"Working at Workouts: Commercial Real Estate Debt in Distress" case study depicts how Drive Property Solutions, in partnership with Spiner Capital, won a Federal Deposit Insurance Corporation auction of distressed debt which included a defaulted mortgage note covering a retail strip mall in Savannah, Georgia. Sam Schey, an asset manager at Drive, is now challenged on how to gain recoveries from the nonperforming loan.
Harvard Business Review (KEL697-PDF-ENG)
December 19, 2011
Case questions answered:
- Why is the loan in default? Consider the economic factors, financing factors, and any factors personal to Burton himself.
- What are the qualitative benefits and costs to each of the three default resolution options? (foreclosure, the discounted payoff from First Community Savings Bank, and a workout with Drive Property Solutions)
- Calculate the expected annualized IRR to Drive for each option. Ignore Drive’s partnership and assume that the initial cost of the distressed note ($465,000) was incurred entirely by Drive, that it was paid today (1st June 2010), and that Drive will receive all future cash flows. This amount becomes the “Cash Flow Zero” for your IRR calculations. If you run into problems with the (X)IRR calculation, first make sure all of the cash flow signs are correct.
a. For the foreclosure option, make the following assumptions:
i. The duration of the foreclosure process is three months
ii. The legal and administrative costs associated with the foreclosure are $50,000, due at the end of the foreclosure (that is, 3 months from today)
iii. The duration of the sale process (which follows the completion of the foreclosure) is nine months
iv. Therefore, the sale of the property will take place one year from today (1st June 11) and is based upon the property valuation calculated in Sheet 2 of the property cash flow statements provided to you. Expected cash flows to Drive (cell C22) must be reduced by 5%, to cover broker and other administrative costs associated with the sale.
v. There are no significant costs associated with the environmental liabilities of the property
vi. There are no cash flows from the deficiency judgment, and the cash flows before the eventual sale of the property (i.e. rents, maintenance, and capital expenditures) are also zero.
vii. Label each cash flow with its appropriate date, and use the XIRR function in Excel to calculate the IRR. You should have five (5) cells of cash flows in total: one for now (time zero, representing the time of the distressed note purchase), and one for each 3-month interval thereafter.
b. For the discounted payoff option from First Community Savings Bank, make the following assumptions.
i. The completion of the discounted payoff option takes three months from the time the note is purchased
ii. The amount of the payoff, as stated in the case, is based on a 75% LTV.
iii. The value of the property for the purpose of calculating the loan amount is based upon the valuation obtained in Sheet 1 of the Excel file provided (again, cell C22)
iv. Once again, attach the appropriate dates to each of the cash flows and use the XIRR function to calculate the IRR. You should have two (2) cells of cash flows in total: one for now, and one for three months from now, when the note sale is completed.
c. For the workout option, you will need to generate two sets of cash flows – one in which Burton successfully meets his obligations under the new terms, and one in which Burton defaults again. Each scenario has a 50% probability, so you will average the cash flows across the two scenarios and use these averages to calculate your IRR. Given the longer time period over which these two events play out, you should group your cash flows by year (rather than by month or date) and use the standard IRR formula in Excel. Finally, given that the re-default scenario plays out over 4 years, and the successful workout plays out over only 3, just assume cash flows of 0 for the good outcome in year 4 when taking averages across the two scenarios. For each of the scenarios, make the following additional assumptions:
If all goes according to plan:
i. Burton pays interest only for the first 6 months, and the fully amortizing payment thereafter according to the new terms of the loan. In the 3rd year, he pays back the outstanding balance on the loan in addition to the twelve monthly payments.
ii. Assume the prime rate will remain at 3.25%, so the interest rate on the loan stays constant at 5.25% after the first year. (The initial interest rate is 6%).
iii. In this case, there should be four (4) cells of cash flows in total: one for now (time zero), and one for each YEAR of loan performance thereafter.
If Burton re-defaults:
i. Burton fails to make the 36th loan payment.
ii. Foreclosure happens immediately, which causes Drive Property Solutions to incur $50,000 in foreclosure costs (as in question 3a) at the very end of year 3.
iii. Drive sells the property at the end of year 4, at the value estimated in cell C22 of Sheet 3, less 5% broker, and administrative costs.
iv. There are no significant costs associated with the environmental liabilities of the property.
v. There are no cash flows from the deficiency judgment, and the cash flows before the eventual sale of the property (i.e. rents, maintenance, and capital expenditures) are also zero.
vi. In this case, there should be five (5) cells of cash flows in total: one for now (time zero), three for the years in which Burton is making payments, and one for the time it takes to sell the property post-foreclosure
- What type of resolution would you recommend Schey pursue? Explain your answer. Is this the resolution with the highest IRR? What problems might you foresee in choosing the option based solely on IRR? Typically, NPV is considered the “failsafe” option in investment decision-making. What challenges might we encounter in trying to use NPV to rank our choices in this particular instance?
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Case answers for Working at Workouts: Commercial Real Estate Debt in Distress
This case solution includes an Excel file with calculations.
1. Why is the loan in default? Consider the economic factors, financing factors, and any factors personal to Burton himself.
The loan is in default because of multiple economic factors, financing factors, and Burton’s personal factors. As the economy began to weaken in the latter half of 2007, commercial property owners had to lower rents to avoid vacancies. From 2008 – 2010, the vacancy rate in retail properties rose from just under 6.6% to 7.6%, while the quoted rental rates decreased from $17.50 – $16 during the same span.
The property’s cash flow seemed to be particularly tied to the success of the community. Due to the collapse in the construction industry as well as stricter immigration laws in Georgia, all of the tenants had suffered a decline in their sales, and as a result, Michael Burton allowed his tenants to pay far less than their contracted rent. This led to not being able to meet their own loan obligations, and loans like this one defaulted.
According to Schey, the loan was composed of “loose” underwriting. On the initial appraisal, Burton received a $1,250,000 loan based on the value of 1,350,000 resulting in an LTV of 92.6%. Schey’s friend, Marina McFadden of CBRE, had recently sent him an opinion of value suggesting that currently, the property would fetch somewhere in the neighborhood of $805,000-$906,000, representing sales prices of $66 and $74 per square foot.
The LTV has now changed to become well over 100%. Six months of accrued interest means there is $60,138 of default interest. In addition to late charges and two years of unpaid property taxes in the amount of $31,500, meaning this loan is getting harder and harder to recover.
Michael Burton had formed Burton Properties, LLC, in early 2003 for the purpose of operating a convenience store in Atlanta. After four short years of running the store, he had built up a reasonable portfolio of similar projects but had decided to change paths. He was a general contractor by training but took a job at a local high school as the varsity men’s basketball coach in his hometown of Savannah. Though he no longer had an interest in operating retail outlets, he understood the value of real estate holdings as an inflationary hedge for his retirement fund.
With the help of his attorney, Jonathan Stewart, Burton sold some of his real estate holdings, and in the spring of 2008 used the proceeds to purchase Northwinds Community Crossing, a property he believed would generate significantly more cash flow and require far less day-to-day management. Looking at Table 3, we see that a lot of the other properties in his company were also not doing well. Additionally, Burton only has $3,301 of cash in assets and $8,409 in credit card debt, so all in all, he is not in great financial shape.
2. What are the qualitative benefits and costs to each of the three default resolution options? (foreclosure, the discounted payoff from First Community Savings Bank, and a workout with Drive Property Solutions)
- In Georgia, judges are given the right to appoint the receiver of their choice. There was no guarantee as to who would be appointed. This was a “wild card” situation. A local judge could enlist a competent property manager, but could also appoint “friends of the court” who could just as easily be incompetent, combative, and ultimately have a negative impact on the property’s performance
- Without the appointment of a receiver, Schey would never know for sure whether the property’s cash flows were as Burton reported. The original note did not contain a lockbox provision, so Burton was collecting the rent personally
- If the property was sold through receivership and the sales proceeds were not enough to cover the principal owed, Drive Property Solutions would lose the right to seek a deficiency judgment against Burton.
- According to the Phase II Environmental Report from the FDIC case filing, the three underground storage tanks on the subject property were protected under the G.U.S.T Trust Fund. Though the storage tanks were installed at the site in February 1991, and the location has not been receiving gas since 2001, the environmental risks were particularly uncertain.
- Drive had the legal right to foreclose on the property and take ownership, and Schey understood that in Georgia, this would allow Drive to take ownership in less than two months.
- Appointment of receivership was a viable option, executable within a matter of days following filing.
- Given that the loan was issued with recourse, there might be additional value to Drive Property Solutions hidden among Burton’s other assets, and Schey did not want to rule out that option either.
Discounted Payoff from FCSB