financing inflated the price by as much as 20 percent, according to the agency’s own calculations. The FDIC then sold $1.38 billion of notes backed by the assets and carrying a government guarantee.
The FDIC is also offering as much as $1 billion in additional financing to provide working capital and complete projects.
“The private-equity investors definitely have an incentive to take on more risk while managing the loans,” said Steven Kaplan, a finance professor at the University of Chicago’s Booth School of Business. “It’s a well-structured deal because the FDIC averted a fire sale and retained some upside, but the leverage means managers would rather take a chance on a big gain -- and a potentially big loss.”
The Corus deal is one of 14 structured sales the agency has completed, covering $15.9 billion in assets, according to the FDIC. The agency said the value of its retained interests in the companies managing the assets is $7.2 billion.
Winners of other auctions include Lennar Corp., the third- largest U.S. homebuilder, and its distressed-investing unit Rialto Capital Management LLC. Private-equity firm Colony Capital LLC, headed by Thomas Barrack, has bought stakes in two structured sales, including an interest in a $1.85 billion portfolio of loans from 22 failed banks announced on July 14.
During the last banking crisis, from 1980 through 1994, the FDIC, thrift regulators and the Resolution Trust Corp. disposed of $924 billion in assets, according to FDIC publications. Only about $25 billion of that was through partnership arrangements.
This time the FDIC is holding on to billions of dollars of assets through such partnerships and offering its partners interest-free loans.
“What we’re trying to avoid is creating the kind of financial incentives that cause the liquidation of the portfolio at fire-sale prices, which could further depress already distressed markets,” the FDIC’s Barr said. “The structured transaction enables the FDIC’s managing partner to take a longer-term approach to the loans, allowing for an orderly workout period.”
‘Overhang of Inventory’
The strategy has made the FDIC and its partners the owners of thousands of condominiums in troubled markets.
“As a borrower, I had no complaints,” said Radow. “As a taxpayer, I had questions. This should be examined.”
Michael Lea, a visiting professor of finance and director of the Corky McMillin Center for Real Estate at San Diego State University, said the risk was worth taking.
“If you think the market is coming back, that prices now are unrealistically low, then this is the best wealth-maximizing strategy,” he said. “But it doesn’t clear the market or clear that overhang of inventory.”
That view was echoed by Robert Litan, vice president for research and policy at the Kansas City, Missouri-based Kauffman Foundation and a member of a presidential-congressional panel that assessed the RTC’s results. While the FDIC’s new approach carries greater risks for the deposit insurance fund, it is justified by economic circumstances, he said.
“What the RTC did is a good strategy after a shallow recession,” Litan said. “Now, with a more depressed market, the financial crisis and a fragile economy, there is a much greater risk of a snowball effect if the FDIC just unloads everything.”
The FDIC seized Corus, a unit of Chicago-based Corus Bankshares Inc., last September. In October it auctioned a stake in the bank’s real estate development loans to the Starwood-led group, which also includes New York hedge fund Perry Capital LLC, developer WLR LeFrak and private-equity firm TPG Capital.
Perry Capital is headed by former Goldman Sachs Group Inc. partner Richard Perry. WLR LeFrak is a joint venture of the real estate firm LeFrak Organization of New York and WL Ross & Co., which is run by billionaire Wilbur Ross.
The Starwood-led group bid about 20 percent more than its nearest competitor, people familiar with the matter said, offering $554.4 million in cash for its stake. The bid valued the assets at $2.77 billion, or about 60 percent of the loans’ face value.
‘Asymmetric Risk Profile’
Barry Sternlicht, chairman and CEO of Greenwich, Connecticut-based Starwood, told potential investors on a conference call in February that it’s “very hard to lose money on a transaction like that.”
He said on the call that prices had to drop 40 percent from their already depressed levels for the partnership to lose. Starwood paid $123 a square foot for buildings that cost almost $400 a square foot to build, Sternlicht said.
“That’s the kind of asymmetric risk profile you love in a deal,” he said on the call, a transcript of which was obtained by Bloomberg News.
The FDIC also provided a management fee of 1 percent of outstanding debt, about $45 million in the first year, plus as much as $1 billion in additional loans to complete projects, prepare them for market and cover other costs.
The structure of the deal “is very, very smart,” said Wade Hundley, 44, CEO of ST Residential LLC, which was created by the private investors to manage the portfolio. “We’re not making decisions based on the financing because it’s zero percent. No one has a gun at our heads. This allows us to avoid fire sales, which would drive down the market for everybody.”
Hundley said ST Residential has so far modified 14 loans, easing the terms for borrowers, and foreclosed on 30. It expects to seize 50 of the projects, he said. In Atlanta, the seven buildings the company owns, with more than 1,300 condo units, are being kept off the market until prices stabilize, he said.
While Hundley declined to comment on Radow’s experience, he acknowledged that there have been a “very few” instances in which borrowers were asked to stretch out payments.
“It’s not always bad to stretch out the repayment when you’re working with zero-percent financing,” he said.
Some projects are worth so little relative to their loan balances that the developers have handed over the properties. James Borders, CEO of Atlanta-based Novare Group, which had loans for condominium buildings in Atlanta and Tampa, has consented to foreclosures and is now on contract to manage the assets for ST Residential, he said.
South Beach Condos
Two developers fighting a foreclosure in Miami’s South Beach, Alessandro Ferretti and Piero Salussolia, say ST Residential could make more money by letting them finish their almost completed project rather than seize the property.
“The real problem is that they’re not in this like a lender,” said Thomas Lehman, a partner at Levine Kellogg Lehman Schneider & Grossman LLP in Miami who is representing the developers of the 202-unit Artecity project. “They’re in it to hold and sell the properties.”
Hundley said the loans were worth far more than the condominiums and that foreclosure was the only realistic option.
“These developers are all big boys,” he said. “They knew what they were doing when they invested in these properties.”
Steven Fifield, the developer of a 291-unit condominium project in Waikiki, Hawaii, who lost his property to ST Residential in a foreclosure, called the terms of the FDIC sale “a genius deal.”
“They can wait the market another year if they have to,” said Fifield, who is working for ST Residential to help market his development. “They’re guaranteed to make a profit. It’s just not sure how much.”