Member Article

 

Introduction

 

The Great Recession is producing unprecedented levels of foreclosures1¡ªdeeds©/in©/lieu of foreclosure, bankruptcies, receiverships and other transactions in which financial institutions acquire control of real estate assets that must then be managed and sold.2 Interrelated, of course, is the fact that real estate values have fallen¡ªand continue to fall¡ªto varying degrees for most property types and in most markets and sub©/markets.3 This two©/part article will examine the background of the financial crisis, the impact of the financial crisis on financial institutions' management of real estate owned (REO) assets, and discuss a triage process institutions might use from the time they take control of those assets until they are sold.4 Part One will discuss the first two milestones of this process¡ªexamining all aspects of the real estate assets acquired by the financial institution and formulating a management and disposition strategy. Part Two, to be published in the May issue of the Banking & Finance Law Report, will cover the last two milestones of this process¡ªmanaging and disposing of the REO assets¡ª and will also contemplate what the future may hold for commercial real estate.

 

D¨¦j¨¤ Vu All Over Again¡ªBut Worse

 

There is no shortage of books and articles describing the causes of the "Great Recession".5 This article does not purport to revisit those topics. Instead, it examines and suggests strategies to deal with the REO assets that financial institutions now, or will, control.

 

But even a forward©/looking view should be informed by the past. What has occurred¡ªand will continue to occur¡ªis not unlike what happened between 1987©/946, when the last major real estate recession caused a fundamental restructuring of the values and ownership of commercial real estate and marked the beginning of the shift¡ªfrom Main

Street to Wall Street¡ªin the manner in which real estate is financed. During that time period, the confluence of a number of factors, a "perfect storm" if you will, occurred¡ªthe Tax Reform Act of 1986 (which outlawed deep tax shelters for syndicated real estate transactions) became effective, the economy took a downturn, the savings and loan industry collapsed, many commercial banks faced severe financial difficulties and, as a result, suffered a lack of liquidity¡ªcaused a major real estate crisis.

 

The manner in which that crisis was managed and ultimately resolved, and the lessons learned, help us understand how to approach the current situation in a prudent and informed manner.

 

Understanding What You Have Acquired

 

The first step a financial institution should take after it acquires control of an REO asset is to understand all aspects of the asset itself and the issues that will affect its management and sale. Most REO assets have at least one thing in common¡ªone or more property©/specific issues.

 

REO assets, in fact, tend to have multiple issues which can be market driven, property©/level, financial or otherwise. The issues must be identified, understood, and resolved, because any issue will adversely impact the pricing and timing of the sale of an REO asset. There frequently is no rational correlation between an issue with an REO asset and the negative impact it will have on market value. While the reduction in market value is often due more to perception than reality, the market will discount an REO asset for virtually any issue.

 

A financial institution's knowledge of an REO asset at the time it takes control will vary. Some financial institutions will have performed significant diligence, thereby possessing a detailed understanding of the REO assets they acquire. Oftentimes, this knowledge comes from the manner in which financial institutions underwrote and administered the loans secured by those assets. On the other hand, a financial institution may have acquired a loan, or portfolio of loans, as a result of its acquisition of another financial institution. While the acquiring institution would have performed some level of diligence, it is typically less extensive than would have been conducted had it originated the loan.

 

A seller of REO assets that understands all of the market and property©/specific issues and has a cogent strategy for selling them will typically achieve higher sales prices and sell the assets more quickly, while also minimizing post©/sale liability. A well-informed financial institution will understand all the characteristics of an asset¡ªthe good, the bad and the ugly.

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