In the October Issue
- Goodman Capital Investment Strategy
- Understanding and Mitigating Risks
- Due Diligence Process
Part 2: Investing in Distressed Commercial Debt in NYC
Last month, we did Part 1 of “Investing in Distressed Commercial Debt in NYC.” We’re going to follow-up on that discussion this month by going into more depth regarding risk, due diligence and diversification.
We spoke a little about Goodman Capital in our last newsletter, so we want to start this month by diving a little more into their investment strategy. As I said, they’re the specialist we work with on investing in distressed commercial debt. They’ve provided us with a wealth of valuable information which I’m sharing with you here. Let’s get started.
Goodman Capital’s Investment Strategy
Below are some of the key components of Goodman’s investment approach:
- involves acquiring senior-position distressed loans (NPLs)
- underwriting at conservative investment-to-value
- targeting post-default NPLs accruing up to 24% per annum
- ensuring strong and stable underlying collateral
- focusing on below the radar deals (< $20 million)
- managing the foreclosure process to accrue more default interest, and push the asset to auction at an optimal point to maximize ROI
The benefits of this approach are numerous, but here are some of the primary ones:
- Niche counter-cyclical investment strategy
- Superior risk-adjusted returns in current market
- Significant downside risk protection
- Recourse to underlying collateral and PGs
- Non-correlated returns with stock market
- Strong financial risk protection with no leverage
In conjunction with Goodman Capital, we’ve discovered some of the best distressed commercial debt opportunities in New York. Obviously, construction continues to boom in NYC which provides phenomenal opportunity in commercial distressed debt investment, particularly if you can get into these projects from a lender perspective at the low LTV ratio.
In my opinion, instead of investing in leveraged equity and speculating, I would rather buy commercial debt when the project sponsor or developer has run into problem. Why? It’s simply a much safer opportunity with greater upside.
Understanding and Mitigating Risks
When it comes to investing, it’s important to know the risk associated with each investment (and commercial debt is no exception). Let’s explore three different types of risk that you should keep in mind when looking into investing in commercial debt.
Legal Risk: Risk of loan enforceability due to poor loan documentation
Legal risk has to do with your ability to enforce the loan. If the loan has poor documentation written by a hack which makes it impossible to make sense out of the loan documents, then you have a problem on your hands. If you don’t have a competent attorney and you failed to do your due diligence, you may end up with worthless paper.
In your due diligence process, how do you determine if the loan documents are good quality? You’ll know when you know: the buyer of the note must conduct a deep dive to confirm the enforceability of the documents. That’s another risk mitigation strategy.
Operational Risk: Risk of Poor Execution
Risk of poor execution is a concern in any business, and in this business, collecting on a defaulted debt is the goal. In other words, the note buyer must position himself to implement and execute a good loan workout and foreclosure process, whether it be through in-house lawyers or via external counsel. The buyer must be prepared to rehab and reposition the asset to maximize resell value under a take-back scenario.
Market Risk: Risk of loan value loss due to market factors
As everywhere, it’s possible that the market can correct. New York City is certainly not exempt from market corrections. Despite the outstanding run we’ve been on for a while now, it’s possible that we’ll see some level of correction occur here. It’s already happened with high-end condos which have taken a significant beating. Other assets may be in line to struggle sooner rather than later.
Therefore, I would absolutely advise investors to avoid certain assets whose assigned value is susceptible to change due to market factors. For example, a $40 million asset could become $35 million or even $30 million. That’s why low LTV is important, the cost to value or investment to value. There is significant downside risk protection from strong collateral in the investment to value ratio of 50-60%. It’s risky business going beyond 65% ITV. Look for first-position loans which provide seniority in the capital structure above all other stakeholders.
Due Diligence Process
Engaging in a due diligence process is vital in this type of investing, and there are two sub-categories, asset level and loan level, that are essential to review.
With asset level due diligence, you’re making sure the building is both high quality and worth the money. Loan level pertains to whether or not the paper you’re buying is of high quality.
You have to take these steps in order determine the collateral value securing the loan and compute your LTV. It’s crucial that you’re protected as the lien holder when you take the asset back. It’s also vital that you determine how much capital is required to protect your investment.
As an example, if you bought the note for $17 million, you’ll likely need another $500K to be able to foreclose. In essence, you’ve got to have the capital to be able to execute the strategy because of the cost of the foreclosure. Later in the process, if you need to bring the building up to the market condition, you may need to invest another couple of million dollars in renovations. Understanding the projected costs is important.
Furthermore, you have to do a detailed property inspection with the property management team in order to know what works and what doesn’t.
As part of the ongoing due diligence process, it’s important to conduct third-party reports on commercial properties, particularly environmental and title reports. You need to know for sure if you’re buying first lien paper, if there are any unpaid taxes, and whether or not there are junior liens or judgments on the property. It’s paramount that you’re 100% apprised of the full title situation which means getting a correct appraisal, knowing the real value of the property, its overall condition, and any zoning regulations in the area. Environmental Report: Does the property have environmental risks?
In addition to having the budget necessary for the rehab and foreclosure, you’ll also need additional reserves. If there are any capex required, you may consider negotiating when you buy the note.
Loan Level Due Diligence
In terms of loan level due diligence, you’re reviewing a bunch of documents and determining if they’re enforceable in the city or state and local laws. Determine if they were written by competent, skilled professionals and whether you can recover the investment and default interest. Understand that CEMA does not remove liability from faulty documents.
Let’s consider another scenario that may occur. Your documents are in good order and allow for you to recover your principal, but it turns out you have an interest rate written that is not allowed by local regulations. What happens under this condition? You must anticipate and head off legal hurdles. Ask yourself, who’s the borrower? Are they going to file for bankruptcy? Might they counter sue?
In buying the paper, you’re stepping into the role of the lender, so you must pick and choose your battles wisely. Do a thorough review of the loan documentation, check enforceability, and consider getting a third-party opinion from external counsel even if it’s just for the sake of have it. Conduct a recoverability review which includes a review of loan terms, the default interest rate, late charges, exit fees, etc.
Do all of these things to ensure that you’re buying quality paper.
Understanding the potential risks, taking steps to mitigate them, and doing your due diligence are non-negotiable in my opinion as necessary steps in the process of stepping into the complex but rewarding world of distressed commercial debt investing.
Diversification is the Key
To recap, distressed commercial debt offers a significant and growing opportunity as we head into an economic downturn. I believe that there will be many deals that are high quality. Within this game of default commercial paper, it’s a game of specialists which certainly requires a team and experience as discussed above.
Investing with Goodman capital in my view makes a lot of sense. As a fund manager, I continue to diversify. To me, it’s critically important not to put too many eggs in one basket. So, if you’re interested, find out for yourself; contact Eric, talk to him, and make your own decisions. But the point is, you don’t ever want to put too much into one thing, no matter how good the strategy appears. You still have to maintain diversification of your portfolio. And that’s the key consideration in every lesson that I strive to teach.
As always, if you’re interested in learning more about how you can invest in the Tempo Opportunity Fund LLC, please visit https://tempofunding.com/fund/ or contact me, Mike Zlotnik, at firstname.lastname@example.org 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:
Thanks for reading,
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.