Investing in Distressed Commercial Debt in NYC

In the October Issue

“An investment operation is one which, on thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” ~ Benjamin Graham

Intro: An Overview of Current Market Condition

As we’ve stated before, it’s clear that the economic expansion is at the peak of the cycle which indicates that a slowdown is inevitable. Based on the fact that the Yield Curve has become inverted, it’s highly likely that a recession will follow in the wake of the slow down. Other factors that play into this forecast include historically high Asset Prices supported by low and dropping interest rates. Furthermore, the Fed has started to ease off in their acknowledgment of low inflation and soft GDP growth. Heavy construction of residential affordable housing units continues which is another tell-tale sign. When we consider that new job growth has decelerated, the unemployment rate is also likely to rise. Although there is no crystal ball, all signs point toward a recession, which means the real question we should be asking is when, not if, one will occur. My guess, again minus a crystal ball, is sometime in 2020. Of course, savvy investors have already taken note of the signs and will have begun their strategies to capitalize on opportunities that present themselves in a decelerated climate. Preparing to deploy capital and knowing where to look in order to get the best deals is also part of the equation. You can almost be guaranteed that numerous opportunities in the realm of Distressed Commercial Debt will present themselves, and, as the intensity of the recession increases, more of them are likely to follow. During a recession, when an economy typically slows down, developers struggle and someone else benefits from their loss. It’s a fact that those who make money in this environment often capitalize on someone else’s misfortune. While this sounds may sound objectionable to some , bear in mind that there’s an old real estate saying that someone else’s distress is someone else’s opportunity. If you’re an opportunistic investor and know what you’re doing, it’s likely you’ll be on the positive side of this equation. As the economy slows down, more distressed debt opportunities emerge, and this happens as a result of a number of factors.

Opportunity: Distressed Commercial Debt

Investing in distressed commercial debt, when properly executed, can create significant safety of principal, good downside protection, and a solid rate of return on investment. Distressed commercial debt is a growth investment, not for cashflow, but for appreciation. Because you’re buying distressed notes, they don’t pay anything, but they provide significant accumulation of default interest which increases the value of a balance due. And, ultimately, upon foreclosure or upon the borrower repayment, if properly executed, you will get all your principal back along with your accrued interest.

What’s Driving Commercial Debt Distress

Let’s look at where distressed commercial debt typically comes from. There are basically two types: property distress and borrower distress.

1. Property Distress
These consist of projects that have run over schedule and over budget. What happens next is the project hits term maturity, and the lender doesn’t want to extend the loan but would rather sell the note to recover their cash. Factors contributing to projects running over timeline and budget range from poor project and contractor management to unanticipated delays brought about from inspections, other violations, and stop-work order delays. Upon term maturity on these projects, many banks, when they sense a project is in trouble, get nervous and want their money back in some cases. It’s understandable that they don’t want to be hamstrung by a problem project holding the default paper. Banks need to have additional reserves on hand for defaulted loans which they’re not fans of because defaulted loans don’t look good on their books. Of course, these loans could end up being profitable for the bank from a higher interest rate collection, but that’s not the business they’re in– Their business is to have performing loans and heavy regulations. It’s not their business to be in the foreclosure business. Their business revolves around the paper performing, and they want to sell immediately upon default. When a bank loan approaches default, they actually have started shopping around to unload the paper. And that’s where the opportunity emerges for specialists to come in and buy the paper.
2. Borrower Distress
This type of financial distress oftentimes comes when a borrower gets a loan for liquidity purposes but fails to improve their condition. For example, a high net worth individual may have inherited some buildings, but due to circumstances in their life, runs into financial difficulty and needs to borrow money, but can’t pay back the loan and end up defaulting. The bank wants repayment and when the borrower doesn’t have the cash to do so, the bank sells the note to recoup their cash.

What a Good Opportunity Looks Like

Acquisition of a 1st lien mortgage at a low Investment to Value ratio, somewhere in the neighborhood of 65% or less would be a good opportunity. Anything under 50% would be an absolute bargain. I recommend looking for an asset with strong collateral (such as newly constructed affordable housing units), which, when combined with low the aforementioned LTV, provides good downside protection. Deals with term maturity are preferable to those with a payment default option. You’re also looking for a seller who is motivated to dispense with his paper and a high default rate (18-14%) along with late fees. As we mentioned above, it might be a case where a developer has taken too long with a project and has past the term on their mortgage. An opportunistic investor can buy that mortgage and start the foreclosure process. There are numerous drivers behind a seller’s motivation to sell off paper. As aforementioned, it happens quite often that banks want to sell the note because they want to get repaid. They never come right out and they’re going to discount a note, but they’re motivated to sell because regulators come in, and they don’t want to see defaulted loan on the books. Many commercial loans in NYC are structured with very good performing rates; a 6% performing construction loan with a default rate of 24% could turn out to be a treasure chest. If you buy a loan that defaults, and you have a 24% default rate and are accruing a really strong return with good downside protection, it’s hard to imagine such a strong risk reward ratio. As it turns outs, default rates are pretty high on these types of loans, typically 18 to 24%. You may be able to buy the note at a discount to Unpaid Principal Balance (UPB) which combines principal plus interest. You might also buy the note at face value and then have the note’s seller transfer the benefit of defaulted interest to you.

Lengthy Foreclosure Periods in NYC: A Blessing or a Curse?

The foreclosure process is notoriously lengthy in NYC which can be both a blessing and a curse. I actually think it’s a blessing while many others I know think it’s a curse. If you can control the process with a pretty strong loan to value ratio, you’ll be able to accrue low interest for a long time. Here, you don’t mind the lengthy foreclosure process; it’s just the opposite in that you appreciate the fact that it’s long and drawn out because it enables you to accrue extra default interest; in other states, fast foreclosures create situations where someone can outbid you at foreclosure auction and all you’re going to get paid is your default interest. It becomes a curse in that it takes a long time which means you have limited liquidity which is something you have to be prepared for.

How We Invest in Distressed Debt in NYC

Investing in commercial distress is very hard to do without a specialist because of the foreclosure process which, as we said above, can be a lengthy process, not to mention an expensive one. If you don’t have in-house foreclosure capability, using outside counsel is a costly undertaking, and they require payment upfront as a rule. Working with a specialist in this business is essential. In New York City, we invest with a specialist firm, Goodman Capital, with significant experience and an in-house foreclosure team. A quick plug for our funds: we’ve negotiated extremely good terms for our flagship fund, the Tempo Opportunity Fund LLC. When you invest through us, you benefit because the terms we get from Goodman are significantly better than the terms available on the streets to the average investor. An additional benefit of our fund is that we provide significant diversification. The above strategy, through Goodman, makes a lot of sense, but when you couple it with a versatile and diverse portfolio, it makes even better sense. You’ve heard me say it before, but I can’t stress enough how critical it is for you to invest in a diversified manner. I want to acknowledge Goodman Capital as the source for a great deal of what follows in the remainder of the newsletter. As I said, they’re the specialist with whom we work on investing in distressed commercial debt. They’ve provided us with a wealth of valuable information which I’m sharing with you here. Goodman Capital has acquired a unique first-position commercial bridge loan in default (NPL), and their negotiated purchase price enabled them to secure a $4 million gain on day one, while continuing to foreclose and accrue 24% default interest until the estimated loan payoff in a couple of years. The loan is secured by a rare 35′ wide mixed-use townhouse in one of the most prime sub-markets in New York City. They were able to acquire significant downside risk protection from seniority in the capital structure and strong underlying collateral.

Wrap-Up

The most important thing to remember in a market slowdown is the idea of diversification. A well diversified portfolio can help mitigate risk and provide a hedge of protection for your investment portfolio. In next month’s newsletter (Part 2), we’ll go more in depth about Goodman’s investment strategy, the risk involved with commercial debt and the due diligence process in acquiring these types of investments. As always, if you’re interested in learning more about how you can invest in the Tempo Opportunity Fund LLC, please visit http://secure.tempofunding.com or contact me, Mike Zlotnik, at mike@tempofunding.com or by phone (917-806-5029). I’ll be happy to forward you the PPM, term sheets, and subscription paperwork or answer any questions you might have. Please don’t miss the latest Episodes on Big Mike Fund Podcast: 044: Increase Cash Flow and Generate Passive Income 043: Are Quad Cities Ideal for Turnkey Real Estate Investments? Thanks for reading, Mike Zlotnik CEO, TF Management Group LLC This newsletter and its contents are not an attempt to sell securities, nor to sell anything at all, nor provide legal, nor tax accounting, nor any other advice. The presenter is a private lending and real estate fund management business, and the information represented herein are purely for educational purposes and represents the opinions of the presented. Prior to making any investment or legal decision you should seek professional opinions from a licensed attorney, and a financial advisor. TF Management Group LLC (TFMG) is an investment fund management company that specializes in both short-term debt financing for real estate “fix and flip” projects, and long-term “value-add” equity deals.