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The process of REO management.

As the REO portfolios of financial institutions across the country have grown, the field of REO asset management has taken on new challenges and changing objectives. A field that saw its infancy stage only a few years ago has developed, out of necessity, into a specialized, multimillion-dollar industry. Asset managers, most of whom came from extensive real estate backgrounds, have learned to temper their traditional ideologies and function within a strict regulatory environment, while attempting to reach new plateaus of creative value enhancement and disposition strategies.

On a day-to-day basis, the asset manager relies heavily upon independent management companies to handle physical, marketing, and reporting requirements of the institution's properties. These individuals represent the property in its most critical area-the marketplace. Therefore, it is paramount that property management companies understand the esoteric principles and goals behind the asset management process if they intend to provide complementary services in a competitive marketplace. This understanding must begin as far back as the loan work-out/foreclosure stage and progress through the institution's holding period until the property is sold.

The property manager must understand the asset manager's position and the institution's plan, not only for the property itself, but also for the financial institution as a whole. Ultimately, the manager should even play an active role in the formulation of value enhancement and disposition strategies.

Firms that are successful will not only retain accounts with banks and S&Ls, but position themselves as strong candidates for future business.

Loan workout/foreclosure

Becoming aware of the institution's position begins with an understanding of the events before a property becomes REO.

Generally, prior to foreclosure, a loan-workout period takes place with the borrower, during which the institution's loan officer must make a very difficult decision. Should the loan officer foreclose on the property and forego the potential of maintaining a performing loan, even at a discounted level? Or, would it be better to renegotiate the loan and risk further deterioration of the underlying asset? If the institution's asset is a junior lien, the loan officer must also determine if there is sufficient equity over the senior lien positions to justify a foreclosure.

At this stage, many institutions will call upon the services of an asset manager and an appraiser to identify the property's unique characteristics and assess its definitive position in the marketplace so that the property's potential and tangible value can be estimated. The loan officer will often call upon the asset manager's expertise to help develop strategic options for each contingency before foreclosing.

Occasionally, the asset manager's real estate background gives him or her the insight to propose creative solutions that the borrower may not have considered or may not be financially capable of pursuing.

For example, a medical office complex was recently foreclosed upon as a result of a creative solution that the financial institution planned to pursue prior to taking possession of the property. The borrower failed to service the underlying debt because the property's parking area was only sufficient to support roughly 70 percent occupancy in the complex, rendering a substantial part of the property's income potential useless. However, in a study with the loan officer, the asset manager investigated the option of assembling a contiguous tract of land, versus pursuing a deficiency assessment, and concluded that the assemblage was the preferred alternative, which increased the property's future income, value, and marketability.

Occasionally, the asset manager, in conjunction with the loan officer, will discover that the property is performing at levels far higher than the borrower's operating reports indicate, which can lead to an injunction against the borrower for improper application of NOI.

Once the asset is determined to be a candidate for foreclosure, a "collection plan," which defines loan negotiation parameters, foreclosure criteria, and initial post-foreclosure activities, is generally prepared. Until the asset is taken back by the institution, the loan manager and asset manager continue to communicate closely on decisions and property developments so that the transition from loan to REO occurs as smoothly as possible.

Selecting a management company

From the institution's perspective, selecting the property's management company is probably the single most important decision that the asset manager will make, given that the selected firm will represent the property in its most critical area-the marketplace. Therefore, the management company's strengths and weaknesses have the most direct impact on performance.

Generally, the asset manager has ample prior notification of the impending foreclosure of an asset from the loan workout officer By the time a management company is needed, the asset manager usually has obtained proposals from several, qualified property management companies and may already have made a selection. This decision is predicated on the requirements of the asset, the applicable resources and specializations each company has to offer, and the fee structures proposed.

As a rule, management firms are judged on their ability to achieve results in three basic areas: marketing/leasing strengths, property management expertise, and accounting/reporting capabilities. Each of these ultimately affects the performance of the asset or satisfies the institution's unique reporting requirements.

The asset manager perceives quality and suitability of a management company in several ways. For example, if a firm employs several CPM[R] members and CPAS, this generally indicates that it will bring seasoned property management experience and effective internal controls to the project. AMO[R] firms are also perceived to be established, quality companies.

Naturally, if the property is an office building, the asset manager will request proposals from companies with demonstrated accomplishments in leasing and managing office projects. If one of the candidates represents a competing project in the subject's market, the institution will probably engage a company that is less likely to have a conflict of interest. If the asset manager does not know the proposed leasing and management staff personally, he or she will typically request resumes on these individuals and will often ask to interview them.

Regardless of the property's ultimate disposition strategy, the asset manager will usually conduct this search under the premise that the management company will be required to cure some of the deferred maintenance and successfully lease the project to prepare it for eventual disposition. Therefore, he or she must select a company that is capable of readily implementing remedial and physical enhancement programs, while aggressively pursuing and consummating qualified lease transactions.

Goal setting/plan development

Once the asset has been placed with a management company and the management agreement has been negotiated for business and legal points, the asset manager's primary responsibility begins. He or she must formulate a prudent strategy to enhance the value of the property without undue capital risk, then dispose of it at a maximum sales price as quickly as is prudently possible.

Unlike traditional property owners, who typically approach real estate holdings with a longterm objective, financial institutions with large or growing REO portfolios are faced with attempting to maximize asset values under vastly different, and typically shorter term guidelines. Because banks and S&Ls are often taking back properties faster than they can dispose of them, their plan of action must strike a balance between prudent value enhancement and expedient liquidation.

Regardless of the amount of time or the sequence of events leading to the foreclosure or deed-in-lieu, REO properties are almost always "distressed" to some extent, and the institution is typically faced with a significant loss against the underlying loan's book value. During the period that the property is held by the bank or S&L, this loss can exacerbate or improve. It is the asset manager's responsibility to develop a strategy that counteracts this loss through capitalizing on value enhancement opportunities, while minimizing exposure to capital risks. These strategies will range from intensive rehabilitation of projects to simply remeasuring a building to ensure it conforms to BOMA standards.

Depending on the institution's assistance agreement, where applicable, book losses may occur on some assets. Therefore, it is no surprise that regulatory agencies carefully monitor the institution's progress with REO properties until they are sold and closely examine requests to risk additional capital.

Even with regulatory constraints, management companies should realize that financial institutions are still capable of providing sufficient capital and support to transform a troubled project into a viable competitor Accordingly, a good asset manager will push for superior effort from each management firm and expect peak performance from properties relative to their respective markets.

Although obtaining approval from supervisory agencies to engage in capital-intensive rehabilitation programs is occasionally time consuming, decisions can still be made on a proactive basis. Accordingly, the asset manager's directive is to identify, seek approval of, and implement value-enhancement programs to increase the net realizable value (NRV).

Budget requesting approval of capital expenditures for the year must be submitted by the institution for each property, and each is carefully scrutinized by the regulatory agency before it is approved. Other capital commitments that have not been previously approved in the budget may need to be submitted through a special request for approval (SRA) to the appropriate regulatory agency, which may accept or reject the request.

Depending on the property's ability to reach optimum performance and value levels within defined time and capital constraints, the asset manager and property manager could be faced with a wide range of potential goals and responsibilities. Therefore, the exact nature of the management company's assignment is often not defined until after the property has been taken over, pending the development of an appropriate disposition plan by the asset management staff.

During the institution's initial analysis, asset managers will value management firms that provide critical marketing and physical data, while being simultaneously responsive to immediate or changing needs. Often, the asset manager will voluntarily bring in a management company's key personnel to help formulate the strategic plan and establish a "team concept" from the onset of the working relationship.

Each bank or S&L has predetermined short-and long-term goals, resulting from both internal and external sources. Particular emphasis is typically given to the asset's estimated ability to achieve the highest NRV based upon a discounted cash flow analysis of each reasonable alternative.

Unless the property is determined to be functionally obsolete, the strategic plan will usually require the curing of some deferred maintenance items, the implementation of a degree of physical enhancements, and an aggressive leasing effort. Rehabilitation efforts must be cost effective and market sensitive. As long as these two points can be proven to the regulatory authorities, the institution's request to spend capital is usually approved.

For instance, an off ice/showroom center located in a competitive market was being vacated by most of its tenants when an institution took over the property. A competing center had undercut the market, which was once $7.00 to $8.00 per square foot, down to $3.00. At those levels, the institution's property would have done well to break even.

But, the asset manager recognized that the property's market location, exposure, configuration, and parking would support retail uses. With the replacement of a few overhead doors with storefronts, the property was transformed into a retail center Today, the center is successfully leased at rates considerably higher than the office/showroom market of which it was once a part.

Usually, the institution's short-term goal with each property is to reduce operating expenses and increase occupancy. The longer term objective is to dispose of the asset at its maximum sale price, the timing of which varies with each strategic plan and with the ability of the institution to deliver marketable title.

Once completed, the property's plan is usually submitted to the Federal Deposit insurance Corporation (FDIC) or other regulatory agencies for approval prior to implementation. In some cases, these agencies will request changes in the plan so that it conforms with regulatory performance or methodology parameters. If the property experiences material change, the plan will be revised by the institution and resubmitted to the regulatory agency for approval.

After the final plan is approved, the specific leasing and operational goals are established and agreed upon between the asset manager and the management company, ranging from lease rates and absorption to operational expenditures. All of these items are individually documented and integrated into a standardized operating budget with a detailed chart-of-accounts and individual assumptions.

Leasing projections are substantiated by a solid evaluation of the rate and absorption characteristics of the property's market and the project's relative position in that market. Expense curtailments must be shown not to impact the quality management of the property negatively, and planned capital expenditures must be demonstrated either to maintain or improve the value of the asset. Implementation of the strategic plan After the detailed budget and performance goals have been developed to correspond with the approved plan, the management company becomes responsible for day-to-day implementation.

Progress is evaluated and overseen by the asset manager through constant communication with the management company, periodic physical inspections of the property, and thorough examinations of detailed monthly operational and marketing reports. These reports generally must conform to a strict, standardized format, comparing the property's actual performance on a line-by-line basis with the specific goals set in the operational budget and the marketing plan.

If the property has performed in line with or above established parameters, corrective action is unnecessary, and the property management company will be considered a strong candidate for additional business. However, if the stated goals are not achieved within a reasonable period of time, the asset manager will conduct an in-depth analysis to determine the cause of the problem and initiate appropriate remedial action.

Typically the asset manager will organize a meeting with the management company, during which he or she will address questions such as: Is the marketing plan realistic? Has the market changed? Do the individuals managing or marketing the project have sufficient experience or talent to achieve these goals? Has there been a turnover in key personnel? Essentially, questions regarding each point of the property's operation should be addressed until the asset manager and property management company reach a new agreement. If this meeting is successful and adjustments to the plan are mutually acceptable, the management company will proceed under the modified plan and be evaluated accordingly. Otherwise the asset manager will be required to re-evaluate the strengths and limitations of current management and consider the prospect of change.

Disposition of the asset

The strategic plan typically addresses disposition parameters and sets a value objective for the property, estimated to occur at a certain point during the institution's ownership period. The plan generally indicates when the property will maximize its NRV potential, meaning that any further value enhancements after that time will not warrant the risk or required capital.

If the strategic plan is to market the property for immediate sale, the value objective may have already been met. For example, the property may have reached a stabilized level of operations, and forecasted increases in value would not compensate for risks perceived with holding the property. Or the property may have entered the decline stage of the real estate cycle, where rental rates and property values are falling.

However, if a longer term holding period is recommended in the federally approved strategic plan, the value objective is projected to be attained at a future date, usually as a result of successfully implementing leasing and physical improvement programs.

Although many banks and S&Ls maintain separate disposition departments, the asset manager and property management company may be closely involved with efforts to sell the property. In some cases, the management company will be asked to assist in disposition of the asset with a third-party broker who has an exclusive listing agreement.

As offers to buy the property are received, the asset manager and disposition officer will run an analysis of each proposal, especially those containing creative financing elements, and compare the offer to appraised value and recent market sales, all relative to the institution's goals.

In the disposition process, the management company should strive to assist the institution and the buyer during the due-diligence period and to provide quality service to both entities. If performed to the satisfaction of all parties, this assistance can lead to the disposition of an asset, further assignments, and a possible continuation of service to the new owner.

Conclusion

Institutions in some areas of the country are expected to continue actively foreclosing on real estate properties for years, which will extend the need for asset management and disposition activities into the future. This represents a significant window of opportunity for property management and brokerage companies that have successfully positioned themselves to fulfill institutional needs proficiently. The key to such success is not typical day-to-day management, leasing, and brokerage, but adapting these services to meet or exceed the property's and institution's stated short-term and long-term goals, within the limits set by the regulatory bodies involved.

Fred R. Sutton, CPM[R] RPA, CCIM, is currently an asset manager and vice president at American Federal Bank in Dallas. Previously, he was an asset management consultant to the banking industry with a national consulting firm.

Kevin A. Streufert is currently an asset management consultant to the banking industry with BEI Real Estate Services, a national real estate consulting firm based in Dallas.

A Bird's-Eye View of the RTC: An Interview With Lamar Kelly, jr. Editor's note: The following article is based on a presentation given by Lamar Kelly, Jr, director of asset and real estate management, Resolution Trust Corporation, Washington, D.C., at the 1990 IREM Asset Management Symposium.

I do not want to dazzle you with numbers, but I think it is instructive to look at a few figures as a way of comprehending the problems we face at the RTC.

As of year end 1989, there are 281 conservatorships with total assets of $106 billion. The estimated loss in those institutions was $31.2 billion. Either under RTC control or likely to fail are between 558 and 628 institutions, depending on whose numbers you accept.

In addition to those likely to fail are the distressed institutions. If you add this group to the total, the thrift problem represents an estimated asset value of between $481 billion and $541 billion.

So you can see that we face a tremendous challenge in resolving the problem.

I would point out that our strong preference is to work with debts, to restructure debts, to settle debts with refinancing, or to use any other means that we can to keep from acquiring real estate. But if our efforts fail, we have to institute foreclosure.

However, we hope to be disposing of property as we acquire new ones through foreclosure. Our goal is to never let our property inventories build to the high levels reported in some of the media.

This does not mean that we will be dumping assets, as so many fear Legislation requires that the RTC dispose of properties at no less than 95 percent of the fair market value in distressed areas and no less than 90 percent in nondistressed areas.

We had sold approximately $15 billion in assets by the end of 1989. 1 think this is a credible track record, although we feel that the speed with which we are able to resolve institutions and sell assets will accelerate as the RTC becomes more established.

To accomplish these goals, we have about 2,300 employees, with an anticipated total of 5,000 employees in 1991. Some of these employees will be acting as managing agents in operating institutions and as credit specialists. Others will be investigating fraud and abuse in preparing for civil and criminal actions. However, almost half of these employees will be overseeing the activities of private-sector contractors.

We estimate that two-thirds of all expenses we will incur will be fees to private contractors-property managers, appraisers, and other real estate professionals. Without question, we expect to be the largest utilizer of private-sector real estate services in the history of this country. Hurdles to private-sector employment There are three primary hurdles that a private-sector provider will have to jump before working with the RTC. The first is the conflict of interest regulations contained in the statute. These regulations bar those who have demonstrated a pattern of default, or who have caused substantial losses to the insurance funds. Anyone convicted of a felony is also barred.

The second hurdle is collection barriers promulgated by the RTC. This regulation bars anyone who has defaulted on an obligation to FDIC, RTC, or FSLIC. Organizational bars prohibiting conflicts of interest form the third hurdle.

We have tried to build some flexibility into these restrictions by offering a six-month grace period on new conservatorships. We have also placed a minimum of $25,000 on the value of services covered by regulation. Normal maintenance operations are also excluded.

The second step in the provisional contract services is a competency evaluation. Firms must demonstrate competency through a track record or through their management personnel. We absolutely cannot afford to have the least experienced property managers involved in this process. This is not a totally price-driven mechanism.

We are very concerned that we will not be able to attract enough competent asset managers to this process. I would strongly encourage all of you to register To date we have sent out over 6,000 registration packets and received 1,400 back. It might surprise you to know that none were disqualified. There is a great deal of flexibility built into the system.

The actual contracting for asset management services has already begun, and as the resolution process speeds up, contracting with the private sector will also accelerate. The RTC needs knowledgeable asset managers and will for several years to come.
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Title Annotation:Asset Management; includes related article on the Resolution Trust Corp; management of foreclosed property; real estate owned
Author:Sutton, Fred R.; Streufert, Kevin A.
Publication:Journal of Property Management
Date:Jul 1, 1990
Words:3606
Previous Article:Short-term measures, long-term markets: a summary from the 1990 IREM Asset Management Symposium.
Next Article:Analyzing property management performance.
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