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REO Properties: Legal Strategies for Lenders and Purchasers

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e de s a d u c ase sEvaluating Business Options and Minimizing

Legal Risks With Bank-Owned Real EstateA Live 90-Minute Teleconference/Webinar with Interactive Q&A

Today's panel features:Don Neff, President, La Jolla Pacific, Ltd., Irvine, Calif.

Ren R. Hayhurst, Partner, Bryan Cave, Irvine, Calif.Brian D Ruben Partner Deloitte & Touche Chicago

A Live 90-Minute Teleconference/Webinar with Interactive Q&A

Brian D. Ruben, Partner, Deloitte & Touche, Chicago

Wednesday, June 2, 2010

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REO Properties: Legal St t i f L d & Strategies for Lenders &

Purchasers

Don Neff, CEO/PresidentL J ll P ifi LtdLa Jolla Pacific, Ltd.

Topic Overview…

• Banks: who & what?• Regulatory Framework• Banks’ REO Challenges• Disposition Strategies• REO Asset Categories & Risks• PCARs & Due Diligence• Repositioning to Add Valuep g

5

Banks: Who & What?

• Who are the banks?R i l C it B k- Regional Community Banks

- Have become active through FDIC cost sharing

- Money Center Banks - Appear to becoming active with in-house REO teams- IndyMac, US Bank, Wells/Wachovia, BofA

• What is the bank acquiring? - Product type- Location- Stage of completion

Condition6

- Condition

Banks’ Regulatory Environment

• Regulatory frameworkEstimated 515 Regional Community Banks on “Watch List”- Estimated 515 Regional Community Banks on Watch List

- If less than 2% Capital Structure, likely to be taken over in 30 days- Assets then marketed to healthy banks through bid process

FDIC/Healthy Bank 80/20 cost sharing split on loan losses- FDIC/Healthy Bank 80/20 cost sharing split on loan losses• Distressed loans become Non-performing Assets• Non-performing Assets lead to either adversarial

foreclosure action or friendly “deed in lieu” of foreclosure• Shift from borrower to bank into single purpose LLCs per

property (Once FDIC approval is received)p ope ty (O ce C app o a s ece ed)• Bankruptcy of borrower slows foreclosure process

- In Nevada, bankruptcies increased 58.6% from 2008 to 2009Use of Co rt Recei er limits risk of CDL to bank

7

• Use of Court Receiver limits risk of CDL to bank

Banks’ REO Challenges

• Banks are not set up to handle real estate• Do not fully understand construction risks, liability,

insurance, and customer service/warranty bli tiobligations

• Distressed assets either get “worked out” or folded into REO portfoliointo REO portfolio

• Banks must perform proper due diligence and figure out what they have acquired in order tofigure out what they have acquired in order to determine best disposition strategy

• Three options to consider8

• Three options to consider…

Three Disposition Strategies

• Preserve and hold assetM tl f ibl f l d bl t d l t fi i h d l t- Mostly feasible for raw land, blue-topped lots, or finished lots

- Avoids potential risk and maintenance issues with vertical construction

• Bulk sale to investors/builders- Perhaps most risk-averse strategy- Banks may struggle with heavy discounts (insolvency)Banks may struggle with heavy discounts (insolvency)

• Build out and retail to consumer- Able to minimize short-term financial losses- Potential risk/liability issues with construction defect litigation- Cost-benefit balance of capital needed vs. higher future returns- Discounted cash flow analysis: What is bank “hurdle rate”?

9

y

Example Bank Portfolio of REO Assets

• Single family developments25 h l t d bdi i i- 25 home completed subdivision

- “Broken” master planned community- 60 completed homes- 35 partially completed homes- 120 partially finished lots (with on-site infrastructure)- Off-site Infrastructure partially complete (eg, 1st lift of asphalt,

backbone power etc )backbone power, etc.)- Multiple banks involved (frustrated Asset Mgrs are “herding cats”)- Multiple HOAs, common areas partially complete (bonds exposed)

• Attached developments (3 4 story wood framed)• Attached developments (3-4 story, wood-framed)• Mid-rise/ high-rise projects (concrete/steel)

- 2 empty 20+ story condo towers (rental conversion?)10

- 2 empty 20+ story condo towers (rental conversion?)

Asset Type (Definitions)

• Raw land & paper lots A d t t ti t t li i l t- Approved tentative tract map or preliminary plat

• Blue-topped lots- Rough graded but with only basic infrastructure- Rough graded but with only basic infrastructure

• Finished lots- Water, sewer, storm drain, street improvements, power, , , p , p

• Partially completed homes- Foundations, framing complete, dried-in,

• Finished homes- Certificate of Occupancy, Notice of Substantial

Completion11

Completion

Master-Planned Community

13

Town Home/Condominium Project

16

High Rise Towers

17

REO Risks by Asset Category

Sample Residential REO Risks Paper LotsBlue Top Lots

Finished Lots

Partially Completed Homes

Finished Standing InventoryHomes Inventory

1 Entitlement expiration2 City/county fees3 Unforeseen soils issues4 Insufficient soils compaction4 Insufficient soils compaction5 Environmental violations (SWPPP's)6 Hazardous materials on‐site / illegal dumping7 Fall hazards / attractive nuisances8 Missing or damaged infrastructure9 Theft or vandalism9 Theft or vandalism10 HOA litigation11 Homeowner litigation12 Water intrusion / weather barriers13 Foundation deficiencies14 Structural framing deficiencies14 Structural framing deficiencies15 Structural deficiencies16 Inadquate MEP systems17 Acoustical deficiencies (attached product)18 Green washing19 Statute of limitations liability ‐ 10 year tail

18

9 Statute o tat o s ab ty 0 yea ta20 Deferred maintenance

Risk by Assembly (& Other Issues)

• Soils issues• Concrete foundations• Structural framing• Weather barriers• MEP (mechanical, electrical & plumbing)• Acoustical (for attached product)• Attractive nuisances (maintenance, trespass, etc.)( , p , )• Entitlement Issues (expiring permits, fees, etc.)• Title (liens, judgments, easements, etc.)

19

e ( e s, judg e s, ease e s, e c )

Property Condition Assessments

• “PCAR” Reports- Level A

- Used for all five asset types- Existing conditions analysis & photo records- Deferred maintenance & recommended repairsp

- Level B (Report A +)- Primarily used for partially finished lots, partially complete homes- Estimated costs to completep- Remaining lifecycle of components- Components include building interiors, exteriors & common areas

- Level C (Report B+)( p )- Used for large residential & commercial projects- ADA accessibility review- Life safety review- C of O & permits review

Code compliance review

20

- Code compliance review

Due Diligence Source Docs

• Project management files*• Purchase contract files• Field construction files*• Homeowner lot files• Customer service files• Warranty service files• Insurance certificates• Lead bank underwriting documents• Government (plans, permits, bond & fee ltr)

21

Go e e (p a s, pe s, bo d & ee )

“List of 50” Archive Docs (Examples)

• Project Mgmt Docs- A/E plans and calcs

Conditions of approval

• Field Construction docs- Gov’t inspection reports

QA/QC reports- Conditions of approval- Bldg permits- Geo-technical reports

- QA/QC reports- Homeowner walk-throughs- Superintendent daily logs

- Final compaction tests- Precise grading plans- Sequence lists

- SWPPP compliance - Material samples used- Structural reportsq

- Off-site/on-site contractsp

- RFIs/ASIs

22

Repositioning to Add Value

• Product Differentiation (think like car manufacturers)( )- USA: Cadillac vs. Chevrolet- Germany: Porsche vs. Volkswagon- Japan: Lexus vs. Toyota

• Repositioning Strategies Vary by Product & Lifecycle- Post Construction:

- For-Sale to Rental conversion- During Construction:

- Re-phase for new product mix & smaller releases- Re-bid all trade-scopes by phase- Reduce specification level & re-bid again

- Pre-Construction: - Value Engineer/Re-Design to simplify structures & wring out costs- Re-map for density &/or land use changes

23

p y g- Map extensions to preserve value

THANK YOU

Don [email protected]

REO Properties: Legal p gStrategies for Lenders and

PurchasersPurchasersRen Hayhurst (Irvine,CA)

949-223-7125; [email protected]

Overview of Note and REO Sales • Note Sales

– Acquire Debt, Not the Underlying AssetSeller is the Lender Not the Borrower/Debtor– Seller is the Lender, Not the Borrower/Debtor

– Subject to Defects in Documentation, Title, etc.– Must Complete Foreclosure Process Before Assuming Control

of the Propertyof the Property– Know Your Enforcement Options

• REO SalesT k Titl t th A t D l Di tl ith O– Take Title to the Asset; Deal Directly with Owner

– Must Wait for Remedies to be Completed– Uncertainty Pending Foreclosure

Note Sale Issues • Abundant Product Available

– Wave of Commercial Loans Maturity or In Default• Banks More Likely to Sell than Special Servicers

– Numerous Potential Purchasers

• Reasons for Lenders to Sell– Avoids time and expense of foreclosure– Avoids risk of being stuck with REO for lengthy period

Preferred Disposition Method for the FDIC– Preferred Disposition Method for the FDIC

Note Sale Issues (Part 2) • Reasons for Investors to Purchase

– Can Often Get Better Pricing on Note SalesC P id G t O ti B T f i O hi f E ti– Can Provide Greater Options By Transferring Ownership of Entire Debt Package

• Obstacles– Pricing Very Uncertain – Lenders reluctant or unable to sell at too

steep of a discount– Purchaser must have the ability to deal with the foreclosure process

P h A B k t /F l Ri k– Purchaser Assumes Bankruptcy/Foreclosure Risk• Risk Sharing is Difficult to Negotiate

Due Diligence Issues

• Due Diligence Challenges– Note Sales Require Due Diligence on:

• The Loan, • Condition of Title, and • Condition of the Property.

– REO Sales Requires Standard Property Purchase Due Diligence

Due Diligence – Note Sales

• Loan Issues– Must Understand Risk of:

• Borrower Bankruptcy, • Lender Liability Claims, • Defects in Loan Enforcement

• Title Issues– Must Understand Effect of Foreclosure On Title

• Eliminate Junior LiensEliminate Junior Liens• Effect on Development Rights?

• Property Due Diligence

REO Sale Issues

• Advantages Over Note Sales– Title is Cleaned Up for Purchaser– Bankruptcy Risk Eliminated– Can Be Structured in a Manner More Familiar to Purchasers

• Requires No Special Expertise or Experience as Required for Note Sales

• Obstacles– Lenders Increasingly Reluctant to Take REO on BooksLenders Increasingly Reluctant to Take REO on Books

• Glut of Residential REO on Lenders’ Books– Long Delays for Buyers and Sellers

Due Diligence – REO Sales

• Focus On Property– Title Report

• Which rights eliminated by foreclosure and which rights survive the sale

– Market Research• Effect of Foreclosure on Market• Tenant Issues – Co-Tenancy Clauses, Rent Reductions, Etc.

– Environmental Report– Effect of Judicial Foreclosure vs Non-Judicial Foreclosure on

Redemption Rights

Alternative Transaction Options

• Alternatives to Foreclosure– Deed in Lieu of Foreclosure– Title Subject to Competing Liens and Other Defects

• Consensual Foreclosure– Permits a Lender to “Clean Up” Title And Can Speed Up thePermits a Lender to Clean Up Title, And Can Speed Up the

Process

• Consensual BankruptcyRi k Of T t O J di i l I t f– Risk Of Trustee Or Judicial Interference

REO Properties: Legal Strategies for Lenders and Purchasers

Brian D. Ruben, Deloitte & Touche LLP+1 312 486 4180+1 312 486 4180

[email protected]

June 2, 2010,

Agenda

Overview

Commercial Real Estate Market & Debt Conditions

Pre-REO PlanningPre REO Planning

REO Valuation Issues

REO Financial Accounting Considerations

Copyright © 2010 Deloitte Development LLC. All rights reserved.

OverviewCRE k t i i d t d d li• CRE markets are experiencing unprecedented declines resulting in escalating mortgage defaults and a sharp spike in REO assets held by lenders. p y

REO is often considered a last resort by lenders after other options such as loan workouts and sales of the loans are considered; this is because many lenders do not have the resources and/or experience tobecause many lenders do not have the resources and/or experience to manage and operate the real estate to maximize its value.

Nonetheless, the number of REO assets has increased dramatically from April 2009 through March 2010; a trend which may continue for the foreseeable future.

There are many valuation and accounting considerations that factor intoThere are many valuation and accounting considerations that factor into the decisions that executives at financial and lending institutions make when converting commercial mortgages to REO assets.

Copyright © 2010 Deloitte Development LLC. All rights reserved. 1

S&P forecasts that the U.S. speculative grade default rate will fall, and that corporate spreads will remain flat in the nearterm. The default rate in the U.S. increased marginally in February 2010, due to distress in technology, insurance, andbanking debt CRE delinq encies in the U S also rose mainl d e to press re in the retail m ltifamil and office

Executive Summary

• Speculative grade default rate increased marginally in January.

banking debt. CRE delinquencies in the U.S. also rose, mainly due to pressure in the retail, multifamily, and officesegments. While loan issuance continued to fall in 2010, high yield bond volume surged, as companies borrowed in thehigh yield market to refinance loans.

U.S. Distressed Debt Update

• Corporate spreads continued to fall, but near term outlook remains flat.• Distress in technology, insurance, and banking debt resulted in a marginal increase in the

distress ratio.

U S CRE Industry

• Among loan types, CRE had the second highest delinquency and charge-off rates acrossall banks.

U.S. CRE IndustryOverview • CMBS delinquencies rose, driven by retail, multifamily, and office segments

• Due to pressure on lenders to liquidate, and encouragement by industry regulators, anincreasing portion of distressed loans are being restructured.

U.S. LeveragedLoan Overview

• Credit quality of C&I loans improved marginally in 4Q09.• Loan issuance fell, as corporate issuers extended debt maturities by refinancing bank debt

with high-yield bonds.

• U.S. high-yield loan volume surged, with companies borrowing in the high yield market torefinance loans and stave off liquidity crunches.

2 Copyright © 2010 Deloitte Development LLC. All rights reserved.

Looming Debt Maturities: Refinancing Might Be Difficult Approximately $4.2 trillion of commercial real estate debt, leveraged loans, and high yield bonds willcome due by 2014. Investors (and policy makers) expect that the economy will improve, underlyingcollateral markets will rally, and capital markets will stay accommodative, allowing this debt to roll over.However, real estate problems and the possibility of higher interest rates could act as a barrier torefinancing options.

$ billions


Source: Morgan Stanley – Global Credit Strategy, December 2009 report.

3

CRE Mortgage ProfileCMBS originations have almost disappeared, while life company and bank originations have stabilized,and originations at Fannie Mae and Freddie Mac also remained stable through the crisis. Of the $3.43trillion commercial and multifamily mortgage debt outstanding as of 3Q09, commercial banks continue tohold the largest share of commercial/multifamily mortgages with $1.53 trillion, or 45 percent of the total.

Quarterly Commercial/Multifamily Mortgage Bankers’ Originations, by Investor Group

Commercial Multifamily Mortgage Debt Outstanding by Investor Group

3Q09: $3 43T; 2Q09: $3 46T3Q09: $3.43T; 2Q09: $3.46T

Commercial Real Estate Investment Transaction Volume To Grow in 2010: Transaction volume remained artificially low in 2009, as banks, CMBS service providers, and other lenders delayed transactions in distressed assets. Analysts expect that the some of these assets will come to market in 2010, potentially increasing sales volume by 20-30 percent from 2009. Analysts also believe that prices, already down 40 percent from their peak in October 2007, may decline another 10 to 20 percent to meet buyers' expectations. Banks likely will begin writing off losses on distressed assets in 2010, which indicates that capital


p y p y g g paccumulating on the sidelines will start to be deployed. As a result, many highly leveraged buildings, many without the capital necessary to attract tenants, will transfer to new ownership, removing what was a major impediment to recovery in the investment market. (Grubb & Ellis Company, a leading real estate services and investment firm)

4

CRE Debt MaturitiesNear-term CRE debt maturities have increased as ‘amend & extend’ dominates lender practices, andapproximately $1.5 trillion of CRE loans (including construction) is set to mature by the end of 2012. Loanmaturities will consist primarily of commercial bank mortgages and construction loans in the near term,owing to their shorter duration. CMBS loans have sizable upcoming maturities in 2011–12 and in 2016–17,corresponding to 5- and 10-year loans originated during the peak securitization wave in 2005-07.

Construction Loans a Key Concern

• Maturing construction loans, which are 2–3 years in duration, will have been writtenduring the peak of the credit bubble, andoften included sizable interest reservesthat are rapidly being exhausted asdevelopers fail to reach pre-recession proforma cash flow projections.

Distressed CRE Presents Opportunity to Investors: “CRE distress will present buyers with attractive investment opportunities, albeit at a gradual pace.With incentives to avoid large-scale foreclosures and liquidations, lenders will likely extend performing loans and modify delinquent loans. However, asleasing velocity improves in 2010, there should be an offsetting incentive to transfer assets to owners with the funds necessary to optimally manage them. Incases where this transfer does not occur, capital-starved, “zombie assets” will deteriorate. We expect this to result in opportunities for well-capitalizedinvestors (including many public REITs), despite the lack of widespread REO liquidations. Massive liquidations are unlikely, despite a flood of maturities in2010–12. We expect a vast majority of loans to be modified and extended, particularly in CMBS.” -Morgan Stanley


p j y , p y g y

Source: Commercial Real Estate 2010: Investment Cross-Currents, Morgan Stanley, January 7,2009.

5

CRE Loan Defaults To Impact Mid-Size / Regional BanksThe volume of nonperforming commercial, construction and land loans is likely to jump 21.6 percent to $165.0 billion in2010, up from $135.7 billion in 2009 – the highest volume of “bad” loans in 18 years. Of the $135.7 billion in nonperformingloans recorded in 2009 commercial mortgages totaled a record setting $54 5 billion compared ith j st $9 3 billion at the

Nonperforming commercial construction and land loans

loans recorded in 2009, commercial mortgages totaled a record-setting $54.5 billion, compared with just $9.3 billion at thepeak of the market in 2007. Although big banks ($100+ billion in assets), such as Wells Fargo and BAC, recorded the largestdollar amount of nonperforming loans at $47.6 billion in 4Q09, the banking giants did not suffer the effects of troubled loansto the degree that smaller banks did, as smaller banks have larger exposure* and lower reserves for credit losses.

Nonperforming commercial, construction and land loans ($B) Write downs to climb:

• Relatively little of the defaulted loan volume has beenworked out by selling the loan at a loss or foreclosing on theproperty. Banks have been reluctant to accept such losses,even as nonperforming loans burgeoned. So the value of

$foreclosures has remained disproportionately low, totaling $24.2billion in the fourth quarter.

• According to Foresight Analytics, the process of writing offtroubled loans is only about 60 percent complete. In 2009,banks took $39 billion in charge offs, and they are expected towrite off another $30 billion to $43.3 billion in 2010. The bulk oft bl d l d f b t 2003 t 2007 t th h i httroubled loans were made from about 2003 to 2007, at the heightof the CRE market.

• Community and regional banks nationwide hold roughly $860billion in commercial mortgages and construction anddevelopment loans. As such, they are likely to experiencehigher losses compared to large banks

Small Banks’ Larger Exposure Could Cause Bank Failures: “For banks in that $100 million [in assets] to $100 billion size range, CRE really is the main loan type, as opposed to single-family residential or other loan types like business lending. Nonperforming commercial loans more than 90 days past due, and commercial mortgage charge offs, have hit regional and mid-size banks proportionally harder and are, in fact, so damaging that they could “definitely”


g g g , g p p y , , g g y ycontribute to new bank failures this year( 2010).” -Foresight Analytics

*CRE as a percent of total loansSource: Foresight Analytics

6

Si ifi t h i th CRE M k t h d

Commercial Real Estate Market Conditions• Significant changes in the CRE Market have occurred

There has been a drastic reduction in US Transaction Volume ($mil)

Property Type 1Q 2009 1Q 2010 % ChangeOffi 42 406 16 947 60 0%sales activity within the market over the past

12 months across all property types.Office 42,406 16,947 -60.0%Industrial 15,047 8,459 -43.8%Retail 14,945 13,803 -7.6%Hotel 7,278 3,227 -55.7%Apartment 27,129 16,629 -38.7%

Property returns (inclusive of income and value changes) have also been severely impacted.

Source: R eal Cap ital A nalyt ics

% Returns (Including Income and Value Changes)

Property Type1Q 2009 to

1Q 2010 4Q 2009 1Q 2010Annual Since

InceptionInception

DateProperty Type 1Q 2010 4Q 2009 1Q 2010 Inception Date

Office -11.34% -2.75% 0.86% 8.00% 4Q 1977Industrial -10.62% -2.59% 0.64% 9.02% 4Q 1977Retail -5.89% -0.92% 1.13% 9.20% 4Q 1977Hotel -13.33% -3.63% -0.42% 7.68% 1Q 1997Apartment -9.27% -1.81% 0.42% 8.03% 3Q 1984


p % % % % QNational -9.59% -2.11% 0.76% 8.72% 4Q 1977So urce: NCR EIF

7

Commercial Real Estate Debt Conditions• Debt maturities are looming• Debt maturities are looming

An estimated $2.5 trillion in debt on CRE is projected to come due between 2010 and 2013. It is projected that pcoming debt mat rities ill e ceed $500 billion inIt is projected that upcoming debt maturities will exceed $500 billion in 2010 and peak at nearly $600 billion in 2012.Upcoming debt maturities combined with the downturn in CRE values/returns and much tighter underwriting standards point to thevalues/returns and much tighter underwriting standards point to the potential for significant distressed debt in the near term.

Defa lt rates contin e to climb• Default rates continue to climb

7.8% 7 6%

10.8%

13.0%

10%

12%

14%

CRE

Loan

s

0 4% 0.7% 0.7%1.5%

3.1%3.8%

7.8% 7.6%

2%

4%

6%

8%

% o

f Out

stan

ding

C As of March 31, 2010 Delinquencies were 12.8%


Source: US CMBS Market Trends: Fitch U.S. CREL CDO Delinquency Index, Fitch Ratings, March 31, 2010.

0.4%

0%Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10

Commercial Real Estate Debt Conditions (cont.)Di t d D bt M k t b P t T• Distressed Debt Market by Property Type

There is distressed debt in the market for every property type• Multi-family and retail have the highest level of delinquency

Delinquent Loans by Property Type Delinquent Loans as percent of CMBS D li b P t T

• Across all property types, development assets have a very high level of delinquency, because the fair value of the property may have declined and there is, in most cases, no projected income for 5 to 7 years.

Healthcare 0.36%

Hotel15.93%

Other12.62%

1,1701,237

1,000

1,200

1,400

10,000

12,000

14,000

q y p y yp Delinquency by Property Type

Industrial3.24%

Retail24.10%

288

240

501

374 400

600

800

4,000

6,000

8,000

Multi-family23.87%

Off ice

181 8,131 1,656 12,183 10,157 12,300 6,44016

240

0

200

0

2,000


Off ice19.90%

Value of Loans ($ Millions) Number of Loans

Source: Monthly Delinquency Report, Realpoint Research, March 2010

9

Di t d D bt M k t b U S L ti

Commercial Real Estate Debt Conditions (cont.)• Distressed Debt Market by U.S. Location

There is distressed debt in the market in all geographies.• Florida, Texas, and California account for approximately 30% of CMBS delinquency.• The 10 largest states by delinquent unpaid balance comprise 57.4% of CMBS

delinquency.

Delinquent CMBS Loans by State as of 31 March, 2010

269

460 455

350

400

450

500

5,000

6,000

7,000

186

231

157

237

154

221

182

150

200

250

300

3,000

4,000

6,640 4,360 4,304 3,080 2,455 2,152 1,676 1,620 1,581 1,422

86

0

50

100

150

0

1,000

2,000

C lif i Fl id T N Y k A i N d G i Illi i Mi hi Ohi


California Florida Texas New York Arizona Nevada Georgia Illinois Michigan Ohio

Value of Loans ($ Millions) Number of Loans

Source: Monthly Delinquency Report, Realpoint Research, March 2010

10

Di t d A t t REO

Commercial Real Estate Debt Conditions (cont.)• Distressed Assets to REO

Size ($ Amount) of Distressed and REO Assets

Distressed Assets as of March 31, 2010st essed ssets as o a c 3 , 0 0

171.24 Distressed Assets Total $196.39

billion

$ B

illi

on

s

Delinquent/default Foreclosure

25.15 29.75

Troubled/Restructured Lender REO Resolved

$

Foreclosure/adminOwner/GP Bankrupt

Maturity DefaultMezz Takeover

Deed-in-Lieu


Source: Troubled Assets Radar, Real Capital Analytics, March, 2010. Note: In previous versions of the Troubled Assets Radar, “Restructured” was not a category. Real Capital Analytics states that most of these assets were considered to be “Troubled” in previous TAR reports.

Commercial Real Estate Debt Conditions (cont.)Di t d A t t REO ( t )• Distressed Assets to REO (cont.)

Increasing number of troubled and restructured loans

Increasing percentage of troubled loans that are taken into REOIncreasing percentage of troubled loans that are taken into REO• The carrying value of distressed REO properties has increased by approximately

196% over the last twelve months.

Type 3/31/2009 3/31/2010 % Change

Distressed Assets ($billion)

Troubled/Restructured 68.39 171.24 150%Lender REO 8.49 25.15 196%Distressed Assets 76.88 196.39 155%

Resolved 9.28 29.75 221%S o urce: Tro ub led A ssets R ad ar, R eal Cap ital A nalyt ics , M arch, 2 010


Note: In previous versions of the Troubled Assets Radar, “Restructured” was not a category. Real Capital Analytics states that this category includes loans that are in the process of being resolved but are still considered to be troubled; most of these assets were considered to be “Troubled” in previous TAR reports.

REO Valuation IssuesF i V l D fi d• Fair Value Defined

Fair value is defined under GAAP as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction b t k t ti i t t th t d t ”between market participants at the measurement date.”

• Not a forced liquidation or distress sale

• Does not incorporate transaction costs

• Exit price concept

• Principal or most advantageous market

• Market participant concept


• Highest and best use concept

13

REO Valuation Issues (cont.)V l ti C id ti• Valuation Considerations

To adhere with guidance published by the FDIC, financial institutions should obtain a new or updated valuation that complies with state law t th ti f i iti f REO ll th A i l R l tiat the time of acquisition of REO, as well as the Appraisal Regulation

(12CFR Part 323), Interagency Appraisal and Evaluation Guidelines.

M t t l i i tit ti t bt i l i diMany state laws may require institutions to obtain annual or periodic valuations for each REO property to determine that any material change in market conditions or the physical aspects of the property are recognizedrecognized.

Upon the disposition of REO, certain state laws may require appraisals if an institution is selling an asset or financing the transactionif an institution is selling an asset or financing the transaction.


REO Valuation Issues (cont.)V l ti T h i• Valuation Techniques

Fair value accounting guidance states that “valuation techniques that are appropriate in the circumstances and for which sufficient data are

il bl h ll b d t f i l ”available shall be used to measure fair value.”

There are three generally accepted valuation techniques for estimating th f i l f l t tthe fair value of real estate• Market Approach• Income Approach

C t A h• Cost Approach

In some cases a single valuation technique will be appropriate and in th lti l l ti t h i ill b i t Ifother cases multiple valuation techniques will be appropriate. If

multiple valuation techniques are applied, the indications of value derived from each technique should be weighted and reconciled appropriately


appropriately.

15

REO Valuation Issues (cont.)Wh d t i i th f i l f l t t t• When determining the fair value of real estate, one must consider the following components of value:

Tangible components of commercial real estate typically include:Tangible components of commercial real estate typically include:• Land;• Building;• Site Improvements; andSite Improvements; and• Tenant Improvements.

Intangible components of commercial real estate may include:• Foregone Rent and Expenses;Foregone Rent and Expenses;• Unamortized Leasing Commissions and Legal Expenses;• Above and Below Market Leases;• Customer or Tenant Relationships; andCustomer or Tenant Relationships; and• Management Contracts.

Liabilities assumed or transferred• Fair value of Senior debt (if in a mezzanine position)


Fair value of Senior debt (if in a mezzanine position)• Other liabilities

16

Pre-REO PlanningF t f l d t id• Factors for a lender to consider

• Is the property distressed or is the borrower distressed?• What are the potential risks of owning the property and how can they

be mitigated?• Is construction on the property completed or is it considered a

development asset?• What are the management requirements of the property? Does the

lender have the resources and experience to manage the property in a way that maximizes the asset’s value?

• What are the benefits and costs of outsourcing certain aspects of the asset/property management?

• What are the short-term capital requirements (including dealing with p q ( g gany deferred capital or maintenance expenditures) to maintain the property and keep it competitive in the market?


Pre-REO Planning (cont.)F t f l d t id ( t )• Factors for a lender to consider (cont.)

• What are the normal operating expenses to be incurred during the holding period?

• What is the expected timeframe until a sale (holding period) to a third-party once the property becomes REO?

• Can the anticipated appreciation or depreciation during the holding period be projected?

• What are the costs to take the property into REO and what are the projected costs to sell the property (e.g., advertising, broker’s commission)?

• What type of internal controls should be implemented to manage risks?

• How should the property be accounted for under U.S. GAAP?• What type of valuation policy should be implemented?• What are the tax implications?


What are the tax implications?

18

REO Financial Accounting Considerations

Th di iti t t d t i th l ifi ti f th• The disposition strategy determines the classification of the REO and its initial accounting treatment

Held for SaleHeld and Used

• Held for Sale• Held for Sale Requires an immediate sales strategy. Specific criteria must be met to be classified as "Held for Sale"• Management must be committed to a plan to sell the asset.• The asset must be available for immediate sale in its present

condition.• The sale of the asset must be probable within one year.• The asset must currently be marketed for sale at a reasonable

price.


REO Financial Accounting Considerations (cont.)

A ti id ti f “H ld f S l ”Accounting considerations for “Held for Sale”• At acquisition, the REO is recorded at its fair value less estimated

selling costs. This amount becomes the “cost” or initial carrying value f th f l d l t tof the foreclosed real estate.

• Legal fees and other direct costs incurred by the lender.• During the holding period, each foreclosed real estate asset must be

carried as outlined above. • Subsequent changes in property values

Decline in value Increase in value



If th i t f “H ld f S l ” t t t t t th• If the requirements for “Held for Sale” treatment are not met, the REO will be classified as “Held and Used”.

A financial institution acquiring an REO asset that will be “Held and Used” is generally required to account for the transaction in a manner consistent with accounting for business combinations.• Recognize and measure identifiable assets acquired and the liabilities

assumed related to the property based on fair value.• Record a loss on foreclosure of the loan asset for any excess of the recorded

net investment in the receivable satisfied over the fair value of assets receivedreceived.

• Establish the useful lives of each of the REO assets and depreciate or amortize accordingly.

• Legal fees and other direct costs incurred by the lender• Legal fees and other direct costs incurred by the lender.



U d U S GAAP th lti l t• Under U.S. GAAP, there are multiple ways to measure impairment of a loan prior to foreclosure.

Creditors have latitude to develop measurement methods that are practical in their circumstances.• Measurement methods may include:

Present value of expected future cash flowsFair value of the loan’s collateral (adjusted to include estimated selling costs if satisfaction of the loan is dependent on the sale of the collateral)Fair value based on a loan's observable market price

• The creditor may choose a method on a loan by loan basis• The creditor may choose a method on a loan-by-loan basis. Method selected for an individual loan shall be applied consistentlyA change in method needs to be justified by a change in circumstance



I t fi i l i tit ti ' fi i l t t t• Impact on a financial institution's financial statementsInitial recognition of an impairment loss upon conversion of loan to REORecording of real estate operationsAdditional real estate investment disclosures under GAAPPeriodic assessment of impairment of REOReclassification of “Held and Used” to “Held for Sale”



Oth fi i l ti i li ti f i REO• Other financial accounting implications of managing REOIncrease in infrastructure and asset management costsChanges to internal control and scope of ICFRg pImpact on regulatory capital requirementsAs an operator of real estate, a lender may experience cash flow and earnings volatilityand earnings volatility.• Occupancy• Rental rates• Incentives provided to tenants• Incentives provided to tenants• Capital expenditures• Unreimbursed operating expenses

P t i i t• Property impairments


This presentation contains general information only and is based on the experiences and research of Deloitte practitioners. Deloitte is not, by means of this presentation, rendering business, financial, investment, or other professional advice or services. This presentation is not a

b tit t f h f i l d i i h ld it b d b i fsubstitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte, its affiliates, and related entities shall not be responsible for any loss sustained by any person who relies on this presentation. p


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Deloitte refers to one or more of Deloitte Touche Tohmatsu, a Swiss Verein, and its network of member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/us/about , g y p p yfor a detailed description of the legal structure of Deloitte Touche Tohmatsu and its member firms. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries.


Common REO Issues- Regulatory Considerations• Holding Period

– Only Applies to Regulated Institutions– 5-Year Maximum – Regulatory Drive to Sellg y

• Appraisals– Valuation for Foreclosure/Bidding Strategy– Hold vs. Sale Considerations

• Property Inspection– Use, Repair and Maintenance Issues

• Environmental Audit– Foreclosure Review– Use, Repair and Maintenance Issues– Alternative Remedies – Personal Liability

Holding and Operating REO Properties• Survey and title• Land use• Successor liability • Construction defect liability risks for unfinished projects• When REO is unit of larger project

Survey and Title Considerations

• Use of Prior Survey– Update or Re-Certify Survey– Alternatives – Title Company Products (Plotted Easement

Map, Etc.)

• Title Policyy– Binder if Foreclosing Owner– New Title Policy for Purchaser

Potential Problems• Potential Problems– Easement, Setback and Parking Issues– Mechanics’ Liens, CC&R Assessments

Survey and Title Considerations II:Emerging Title Issues• Creditor's Rights Issues

– Consideration for Upstream and Downstream Guarantors– Solvency Representations/Source of Equity

• Broken Priority – Financial Statements From Borrower/GuarantorsFinancial Statements From Borrower/Guarantors – Signed Indemnity Agreement from Borrower/Guarantor– Construction loan agreement

Cost Break Down and Loan Budget• Cost Break Down and Loan Budget– Cash Deposit/Letter of Credit

Land Use Considerations

• Entitlements– Unstarted Project – Beware of:

• Moratoriums, • Changes in Developments Plans, • Expiring Development Agreements, and• Replacement Bonds

• Rent Control– Typically Survive ForeclosureTypically Survive Foreclosure

Successor Liability

• Leases– Review Liability Under SNDA:

• Past Defaults, • Defaults During Ownership, and• Assignment Liability,

• HOA/CC&R Defaults and Assessments– Typically Do Not Survive Foreclosure

• Profit Participation/Marketing Fees• Profit Participation/Marketing Fees– Controlled by Agreements and Subordinations

Project Development Challenges

• Stepping Into Former Project– Bonds need to be replacedp– Broken Subdivisions

• Gaining Control of the Declarant’s Rights– Expired Entitlements and Development

Agreement - Moratoriums– Fee Credit issues - Reimbursements?Fee Credit issues Reimbursements?

Project Development Challenges II

• Cities Not Likely To Approve Large Projects– Fragmented Developmentg p

• Bond Security– Set-Asides May No Longer Work– Cash Deposit or Letter Of Credit

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