From 'Stop Loss' to 'Start Recovery':
For banks to maximize value on foreclosed properties, they need to think and act more like owners.
by Patrick Vedra, for Banking Strategies (bai.org) July 1, 2010
Bankers may be their own worst enemies when it comes to maximizing return on non-performing real estate developments and real-estate-owned (REO) or foreclosed properties.
Why? Because the key to REO success is thinking like an owner, not like a lender. Lenders usually are focused on monetizing a property’s current value; owners look for ways to enhance value.
Changing your mindset from lender to owner may be challenging, but doing so can help increase an REO development’s value by 20% or more, based on our experience on numerous projects. The shift from a “stop loss” to a “start recovery” strategy involves four basic steps: take charge of the property immediately to begin managing it; collect as much information about the property as soon as you can; make changes necessary to adapt the property to current market conditions; and uncover “hidden obligations” of the previous owner.
Taking these four steps will go far toward maximizing the bank’s eventual recovery on the foreclosed property.
Building Goodwill
Lenders are trained to take a financial approach to REO. That means the focus is on reducing holding costs and recouping as much as possible of the bank’s outstanding loan by quickly selling the non-performing real estate development at liquidation value. Such a stop-loss perspective overlooks a critical fact: the value of an REO property today is considerably lower than it could be if the bank actively tried to maximize the property’s value.
The first step toward thinking more like an owner than a lender is moving quickly to reduce risk and build goodwill with the relevant stakeholders. Waiting even a week to take charge of a non-performing real estate development can exponentially increase losses, risk and liability.
Consider that partially completed developments usually include open trenches, building materials lying about, unfinished buildings and the like – which are irresistible to children and potentially dangerous to everyone. The few weeks you take getting ready to take charge of the property can easily be the same few weeks during which injuries occur, generating lawsuits, expensive liability and bad press.
In addition, foreclosed developments often spark widespread anger among residents, city officials and others. Residents may be upset about the developer’s unfulfilled promises, deferred maintenance and dangerous conditions. City officials may be seeking missing taxes and vendors and contractors want to be paid for services already rendered. The longer you delay, the greater their irritation and the more difficult it will be to work with these stakeholders in the future.
First, send a letter to all stakeholders notifying them that you own the property and that you will move quickly to remove hazards. Then ask for a few weeks in which to get organized. In our experience, this approach will buy you time and foster goodwill that will be essential later.
In one incident known to us, a lender that foreclosed on a Texas subdivision waited several weeks to begin managing the property. Unfinished buildings that were exposed to the weather deteriorated further. Homeowners fired off hundreds of angry emails every day. Builders clamored for approval to proceed. The asset manager was forced into doing damage control for a property about which he knew nothing, instead of focusing on remedying dangerous conditions or enhancing the property’s value.
The second major step is to gather information. Ignorance is extremely costly when managing a non-performing real estate development. Yet many asset managers who become reluctant owners initially have very limited information about the property.
Acting like an owner means conducting a thorough due diligence process to fill in the blanks. Try starting with the property’s most recent appraisal, focusing mostly on sections that describe the physical property and include maps, photos and the like. The appraised value is arbitrary at this point.
Creating your own version of a “buyer’s checklist” may also be helpful. By detailing what you already know and need to find out, people to meet and sources to explore, a checklist can help keep your due diligence on track and ensure that you don’t overlook any important steps.
Amazingly enough, former owners may also provide valuable information. Many are forthcoming about the development, consultants and important stakeholder relationships. Often, former owners willingly provide plans, plats, regulations, third-party agreements and other ideas.
Think of due diligence as meeting two valuable objectives. One is helping you understand the parameters of the property so you can manage it effectively. The second is increasing the property’s value. The more complete the information you can offer potential buyers, the higher the property’s sales price.
‘Hidden’ Obligations
The entitlements vested in a property (i.e., zoning and/or land use rights) are fundamental to its value – or lack thereof. So it is critical to identify entitlements during your due diligence search. Then you can begin to protect or renegotiate them to enhance the development’s value. As an owner, your goal should be to maximize flexibility so a potential buyer has options to develop the property for the greatest return.
For example, a group of lenders recently took possession of a parcel that was originally zoned for over 15,000 condos and homes. But changing market conditions cast doubt on the value of so much new inventory. We approached city officials on behalf of the lender group and suggested building only 9,000 homes plus retail spaces; the city eagerly accepted. In this case, the lower density reduces infrastructure as well as demand for city services by a factor several times greater than the loss in units. As an added benefit, the retail properties will generate sales taxes.
This is one area in which the goodwill you establish when you take possession of a property can make all the difference. Local government officials may be more inclined to cooperate with lenders whom they perceive as concerned for a development’s long-term impact. Demonstrating your intention to be a good steward for the property and compromising to meet the city’s objectives – such as lower density or an environmentally-friendly development plan – can help you obtain the flexibility you need to increase the development’s value and its appeal to buyers.
One aspect you need to pay attention to are “hidden obligations.” Do you know if you’re responsible for constructing offsite infrastructure to serve your development and others? For example, must you build fire stations to protect thousands of acres of empty desert? Do you have to create a special utility district to get reimbursed for public infrastructure you build?
It’s possible. Property owners often enter into complex multi-party agreements with owners of adjacent developments and/or local governments. While you may be two or even three parties removed from the original agreements, you still “own” their obligations. Unfortunately, these agreements may not be obvious even though they affect a property’s value. So it is important to actively investigate any obligations that affect your property and flag them for potential buyers.
Some of these obligations are officially recorded and former owners, engineers and consultants familiar with the property often have copies. But managing their impact on a property’s value is sometimes more challenging.
For example, we are currently working with a bank that has become the owner of a large development in the southeastern United States. The original developer had executed an agreement with 17 nearby developers and the county to expand a small county road into a regional road. As the development’s new owner, the bank is now obligated to meet the original developer’s responsibilities. But no work ever began and several of the other developers are now bankrupt.
Now what? The bank must negotiate a new multi-party agreement that starts from square one. The process will be exhausting but it is essential because an owner’s job is to eliminate uncertainty for potential buyers. Until this issue is resolved, prospective buyers will exact a steep discount to invest an unknown amount of time in the road project and accept associated risks. A bank owner that eliminates the unknown undoubtedly increases the value of its REO property.
Maximizing return on REO properties may seem especially challenging today, with financial institutions reluctantly owning an unprecedented number of non-performing real estate assets amidst sluggish real estate markets. But you’re better off switching your lender’s hat for an owner’s hardhat. Give up on immediately monetizing a property’s value and maximize it instead.
The sooner you start thinking and acting like an owner who is determined to increase the value of a property, the closer you will be to earning more on your REO properties.
Mr. Vedra is managing director of Dallas-based Carwin Advisors, a real estate restructuring and turnaround firm. He can be reached at patrick.vedra@carwinadvisors.com.