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Staving off commercial foreclosure

David Schechtman of Eastern Consolidated in front of the Manhattan courthouse at 60 Centre Street where foreclosure cases are processed.

This time, the mortgage banking industry is not taking any chances. Stung by the subprime mortgage crisis, the tightening credit market, Wall Street layoffs and other bleak economic indicators, banks are nervous. And this time around — in contrast to other periods in real estate history — lenders are not waiting for the owners of commercial properties to go into foreclosure. Instead they are discounting and selling off mortgages on commercial properties where borrowers are having trouble making payments.

Selling the mortgages rather than going through the foreclosure process is a relatively easy way for banks to cut their exposure to distressed real estate, said Richard Nardi, a partner in the law firm of Loeb & Loeb and the counsel to the Mortgage Bankers Association of New York.

"[The banks] say, 'If I foreclose, I am going to take a 30 or 40 percent loss, so why don't I sell the paper at 15 or 20 percent loss, and save the horror and the brain damage of having to go through this over the next year or two?'"

Real estate investors and vulture funds are buying mortgages on distressed commercial properties and either working out new deals with borrowers or making preparations to foreclose.

Commercial foreclosures have not risen dramatically compared to the last three quarters. According to statistics compiled by real estate research firm PropertyShark.com, in the first five months of 2008, lis pendens notices in the city were filed on 524 vacant properties, 45 office buildings, 33 warehouses and 22 industrial buildings.

However, many of the transactions involving distressed commercial real estate take place behind closed doors and before the property listing ever reaches any part of the foreclosure process.

"It is difficult to track properties in distress. These are obviously private situations, and many of the players involved desperately try to keep them private because the second the real estate community gets a thought in their head that a property might be distressed, it's in nobody's best interest," said Dan Fasulo, managing director of Real Capital Analytics.

While commercial foreclosures are still rare, Fasulo said he believes the majority of properties that are vulnerable were likely purchased in the past couple of years.

"The only people who might get into trouble on foreclosure are a small group of folks who purchased at the top of the market and used [short-term] debt to finance their purchase," said Fasulo. "It was only a window of six, maybe eight, maybe 12 months. It was really from the end of 2006 to the summer of 2007, when that 15 percent froth got into the market."

He added, "I am having trouble finding distress in the market."

Nonetheless, for David Schechtman, senior director of the turnaround and distressed group at Eastern Consolidated, business is busy.

He said he has handled about $110 million worth of distressed real estate so far this year, and that there has been an exponential uptick since last year in these types of transactions.

"My dream two and a half years ago was that the world would be in excruciating pain," said Schechtman, who left a career as a bankruptcy lawyer to get into distressed real estate. "So now I am walking around with a shit-eating grin on my face."

The properties most vulnerable to default, said Schechtman, are ground-up development sites, followed by conversions of existing buildings, such as office buildings being converted to residential property or residential rental properties being converted to condos.

"Some of these guys do not have all of their financing in place — they do not even have the money to pay for the cranes to lift the bricks," he said. "If I were the owner of a development site in Manhattan and I did not have my financing in place, I would not be sleeping soundly."

In addition to the unknown number of commercial real estate borrowers who may be in default, others who are getting pinched by the credit crunch have managed to get extensions on the maturity date of their mortgages to buy more time to refinance, said Nardi.

"I think efforts are made by borrowers and lenders to see if they can get a little bit more time to figure out where the market is going," he said. "But if there is no improvement at all in the availability of financing or general economic conditions, then I think you will see foreclosures start to occur."

Some say they saw the writing on the wall when risky commercial real estate investments were made over the last few years.

"Over the past two or three years it was not at all uncommon to hear people say, 'I am not buying in this marketplace; the numbers do not make sense anymore,'" said Nardi. "And even with some of these very large transactions, people were being asked to take a much longer view than they otherwise might have been willing to take in order to justify the investment in a property. There were a number of sales going on that didn't meet any of the traditional models for how you price and value real estate."

While the full impact of the credit crunch on the city's commercial market may just be starting to unfold, there is no shortage of investors looking for deals on distressed properties.

Most of the Wall Street investment banks have established funds to buy mortgages on distressed properties, said Lawrence Longua, director of the REIT Center at New York University's Schack Institute of Real Estate.

"There are literally billions of dollars that have been raised to buy non-performing debt," Longua said. "So if I am a bank holding a loan, I am unlikely to foreclose because there is such an enormous amount of money that is looking for this stuff."

Currently there are no fire sales on mortgages for distressed commercial real estate in the city, experts said.

Most of the discounts on mortgages and loans involving distressed real estate in Manhattan are about 10 percent, Schechtman said, adding that despite that figure, one major deal he recently handled involved a discount of 19 percent.

Some investors, however, appear to be holding out hope problems will exacerbate and discounts will deepen and be comparable to deals available during the crisis of the early 1990s.

"The vulnerabilities are there, but I don't think that we are in the disaster situation that we were in 16 to 17 years ago," said Longua, who has been retained by a group of investors interested in buying bank debt. "I continue to tell these guys this is not 1992. You are not going to acquire debt at 30 cents on a dollar."

Nardi concurs that the city would need a perfect storm of misfortune to cause a commercial real estate crisis of 1990s proportions.

"The bottom could fall out of the condominium market," he said. "But you would need substantial layoffs of Wall Street people, plus something to pull [the] foreign investors out of the U.S. marketplace."