Duly Noted: Despite Q4 2011 Drop in Distress, Schechtman, Knakal and Others Rack Up Hundreds of Millions of Dollars in the Deals

Even as commercial real estate prices have improved and banks have swiftly moved troubled loans from their books, the phenomenon of distressed note sales has continued unabated.

According to data from Real Capital Analytics, the volume of newly distressed commercial properties dropped to $12.4 billion for the fourth quarter of 2011—a figure that, as the firm pointed out in its February 2012 Troubled Assets Radar report, is the second lowest level seen in two years.

2 schechtman and haupsburg bw Duly Noted: Despite Q4 2011 Drop in Distress, Schechtman, Knakal and Others Rack Up Hundreds of Millions of Dollars in the Deals

Haupsburg and Schechtman.

The volume over the past few full year periods has also declined markedly—$140 billion in 2009 to $92.6 billion in 2010 to last year’s full year total of $60.1 billion. So what gives? Why do note sales continue to be the product of the moment—with experts predicting an uptick, not a slowdown?

David Schechtman, principal and executive managing director at Eastern Consolidated, told The Mortgage Observer that he sees the volume of distressed note sales remaining steady for the immediate future because there remains a lot to move through the pipeline. The accuracy of this prediction may be backed up by Mr. Schechtman’s current workload.

“My belief is that, just based on the volume that needs to transact, we are going to finish out this year with a record amount of transactions—both in plain vanilla real estate but also in the loan and distressed world,” Mr. Schechtman said recently at Eastern Consolidated’s offices. “There will still be a significant amount of portfolio lenders and special servicers straight through 2013. Then I think how much transacting there will be on the distress side will be a function of the new administration and some global economic forces.”

For the time being, though, Mr. Schechtman and others dealing in the space have their hands full. For instance, Mr. Schechtman said that he had completed—since January 1, 2012—16 deals, totaling over $300 million.

Over at Massey Knakal, firm chairman Bob Knakal said that his team had done a steadily increasing volume of the deals recently as well. “In 2010 the volume was around $250 million and last year it was about $350 million,” Mr. Knakal said. He added that the firm’s business in this area will probably again increase for 2012.

“The reason that note sales have been so popular, particularly in New York, is because the foreclosure process is so long and cumbersome that it can take three or four years to foreclose on a property and if a lender forecloses the highest recovery they can possibly hope for is 94 percent of the collateral value of the property,” Mr. Knakal said. “One of the interesting things about the market is that generally it was perceived that about halfway through last year most of the banks had worked their way through their problems and that most of the note sales were coming out of special servicers.” This changed, Mr. Knakal said, toward the end of last year when bank problems again resurfaced.

Other experts agreed that the foreclosure process in New York is lengthy—up to four years long—thereby impacting the volume of distressed note sales that take place in the tristate region. During this time a lot can change, including the borrower’s position.

“The thing to remember with note sales is that the borrower has the ability at any time to pay the note off in full,” cautioned Mr. Knakal, whose firm currently has a note on offer secured by the Fordham and Robert Fulton towers in the Bronx. “When an investor is looking at a note—let’s say the property is worth $60 million—the investor might say ‘Hey I’m willing to pay the full amount for the note because I’m buying the property for less than it’s worth. But I have to keep in mind that until my foreclosure is finished I could very easily have the borrower raise the money and pay off the $54 million that’s owed an I’m out.’ And my whole objective was probably to get into the ownership position on the property.”

Howard Wenig,

managing partner at Belkin Burden Wenig & Goldman, LLP said that a good deal of the firm’s practice involves representing lenders in the foreclosure process. He echoed Mr. Knakal’s sentiments about how lengthy it can be.

“The foreclosure process unfortunately in the past several years has moved to a stage of being exasperatingly long—several years,” Mr. Wenig said. “And depending upon the county it can take longer.”

Two main factors, he said, have increased the chances of a foreclosure resulting in a note sale—and they may actually be signs of an improving economy: healthier banks and improving commercial real estate prices.

“When the crisis first began I think lenders were in a position where they had an interest in not classifying those loans as being in default,” Mr. Wenig said. “That’s where the phrase ‘extend and pretend’ came from—where if a loan was even matured and the money was due and the borrower said ‘I can’t pay you off’ they extended it for two years and nursed the loan along for two reasons. First, the bank became healthier—perhaps selling the loan at a discount—and secondly the market would improve so that the value of the property would increase and they might be able to get paid off.”

But also in flux during the foreclosure process may be the face of the parties involved themselves. Mr. Schechtman and his team—which includes senior director Lipa Lieberman, director Marion Jones and associate director Abie Kassin—just executed a hard, non-refundable $65.3 million contract for a note secured by an eight building portfolio of buildings on and around Broadway in Upper Manhattan. It’s set to close around May 15, 2012. The borrowers included Neil Rubler from Vantage Properties and Area Property Partners’ Richard Mack.

Though he wouldn’t disclose the buyer, sources told The Mortgage Observer that it is Sentinel Real Estate, helmed by John Streicker, which made a deal with Onex Capital Corp., which holds the $23 million in mezzanine debt on the portfolio. Onex, sources said, will get a small return relative to the loan it wrote to walk away.

Mr. Schechtman pointed out that he was brought in 10 months ago by the special servicer, ING Torchlight. “The person who engaged me to market in the secondary market this note, was a special servicer,” he said. “The divisions of the lenders today who are handling the disposition or otherwise resolution of these loans are not the people who made the loans. And oftentimes it’s an amicable process.”

Mr. Schechtman was also just hired several weeks ago to represent General Electric—“It’s a $25 million to $30 million exclusive,” he said, secured by notes on 131 to 133 West 33rd Street. Other deals in the works include a Flushing Bay development site at 39-08 Janet Place in Queens and 85 Flatbush Avenue Extension and 333 Greene Avenue in Brooklyn.

With this volume of business, staffing can be an issue and both Mr. Schechtman and Mr. Knakal said that their firms had taken appropriate measures to staff up when they saw distress looming on the horizon. At Eastern, Mr. Schechtman, who said that he emulates mentor and firm president and CEO Peter Hauspurg on and off the field, talked about how staffing needs had changed because of distress. After leaving law firm DLA Piper as a sixth year associate and landing at Eastern “to take on a desk here—a cubicle—with no salary, no health benefits and no promise of any income other than a phone, the Internet and the Blue Book,” the prevalence of distress necessitated additional hands on deck.

“By the first quarter of 2010 it was steady,” he said, “and it has increased since January 2010 to the point where we continue to staff around it.”

“We knew the credit crisis was going to be very impactful by the end of ’07—it was very clear,” said Mr. Knakal. “And so the beginning of 2008 we started putting together a list of banks, special servicers and starting to contact them. There really was no business to speak of in 2008 because a lot of these banks and special servicers hadn’t even set up departments to deal with the distressed loans because things, for a good part of 2008, still looked like they might be okay. But then the second half of the year it really was clear that things were not going to move well. So we started to see that activity start tangibly in 2009.” The boom in New York City came in 2010, when, he said, there was probably $6 billion to $7 billion of note sale transactions.

Massey Knakal staffed up too. “We hired a director of special assets and basically were using our existing sales force in conjunction with the special asset department to focus on these opportunities,” Mr. Knakal said. The firm currently has a new director of special assets—Matthew Dillon.

At the end of the process, of course, is a buyer—oftentimes, experts said, looking to gain ownership of the property itself. Jacob Frydman is chairman and CEO of United Realty Partners, part of whose aim is to identify value-add and opportunistic real estate investments. The firm is currently raising $2 billion across several different funds to buy real estate, much of it distressed, along the east coast. And, he said, getting the note is one way to accomplish this.

“We’re raising a private equity fund in Europe for European investors who want to invest in the United States and that fund is called United Realty America Fund,” Mr. Frydman said. “The REIT we have in registration is United Realty Trust Incorporated and we think that we’ll be raising additional funds as well as putting out our own capital to invest in both core assets that are generating current cash flows in areas where we can get higher returns than the trophy markets and then value added opportunities in the trophy markets and in other markets as well. Including, as you’ve suggested, buying notes.”

The notes Mr. Frydman and his colleagues might target, he added, are likely to be secured by properties within two hours of New York City. “It makes it easier to get to in case there’s an issue and it’s the marketplace we know best,” he said.

Previously established relationships with bankers, brokers and capital markets people help them identify opportunities. “We also have close relationships with various law firms that deal with these issues and we try to identify opportunities that are not yet on the market so that we don’t find ourselves necessarily in a bidding war,” he said. “Many of these assets eventually go through some sort of a bidding process. We look for opportunities where we can think of the asset in a different way than it was thought of originally. So when we look at a distressed asset we might see an asset that was designed as a particular use and we might want to change that use. It may have been designed as a condominium and we might find that repositioning it as a rental is better.”

It’s a strategy that doesn’t surprise brokers. “The overwhelming majority of the time,” Mr. Knakal said, “getting into the ownership position is the objective” of the note buyer. He added that the increased demand has led to strong recoveries for clients. “The number of people interested in buying notes continues to increase, so the demand is very significant and that has led to strong recoveries for the clients that are selling notes,” Mr. Knakal added.

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