The flavor of the year: default mortgage notes

Baskin Robbins is known for having 31 flavors of ice cream. This month,
the “Flavor of the Month” is “Coconut Grove” while last
month the flavor was “Purely Parfait.”

In the world of commercial real estate, the preferred investment class or “flavor” of the year — not month — is the opportunity to pursue a real estate mortgage note that is in default.

Investment brokers were selling office buildings, multi-family apartment houses and land for residential development at record highs in 2006 and 2007. Today, with limited amount of debt available for financing any real estate transaction, investment sales are down.  

According to Sam Chandan, president and chief economist at Real Estate Econometrics, the default rate on commercial mortgages held by U.S. banks may rise to the highest level in 17 years in the fourth quarter of 2009, as debt for refinancing remains scare. The national default rate rose by 38 percent during the first quarter of 2009, Chandan said.  

Real Estate Econometrics defines the default rate as the percentage of a loan that is past due 90 days or more, and/or if the lender does not expect to receive full payment of interest or principal, or full collection against the real estate collateral.  

“The demand for distressed debt is surprisingly high given the complexities involved in purchasing debt and going through the foreclosure processes,” said Robert Knakal, chairman of Massey Knakal Realty Services. “The buyers of the debt, which our firm has sold, have been established seasoned real estate investors whose objective is to own the real estate on a long-term basis, as opposed to financial engineers who will offer pennies on the dollar to reprocess the debt.”

Every investment broker in New York and from around the United States today is trying to sell mortgage debt. Banks are receiving between 20 and 100 calls every day from investment brokers asking if they can sell defaulted debt. People who never owned commercial real estate are now seeking the opportunity to purchase debt without understanding the technicalities of the transaction.

Sign Up for the undefined Newsletter

By signing up, you agree to TheRealDeal Terms of Use and acknowledge the data practices in our Privacy Policy.

Only a few banks are now prepared to go to the market for the sale of a defaulted mortgage note. The majority of those banks are not willing to provide seller financing to the purchaser. That means the purchaser has to pay for the note at the time of the closing.  

In addition to the financial requirement to purchase the note, the buyer must be willing to assume that it will take between six months to three years before they can take ownership of the asset. So even though the purchaser may have bought the note at a discount, the legal fees, associated fees of foreclosure and the loss of the use of capital may cost the purchaser of the note a higher cost than the value of the asset.  

“I am approached on a daily basis by highly successful business leaders in [the State of] Israel, all seeking the fruits of ownership of defaulted debt,” said the former president of a multi-billion dollar commercial bank who resides in Israel, and prefers to remain anonymous. “All they are projecting is double- and triple-digit profits. Unfortunately, I understand the business, and it is not the business for me.”

For example, a commercial bank in New York City has retained an investment banker to sell the note on a residential condominium near McCarren Park in Williamsburg.

According to the trade, more than 200 investors have signed confidentiality agreements to review the terms of the defaulted note. It is rumored that none of the prospective buyers have had an opportunity to visit and tour the property. One thing is certain, someone is going to purchase the note, litigate with the owner of the property and perhaps in a few years capture ownership of the property.

William Silverman, a managing director at Studley, summed up the default note situation when he said: “I view the prospective purchaser of defaulted debt as one who is looking at a painting by Monet at a distance. From afar it looks great; unfortunately when you get up close you finally realize the full meaning of the painting.”

Michael Stoler is a columnist for The Real Deal and host of real estate programs “The Stoler Report” and “Building New York” on CUNY TV and on WEGTV in East Hampton. His radio show, “The Michael Stoler Real Estate Report,” airs on 1010 WINS on Saturdays and Sundays. Stoler is a director at Madison Realty Capital as well as an adjunct professor at NYU Real Estate Institute, and a former contributing editor and columnist for the New York Sun.