Home builders and real estate investors seem to have a bad case of premature enthusiasm, sparked by the hope that everything is better now that we’ve avoided a global financial melt down.  Many economists and Wall Street analysts now believe we’re likely to see a significant downturn again later this year, and that the economy, real estate and banking all have a long, hard slog ahead.

According to Bloomberg News, Alec Phillips, head of Goldman’s Sachs Washington office, said in an Oct. 23rd note to clients, “The risk of renewed home price declines remains significant.  Our working assumption is a further 5 percent to 10 percent decline by mid- 2010.”  And, on October 23rd, Bloomberg quoted investor Jeremy Grantham as stating that, “ stocks will drop painfully from current level in the coming year amid disappointing economic data and shrinking profit margins.” Grantham is the chief investment strategist at Boston-based Grantham Mayo Van Otterloo & Co., which oversees about $89 billion.

Why?  Well read on….

To start with, unemployment is expected to remain at or above 10% for another year or so, and to decline slowly thereafter.  This will keep the foreclosure rate high, exacerbated by the fact that residential mortgage  resets won’t peak until late 2011.

As a consequence of high unemployment, and the slow pace at which home builders are ramping down new home production, the economy has yet to sell most of the two million surplus homes Wall Street produced in the run-up to the 2006 housing peak.  Only recently have new housing starts for the first time dropped slightly below the number of new home buyers entering the market.  New homes have to be purchased by new home buyers, not just swapped between owners of existing homes, which is a zero sum game.  Prices will move to investment value and remain there until most of this surplus inventory is sold. This will likely take several more years to work through.

As with the residential mortgage backed security pools (“RMBS”) that precipitated this mess in the first place (along with the credit default swaps insuring them), the commercial real estate loans that make up commercial mortgage backed securities (“CMBS”) are going into default at a breathtaking rate. However, they can’t be marked to market, foreclosed or sold due to the completely dysfunctional nature of the CMBS legal structure.  This is now creating a huge overhang of zombie-like non-performing commercial property loans that have  locked up the commercial property markets.  Savvy investors are waiting on the sidelines for a growing tsunami of distressed commercial property to come to market. They will have to wait awhile longer.

Another major factor (and dirty little secret) is that something in the neighborhood of a one thousand banks are still effectively insolvent due to lack of capital  (yes, Virginia, there are that many zombie banks still out there). These banks will need to be merged or liquidated. Even if the FDIC closed 25 banks every month, it would still take over four years just to close them, at a cost to the government of about one trillion dollars.  Most of the non-performing real estate loans carried on the books of these banks can’t and won’t be foreclosed and sold until these banks are taken over by the FDIC. This will further hobble the commercial real estate markets for years to come.

So the good news is that we’ve dodged Great Depression II.  A small celebration would seem to be in order.  However, we wouldn’t party too long or too hard, as that light at the end of the tunnel still looks to us more like another big train headed our way.

An experienced receiver working closely with a sophisticated title insurance company can usually obtain free and clear title for the sales of new condo and tract tract home subdivisions on a retail basis. Here’s how….

For lenders (and their lawyers) seeking to get full value from non-performing condo or tract housing construction loans, and insulate themselves from ten years of construction defects liability associated with the sale of new subdivisions (particularly in California), the best path is to use a court appointed receiver to complete the project and then sell the individual units on a retail basis – just as the original borrower/developer intended to do.  The retail sales of these units offers the highest prices, and the receiver effectively insulates the lender from construction defects claims and a host of related consumer protection headaches. The big stumbling block frequently is mechanics liens.

In its simplest form, it goes like this:

1. The first TD has priority over other most monetary claims of record (i.e. mechanics liens).
2. Mechanics liens that claim priority over the first TD are tendered to the lender’s original title insurance policy to bond around or pay off.
3. The receivership court allows the receiver to sell free and clear of mechanics liens that don’t have priority over the first TD – as would occur in a conventional foreclosure.
4. Relying on the court’s order, the current title insurance company issues clean title insurance policies to the purchasers of individual units.

And, everyone lives happily ever after….Of course, as we ll all know, in real life the devil always seems to be in the details. The title insurance company has to have significant experience issuing title insurance on new subdivision developments, and confidence in the experience and reputation of the receiver completing and selling out the project.  Many experienced title insurance staff don’t yet even know what a receivership is, much less that their firms are now providing title insurance clear of mechanics liens.  The mechanics lien holders may appear in court alleging that their lien has priority over the first TD, in which case the lender will either need to persuade the court to the contrary, or the court will require that the liens be bonded around until the priority of the lien can be sorted out.  This is where the lender or the receiver should demand that the original lender’s title insurer provide the bond to the court or pay off the lien. The lender paid for the title insurance policy – let the insurer sort it out.

There are other issues that need to be taken in to account as well, including the language of the original receivership order, when construction was completed, the timing of the filing of the Notice of Completion, providing adequate notice of the motion to sell free and clear, and the language of the order permitting free and clear sale.  In some cases the lender will need to provide the title insurance company with a limited indemnity. Which is why, as with with everything else, it’s kind of important to have a receiver that has experience selling subdivisions free and clear of mechanics liens and is actually doing it now.

Although, now that I think of it, paying for a receiver’s education sounds like such a charitable thing to do….

If 2008 was the Year of Denial, 2009 will be the Year of Recapitalization.  How much recapitalization? Investment bank Keefe, Bruyette & Woods projects that United States Banks might need as much as an additional $1 trillion in capital, according to the April 24, 2009 edition of the New York Times.

If you’re an investor looking to buy distressed assets, or a fee service provider looking to help lenders to clear away the wreckage, this is important.  For a lender to sell a loan or the underlying real estate, a lender must write down the asset to its current market value – by definition its sales price – in order to close the sale of the asset.  When a lender writes down the value of its assets it must have a certain corresponding amount of additional capital in order to maintain its required reserves.  Otherwise the lender goes out of business. I don’t know many lenders who want to voluntarily go out of business, so writing down assets (including commercial real estate loan) by banks will have to wait until they are ‘encouraged’ to do so by the Federal Government. This explains why so many lenders with significant construction loan portfolios have acted like deer in the headlights, seemingly taking little action to work through their problem loans.  They can’t.

Until a lender has adequate capital to write down its loans and spend the money to market and sell its real estate, it can’t do either. This effectively stops a lender from taking any action – until the Comptroller of the Currency (if its a regulated lender) comes through and audits the books and forces the lender to raise capital or be taken over by another lending institution.

For several thousand lenders, happiness in 2009 and beyond will depend a great deal on how successful they are at the Darwinian process of raising new capital.  It will determine whether they are strong enough to survive as an ongoing institution or become absorbed by other, stronger lending institutions, as has happened already to a number of lenders (for example, Downey Savings and Pomona First Federal were recently acquired by U.S. Bank; Wachovia was acquired by Wells Fargo; WAMU was acquired by Chase; and Alliance Bank was acquired by Zions/California Bank & Trust, to name only a few). On May 26, 2009, Bloomberg News reported that as of the first quarter of 2009, the FDIC had classified 305 federally regulated banks as “problem” institutions, and went on to quote Gerard Cassidy, Managing Director of bank equity research at RBC Capital Markets as saying that, ”as many as 1,000 banks will go down from 2009 to 2012.”

So stay tuned and follow the capital.  When the smoke clears, many of the lenders that originated the loans will not be the ones that work them out, nor will they be the ones that live to lend another day.

How long will it take before housing prices go up again? In reply to that question, I typically respond, “It will probably take a while longer than most people think and will look a lot like the bottom of a bucket.” When I’m asked why, I’ll usually ask them a question in return: “How long would it take to pick up two million BBs off the beach?” Whomever I’m speaking with usually gives me a puzzled and slightly annoyed look and says, “What’s that got to do with the bottom of a bucket, or, more importantly, when the real estate market will hit bottom or what the bottom will look like? And, for that matter, what’s the bottom of a bucket got to do with anything, anyway?”  Its been the best way I can think of to explain my view of the housing market.

Everyone would agree that picking up a BB from the beach isn’t hard. To pick up two million BBs from the beach, you can give a lot of people metal detectors and magnets to help with the job. It’s still going to take a long time. We’ve got to sell about two million surplus homes in the U.S. It will take a long time to sell them. As long as there are significantly more new homes for sale than there are buyers, prices will remain at investment value. This will result in a long, flat bottom to the market - kind of like the bottom of a bucket. Ahhh, you say, now I’m starting to see what you’re talking about….

At the beginning of 2007, by most estimates there were about two million surplus new housing units (condos and single family homes) for which there was no viable buyer. This triggered a melt-down in housing values that in-turn triggered a domino-like melt down of the economy. The bottom of housing market prices will be when new housing starts are less than new first-time buyers coming into the housing market, and individual housing units reach investment value – the price at which an investor can purchase a home and rent it for a profit. In many markets we’re there – or nearly there. That is not to say that there aren’t other important factors at work here – there are. These are the two of the big ones, though.

Surplus homes are homes for which there are no willing buyers at a particular price. In other words, surplus of existing demand. Annualized new housing starts have for the first time dipped to just below the number of new first time home buyers. In the weakest housing markets you can now purchase a new home and rent it for a profit. Investors are entering these housing markets in increasing numbers and purchasing these homes. As long as fewer new homes are built than there are new first time home buyers, these surplus homes will be absorbed into the market. Depending upon what happens with new housing starts and the number of new first time home buyers in the market, the absorption of these surplus homes will occur faster or slower. For example, if the number of new housing starts remains at its current annualized rate of 500,000 and the number of investors and new first time buyers together buy about 1 million new homes each year, it will take about four years to absorb the surplus new homes. Although investors are beginning to purchase these new homes in ever larger numbers, they are still buying them one at a time. 

Until most of these surplus homes are purchased, the market pricing must remain flat as long as there are more homes available to purchase than there is demand for them. Like the bottom of a bucket, the housing market will likely remain flat for a number of years, while the market works its way through excess supply. Then, when demand for housing finally exceeds supply, prices will rise. Add some inflation, and a lag in new housing construction capacity, and prices could rise pretty fast when the surplus is absorbed.

Then we can all tell stories about the the time when you could buy a house so cheaply, you could rent it for a profit. Ah, the good old days….

Remember how the residential real estate markets froze-up beginning in late 2007?  Well, the same thing is now happening in commercial real estate.  Read on….

Commercial mortgage backed securities, also known as conduit loans, are pools of loans for investment grade shopping centers, office and industrial buildings that have been packaged together as a single security by Wall Street ibankers and then divided up into a series of vertical cash flows called tranches. The individual tranches are then sold to a wide variety of investors throughout in the world.  Each tranche has a different rate of return, with the highest rate of return going to the tranche that takes the first losses, and the lowest rate of return going to the tranche that takes the last losses.

For a more detailed, and somewhat prescient discussion of CMBS, check out a 2001 article written by Jeffrey Steiner and Jim Butler of Jeffer, Mangels, Butler and Marmaro at www.entrepreneur.com/tradejournals/article/84184169.html.  Eight years ago they wrote, “Given the pervasive “success” of CMBS financing, it is nothing short of amazing that so many borrowers and their advisors appear to have little understanding of the process, structure, and practical implications of their securitized debt or how to deal with it when times get tough.”  They were right.

Over the next few years about 450 billion dollars of commercial real estate loans in CMBS pools are reaching maturity with rising vacancy and without a significant source of replacement debt to refinance these commercial loans.  This is paralyzing the market for commercial investment property, pushing down prices of performing property to ever lower values through lack of demand, while buyers patiently wait on the sidelines for this tsunami of non-performing CMBS financed commercial property to be foreclosed and put up for sale (I like to think of it as recycling, like green investment). This is the same thing that occurred with residential mortgage backed securities (RMBS) that froze up residential real estate markets beginning in 2007 – and we know how that’s turning out.

CMBS have become so dysfunctional that we’ve seen CMBS loans that haven’t made a mortgage payment in 18 months and are not yet in default, much less foreclosed and put up for sale.  But wait, the Wall Street ibankers that packaged up these securities are uber-smart. They wouldn’t let someone miss an interest payment without a good reason. Well, as it has been explained to me, there are two primary reasons for this.

First, a CMBS pool is a treated by the IRS as a tax pass-through entity as long as the loans are performing. When a relatively small portion of these loans go into foreclosure, the tax pass-through status goes away, making them subject to double  taxation, which is a bad thing.  So the tranches with the last losses (which are still getting paid) are highly motivated to keep properties from being put into foreclosure.

Second, the base value of these pools was insured through the purchase of insurance policies called credit default swaps (yeah, the stuff that pretty much sunk AIG).  When pool properties stop making mortgage payments, they can be given to the issuer of the credit default swap (which, cleverly enough, is why they’re called swaps) in exchange for a cash payment from the issuer of the swap. So, as you would expect, the tranches with the first losses (which are not getting paid) are highly incentivized to put the non-performing properties back to the issuers of the credit default swaps in exchange for cash.

These two positions are badly misaligned.  Throw in a deteriorating economy with very little liquidity and waves of credit tenants that are going out of business at an ever increasing rate, and you’ve got a bona fide mess. Of course, every tranche has an attorney, and so we now have the tranche wars.

What’s the plan? Word is that CMBS master servicers (the financial equivalent of property managers) plan to essentially do nothing until the market and values comes back, cleverly avoiding the whole problem. Since there’s still a lot of cash flow, the goal is to put much of this property into receivership to capture the cash flow in the interim, while they wait out the market. It isn’t clear to me yet whether the courts will allow receivers to remain in place for the many years it may take for the economy to recover, nor is it clear that you can find a way to put in a receiver and avoid putting the loan into default – that’s for the attorneys to sort through.

Since denial and inaction rarely are a good business strategy, I remain confident that the ibankers who created the mess will find a creative (and profitable) way to clean up the mess.  Stay tuned….

What is a receiver? A receiver is an agent of the state or federal court who typically takes possession and control of real estate or a business as a neutral third party pursuant to a court order.  A receiver is frequently appointed at the request of a lender whose loan has gone into default in order to protect the lenders collateral.

Why should you know what a receiver is?  Lenders are increasingly looking to receivers to take control of, complete and/or sell the commercial property securing their non-performing loans. This is particularly the case with new condominium and tract housing developments (especially those that have homeowners associations), since a receiver can effectively insulate lenders from the onerous long term construction defects liability and related consumer protection obligations that come with this type of real estate.There are no formal requirements or training to be a receiver.  However, there is a general expectation by the courts that a receiver will have a working knowledge of how to prepare legal documents and will have a familiarity with basic judicial procedure.  A receiver will be expected to make court appearances, whether or not the receiver is an attorney.  Ironically, the simpler the receivership, the less likely the courts are to allow a receiver to engage an attorney (or other experienced professionals) at the cost of the receivership estate.

Experienced receivers typically specialize in business or real estate receiverships, although many do both.  The primary skill sets of receivers are development, property management, law, business management or accounting. You should always be looking for a receiver with the specific underlying skill set most applicable to the type of loan collateral being placed in receivership, and specific receivership experience with that type of collateral. For example, if you anticipate requesting a receiver to complete and sell a new condominium project, you want to find an individual with condominium development experience that has completed and sold units in receivership. If they’ve not done it before, you will inevitably pay for their education.

Although it involves the operation of real estate, a receiver is primarily the administrator of a temporary legal entity that controls the real estate.  There are outlines on both basic and advanced receivership issues on our web site at www.waldrealtyadvisors.com/downloads/download.html.   The California Receivers Forum offers educational materials and programs through its web site at www.receivers.org.  These educational materials include the Receivership Law & Practice DVD from their most recent educational conference.

Yes, receivers can sell real estate free and clear of mechanics liens.

This is not well known though – not even by title companies, highly experienced bank attorneys or many of the most experienced receivers.  Not because these folks aren’t knowledgeable and sophisticated, but rather simply because there hasn’t been much call for selling real estate by receivers, so the area is full of myth and legend and misinformation.

It’s important now, though.  Really important. Why?  It’s important because the vast majority of defaulted construction loans are for new subdivisions – particularly housing (think condos and housing tracts), but also for hotel, office and retail condos, and they all share one very big long-term liability in common – ten years of construction defects liability for the owners, developers and contractors. Kind of like breaking a mirror, but for a longer time period and worse, this one’s not make believe.

Of course this liability attaches to the lender once they’ve foreclosed on the loan and become the owner. Traditionally the easiest way to remove a mechanics lien was to foreclose, and that’s what virtually all lenders did – the receiver held the property until the lender could foreclose it, and then the lender sold it post-foreclosure, free and clear of liens.  Simple and clear cut, and it gave the lender direct control of the real estate to boot.  And who doesn’t want control, after all.

However, as the result of long term construction defects liability that attaches to new subdivisions, lenders (both originating lenders and private note buyers) and their lawyers are now looking to receivers to sell subdivisions (both wholesale and unit by unit at retail) in order to avoid taking title to the property and taking on endless years of construction defects liability and related consumer protection issues.

Our receivership court orders now routinely provide for the receiver to have the authority to sell subdivisions free and clear of liens, subject to the consent of the lender.  The concept is simple and equitable enough.  Mechanics liens are nearly always subordinate to the lenders first trust deed anyway, which is why foreclosure eliminates them. So selling real property in receivership and paying off the first trust deed on a priority basis makes sense. To the extent that a mechanics lien has a legitimate priority over the first trust deed, that’s typically a problem for the issuer of the lenders title policy, not the receiver. The only issue arises when the lenders title insurance policy showed an exception at the time the loan was originated for construction contracts that commenced before the first trust deed was recorded – but even foreclosure won’t eliminate those mechanics liens. Stop notices pose the same problems and foreclosure won’t eliminate them either.

However, their are some complexities. The title company has to review the specific language of the court order. Most title officers are only now starting to become aware of what a receivership is. So it is important to work closely together with the title company, and to find out which title officer or lawyer within the title company has expertise with the sale of real property in receivership. There are other issues as well that arise for each particular situation, so it’s important to consult with a receiver or banking lawyer who has current specialized experience in this area.

Marc Brooks called me the other day and announced, ”You know, a lender who forecloses on a new subdivision development that was collateral for a non-performing loan may have to pay ordinary income taxes on all of the sales proceeds as a real estate ‘dealer’. On the other hand, when a borrower or a court appointed receiver sells out the subdivision and pays down the loan, the lender gets to remain a lender.” Marc Brooks is the founder and Executive Vice President of Mara Escrow and Mara Exchange, and has several thousand subdivisions under his belt, so he’s a pretty experienced guy. However he is not a tax expert (as he would readily acknowledge).  So I was a little surprised to get the call. I in turn called a tax expert, and he concluded that Marc may be right, subject to the specific circumstances of the loan and the lender.

Generally, as I understand it (and I’m not a tax expert either) the federal tax code says that the owner/developer of a new subdivision that sells more than four units or parcels (the rules are fairly arcane) is a ‘dealer’ and must pay ordinary federal income tax on profits from the sale of the subdivision units or parcels. A lender who is repaid the principal of a construction or development loan by a borrower would only pay taxes on the interest earned. Today this isn’t a big issue for traditional lenders, since in most cases they’re already swimming in losses.

However, it could be pretty important for investors who buy non-performing loans (typically construction loans secured by 1st trust deeds) at a steep discount, and step into the shoes of the lender. It may also be important for profitable lenders who have fully charged off their loan losses, and now stand to make a profit on the sales of their foreclosed real estate. When a lender forecloses on a loan and sells the subdivision, they may become a ‘dealer’ and pay ordinary income taxes on the profit from those sales. However, if the borrower (or a court appointed receiver acting in place of the borrower) sells the subdivision and pays down the loan from the proceeds, the borrower remains the ‘dealer’. The lender remains a lender and receives the repayment of principal and interest from the loan. Depending upon the lender’s basis in the loan and their hold period, the lender may be taxed on the loan proceeds as long term capital gains and not ordinary income.  That’s potentially a 20% reduction in federal income taxes, not an insignificant sum.

Of course, these are pretty complex tax issues and neither Marc Brooks nor I are qualified to give tax advice, so make sure you consult your CPA, tax attorney or other qualified tax advisor before you make any business decisions.

So I’m sitting at lunch with some of the other speakers at a recent commercial loan workout conference (I was speaking on the use of receivers to complete and sell new housing projects), and someone mentions that vulture investors are buying, and in some cases foreclosing on, CFD and Mello Roos bonds to acquire distressed tract housing developments.He goes on to explain that the construction loans that finance new tract housing developments are frequently subordinated to the Community Facilities District (CFD) or Mello Roos bonds that are used by developers to finance the extensive and expensive infrastructure (streets, sidewalks, utilities, etc.) in a new housing subdivision. As a result, when no one is making the bond payments, since the developer is gone and there are no homeowners yet to make the bond payments, the bond holder can foreclose on the housing subdivision – wiping out the construction lender, and everyone else with lower priority liens.

That leaves the construction lender with three options: 1) Bring the CFD bonds current and keep them current (through the developer or a receiver, or after they’ve completed their foreclosure); 2) Try to buy the bonds outright; or,  3) Lose the housing subdivision (the colateral) to foreclosure by the bondholder.

As a result, vulture investors are starting to look for non-performing CFD bonds and buying them at steep discounts to their face value, with the expectation that they will receive a very high return if the bonds are brought current, or to acquire the underlying real estate at a deep discount and then resell it to another developer.

It’s a pure financial play, so these vulture bond investors are particularly focused on housing subdivisions with completed entitlements and construction. If entitlements are not yet perfected, then they’re forced to become developers themselves in order to preserve the public agency approvals. Incomplete construction makes for a fairly complex and lengthy due diligence effort to determine the additional cost to complete the subdivision infrastructure. Both represent challenges that most of these investors are not equipped to address.

So, if construction lenders don’t have enough problems already, they need to be on the lookout for defaulted CFD and Mello Roos bonds on their non-performing housing subdivision construction loans. It’s no longer enough to just focus on the non-performing developer and guarantor that sits above you in priority, you’ve got be looking out below.

Several months ago I earnestly asked a friend of mine who is a land economist, “Where’s the bottom of this housing market?” and he promptly answered, “I don’t know.”  However, being persistent, I asked again. This time he answered, “Well if you could tell me how much zombie housing is out there, I could make an intelligent guess.”

Since he’s very smart and this wasn’t the answer I expected, I cleverly replied, “What is zombie housing?”  To which he responded (and I loosely paraphrase), “It’s all the new housing under construction but not yet completed and sold, added to all the homes that have yet to be foreclosed at some point during this cycle.” I guess it’s sort of the housing version of the ‘walking dead’.

In talking with colleagues since then, I am increasingly impressed that there is a lot of zombie housing out there (well over 5 million vacant housing units) listed for sale in a market where a ‘healthy inventory’ would be only about 1.5 million vacant units listed for sale), and apparently no one yet has a good handle on it.

It is certainly understandable that no one can accurately predict how much housing will be foreclosed without knowing how weak the economy will get.  On the other hand, I’ve not yet read or heard anyone discuss exactly how many single family homes and new housing subdivision units are now under construction that have not yet been delivered for sale. If someone knows, I’d like to hear about it.

Or, maybe it’s just too scary to count the zombies….