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Bank-Owned Real Estate Approaches for Lenders and Builders Legal Considerations When Holding or Managing REO Properties

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THURSDAY, MARCH 8, 2012

Presenting a live 90-minute webinar with interactive Q&A

Ren R. Hayhurst, Partner, Bryan Cave, Irvine, Calif.

Don Neff, President, La Jolla Pacific, Ltd., Irvine, Calif.

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5

REO Properties: Legal & Risk Management Strategies for

Lenders and Purchasers

Don Neff, President/CEO LJP Construction Services March 8th, 2012

Copyright 1995-2012 by La Jolla Pacific, Ltd. All Rights Reserved.

6

Topic Overview…

• REO Trends 2009 to 2011 • BANKS: Who & What? • REO Asset Categories & Risks • PCARs & Due Diligence • Repositioning for Value-adds


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2012 Foreclosure Rate Heat Map


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Foreclosure Markets Ranked

2010 2012 • 1 Las Vegas/Paradise, NV 7.7% 4.1% • 2 Ft. Meyers/Cape Coral, FL 7.1% 2.0% • 3 Merced, CA 6.6% 1.8% • 4 Riverside/SB County, CA 5.9% 1.97%

• 96 Dallas/Ft Worth/Arlington, TX .76% .68% • 105 San Antonio, TX .68% .60% • 109 Houston/Baytown, TX .65% .69% • 125 Austin/Round Rock, TX .58% .57% • 154 El Paso, TX .41% .19%

• 199 Tri-Cities, WA .08% .90% • 200 Tuscaloosa, AL .08% .14% • 201 Lincoln, NE .03% .18% • 202 Utica/Rome, NY .02% .03% • 203 Burlington/So. Burl., VT .01% .04%

USA 2010 Average = 1.2% (1 out of 84 homes)

Source: RealtyTrac Copyright 1995-2012 by La Jolla Pacific, Ltd. All Rights Reserved.

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2010 Housing Transactions – Dallas County

Source: Real Estate Economics Copyright 1995-2012 by La Jolla Pacific, Ltd. All Rights Reserved.

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2012 Housing Transactions – Dallas County


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2010 Housing Transactions – Harris & Travis Counties


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2012 Housing Transactions – Harris & Travis Counties


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Foreclosure Markets Ranked 2010 2012 • 1 Las Vegas/Paradise, NV 7.7% 4.1% • 2 Ft. Meyers/Cape Coral, FL 7.1% 2.0% • 3 Merced, CA 6.6% 1.8% • 4 Riverside/SB County, CA 5.9% 1.97%

• 9 Phoenix/Mesa/Scottsdale, AZ 4.44% 2.96% • 13 Reno/Sparks, NV 3.63% 1.79% • 20 San Diego, CA 2.67% .81% • 26 Los Angeles/Orange County, CA 2.41% .76% • 27 Prescott, AZ 2.41% NA


USA 2010 Average = 1.2% (1 out of 84 homes)


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2010 Housing Transactions – Las Vegas Market


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2012 Housing Transactions – Las Vegas Market


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2010 Housing Transactions – Maricopa County Market


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2012 Housing Transactions – Maricopa County Market


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Foreclosure Markets Ranked 2010 2012 • 1 Las Vegas/Paradise, NV 7.7% 4.1% • 2 Ft. Meyers/Cape Coral, FL 7.1% 2.0% • 3 Merced, CA 6.6% 1.8% • 4 Riverside/SB County, CA 5.9% 1.97%

• 63 Kahalui/Wailuku, Maui 1.2% NA • 65 Hilo 1.1% NA • 72 Kapaa, Kauai 1.0% NA • 143 Honolulu 0.5% .31%


USA 2010 Average = 1.2% (1 of 84)


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2010 Housing Transaction Report – Ewa Beach, Honolulu, & Mililani


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2012 Housing Transaction Report – Ewa Beach, Honolulu, & Mililani


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Banks: Who & What? • Small Banks

- FDIC Insured community banks and savings associations—about 7500 in total across the US - Measures of financial strength based upon “Bankability Composite Score” (per FDIC) - If less than 2% Capital Structure, banks were likely to be taken over in 30 days - FDIC is relaxing this requirement

- Some previously active through FDIC cost sharing—lots of “red tape” to comply; Banks are now opting for mergers and acquisitions w/o federal government intervention

• Large Banks

- Large Money Center Banks (Wells Fargo, BofA, US Bank, etc) - Continuing to be active with in-house REO teams managing assets and dispositions - Some have seen changes in portfolio mix, but have same staffing levels

- For example: residential developments, master-planned communities, condominium towers, commercial buildings, industrial, retail, mixed use projects

- Portfolio mix varies as a function of bank merger & acquisition activity - For example: some banks have been long in Southeastern US residential development markets, so have a larger portfolio to digest

• What are the banks acquiring?

- Product type--see 5 primary asset types (slides 25-26) - Location--location—location is so important for successful repositioning - Stage of completion is also critical--drives risk assessment (PCAR recommendations) - Asset conditions also drive risk assessment—and budget for remedial work


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Banks: Improving Financial Strength

- FDIC Insured Banks on “Watch List” are identified as being “very

poor” to “poor”…in financial strength) - “Watch List” banks decreased from 714 (3/31/11) to 624 (6/30/11)

to 562 (12/31/11)… -21.3% - Banks identified as being stronger financially rose over the same

periods from 3265 (3/31/11) to 3578 (6/30/11) to 3810 (12/31/11)… +16.7%

- The number of banks failing decreased from 40 in mid-2011 to 27 by end of 2011… - 32.5%


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Banks’ Regulatory Environment

• Regulatory framework FDIC/Healthy Bank 80/20 cost sharing split on loan losses… and

profit on the upside also (tool first implemented early 1990s)

• Distressed loans become Non-performing Assets • Non-performing Assets lead to either adversarial

foreclosure action or friendly “deed in lieu” of foreclosure • Shift from borrower to bank into single purpose LLCs per

property (Once FDIC approval is received) • Bankruptcy of borrower slows foreclosure process • Use of Court Receiver limits risk of CDL to bank

- THIS IS VERY IMPORTANT


24

FDIC Changing with the times

• 3 Temporary Regional Field Offices • Handling Asset Dispositions of failed banks

• Irvine, CA opened February 2009, closed January 2012 • Schaumburg, IL opened March 2010, closing Sept 2012 • Jacksonville, FL opened end of 2009, closing late 2013

• “DRR”-Dallas, TX • Division of Resolution and Receivership

• “FDIC”-Washington, D.C. (Headquarters) • Federal Deposit Insurance Corporation • Other regional offices throughout U.S.


25

Banks’ REO Challenges

• Banks are not set up to handle real estate • Do not fully understand construction risks, liability,

insurance, and customer service/warranty obligations • Distressed assets either get “worked out” or folded into

REO portfolio • Banks must perform proper due diligence and figure out

what they have acquired in order to determine best disposition strategy

• Property Condition Assessment Reports are key - Three PCAR levels


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Property Condition Assessments

• “PCAR” Reports

- Level A - Used for all five asset types - Existing conditions analysis & photo records - Deferred maintenance & recommended repairs

- Level B (Report A +)

- Primarily used for partially finished lots, partially complete homes - Estimated costs to complete - Remaining lifecycle of components - Components include building interiors, exteriors & common areas

- Level C (Report B+)

- Used for large residential & commercial projects - ADA accessibility review - Life safety review - C of O & permits review - Code compliance review

Copyright 1995-2012 by La Jolla

Pacific, Ltd. All Rights Reserved.

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Three Disposition Strategies

• Preserve and hold asset - Mostly feasible for raw land, blue-topped lots, or finished lots - Avoids potential risk and maintenance issues with vertical

construction • Bulk sale to investors/builders

- Perhaps most risk-averse strategy - Banks may struggle with heavy discounts (insolvency)

• Build out and retail to consumer - Able to minimize short-term financial losses - Potential risk/liability issues with construction defect litigation


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Example Bank Portfolio of REO Assets

• Single family developments - 15 home completed subdivision—simple to sell—slide 27 - “Broken” master planned community—complex to sell--slide 29

- 5 merchant builders with separate model complexes - 60 completed and occupied homes - 35 partially completed homes (slabs to framing and dry-in) - 120 partially finished lots (with on-site infrastructure) - Regional infrastructure partially complete (eg, 1st lift of asphalt, backbone

power, recreation centers,… all financed with Mello Roos bonds) - Multiple banks involved (frustrated Asset Mgrs are “herding cats”) - Multiple HOAs, common areas partially complete (bonds exposed)

• Attached developments (3-4 story, wood-framed)-- slide 30 • Mid-rise/ high-rise projects (concrete/steel)--slide 31

- 2 empty 20+ story condo towers (rental conversion?)


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Asset Types (Common Definitions)

• Raw land & paper lots - Approved tentative tract map or preliminary plat

• Blue-topped lots - Rough graded but with only basic infrastructure

• Finished lots - Water, sewer, storm drain, street improvements, power

• Partially completed homes - Foundations, framing complete, dried-in,

• Finished homes - Certificate of Occupancy, Notice of Substantial Completion


31

Foreclosed Homes


32

Vandalism at Foreclosed Homes


33

Master-Planned Community Issues


3. Open space (Fuel Mod area--HOA maintained)

2. Finished, occupied homes with Mello Roos bond financed infrastructure (merchant builders A & B)

1. Regional Community Park with recreational facilities (HOA maintained after turnover)

8. Finished lots, slopes (SWPPP protected?) “New” home designs by merchant builder E

7. Blue-topped lots (SWPPP protected?) “New” home designs by merchant builder D

6. Partially Built-footings & slabs (“OLD” design by merchant builder C)

5. Partially Built-houses rough framed (with “OLD” designs)

4. “OLD” model complex and partially built “dried-in” houses)

34

Town Home/Condominium Project


35

High Rise Towers


36

Sample Residential REO Risks Paper LotsBlue Top

LotsFinished

Lots

Partially Completed

Homes

Finished Standing Inventory

1 Entitlement expiration2 City/county fees3 Unforeseen soils issues4 Insufficient soils compaction5 Environmental violations (SWPPP's)6 Hazardous materials on-site / illegal dumping7 Fall hazards / attractive nuisances8 Missing or damaged infrastructure9 Theft or vandalism

10 HOA litigation11 Homeowner litigation12 Water intrusion / weather barriers13 Foundation deficiencies14 Structural framing deficiencies15 Structural deficiencies16 Inadquate MEP systems17 Acoustical deficiencies (attached product)18 Green washing19 Statute of limitations liability - 10 year tail20 Deferred maintenance

REO Risks by Asset Category


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Risk by Assembly (& Other Issues)

• Soils issues • Concrete foundations • Structural framing • Weather barriers • MEP (mechanical, electrical & plumbing) • Acoustical (for attached product) • Attractive nuisances (maintenance, trespass, etc.) • Entitlement Issues (expiring permits, fees, etc.) • Title (liens, judgments, easements, etc.)


38 Copyright 1995-2012 by La Jolla Pacific, Ltd. All Rights Reserved.

Window Installations and Weathering Lumber


Pre-Stucco Weather Barriers Protect the Framing


Gypcrete Before Drywall with Sound Isolation


Gypcrete After Drywall with Sound Isolation


Felt Wrapped Waste at Plates (Condos vs Apts)


Arrestors & Isolators (Condos vs Apts)


Roof Mounted Mechanicals


Two-tiered Isolators


Fire Putty Pads at Plumbing/Electrical

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Post Construction Issues—Deferred Maintenance

• Homeowner Association Maintenance Manuals (HOAs). • Homeowner Resource Maintenance Guides (SFDs). • Videotaped turnover walks & commissioning interviews. • Review of CC&R language and maintenance disclosures • Annual, quarterly, monthly maintenance tracking and reporting. • Property/building assessment reports (PCARs).


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Examples of Deferred Maintenance


49

Disclosures, Specs & Workmanship


50

Due Diligence Source Docs

• Project management files* • Purchase contract files • Field construction files* • Homeowner lot files • Customer service files • Warranty service files • Insurance certificates • Lead bank underwriting documents • Government (plans, permits, bond & fee ltr)


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“List of 50” Archive Docs (Examples)

• Project Mgmt Docs

- A/E plans and calcs - Conditions of approval - Bldg permits - Geo-technical reports - Final compaction tests - Precise grading plans - Sequence lists - Off-site/on-site contracts

• Field Construction docs

- Gov’t inspection reports - QA/QC reports - Homeowner walk-throughs - Superintendent daily logs - SWPPP compliance - Material samples used - Structural reports - RFIs/ASIs


52

Repositioning to Add Value

• Strategies Vary by Product Type & Completion Stage

- Post Construction (limited options): - For-Sale to Rental conversion

- During Construction (more options): - Re-phase for new product mix & smaller releases - Re-bid all trade-scopes by phase - Reduce specification level & re-bid again

- Pre-Construction (many options): - Value Engineer/Re-Design to simplify structures & wring out costs - Integrate green elements (increasing energy and water efficiency) - Re-map for increased density &/or land use changes - Map extensions to preserve value


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THANK YOU!

Don Neff, President/CEO [email protected] www.ljpltd.com


REO Properties: Legal Strategies for Lenders and Purchasers

Ren Hayhurst (Irvine,CA) 949-223-7125; [email protected]

Overview of Note and REO Sales • Note Sales

– Acquire Debt, Not the Underlying Asset – Seller is the Lender, Not the Borrower/Debtor – Subject to Defects in Documentation, Title, etc. – Must Complete Foreclosure Process Before Assuming Control

of the Property – Know Your Enforcement Options

• REO Sales – Take Title to the Asset; Deal Directly with Owner – Must Wait for Remedies to be Completed – Uncertainty Pending Foreclosure

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Note Sale Issues • Abundant Product Still Available

– Wave of Commercial Loans At Maturity or In Default • Banks More Likely to Sell than Special Servicers Who Tend to

Foreclose

• Reasons for Lenders to Sell – Avoids time and expense of foreclosure – Avoids risk of being stuck with REO for lengthy period – Preferred Disposition Method for the FDIC

• FDIC sales can come with protections, such as: (i) Loss share agreements, and/or (ii) Use of the FDIC “super powers”

• Not preferred by FDIC once the note is sold to successor if there is a loss share agreement in place

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Note Sale Issues (Part 2) • Reasons for Investors to Purchase

– Can Often Get Better Pricing on Note Sales – Can Provide Greater Options By Transferring Ownership of

Entire Debt Package

• Obstacles – Purchaser must have the ability to deal with the foreclosure

process – Purchaser Assumes Bankruptcy/Foreclosure Risk

• Risk Sharing is Difficult to Negotiate – most sales are “as-is/where-is”

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Due Diligence Issues

• Due Diligence Challenges – Note Sales Require Due Diligence on:

• The Loan, • Bankruptcy risk, • Potential lender liability and/or defects in loan documentation or

administration, • Condition of Title, and • Condition of the Property.

– REO Sales Requires Standard Property Purchase and Sale Due Diligence:

• Condition of Title, and • Condition of the Property.

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Due Diligence – Note Sales

• Loan Issues – Must Understand Risk of:

• Borrower Bankruptcy, • Lender Liability Claims, • Defects in Loan Enforcement

• Title Issues – Must Understand Effect of Foreclosure On Title

• Eliminate Junior Liens • Effect on Development Rights?

• Property Due Diligence

59

REO Sale Issues • Advantages Over Note Sales

– Title is Cleaned Up for Purchaser – Bankruptcy Risk Eliminated – Can Be Structured in a Manner More Familiar to Purchasers

• Requires No Special Expertise or Experience as Required for Note Sales • Obstacles

– Lenders Increasingly Reluctant to Take REO on Books • Glut of Residential REO on Lenders’ Books • Lose the ability to clean up title (relation back theory of title) • Difficult to structure in “broken” construction loans or deals with

subordinate debt – Long Delays for Buyers and Sellers – Borrower/Purchaser Concerns for the Lender

60

Due Diligence – REO Sales

• Focus On Property – Title Report

• Which rights eliminated by foreclosure and which rights survive the sale

– Market Research • Effect of Foreclosure on Market • Tenant Issues – Co-Tenancy Clauses, Rent Reductions, Etc.

– Environmental Report – Effect of Judicial Foreclosure vs Non-Judicial Foreclosure on

Redemption Rights • Redemption rights very limited in most states and most common in

trust deed states

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Use of Special Purpose Entities • Often Used in Deed-in-Lieu Prior to or in REO Sales Following a

Foreclosure • Reasons for Forming SPE in Foreclosure

– Isolate Troubled Asset from the Rest of the Loan Portfolio/Pool • Who Controls the SPE

– Agent or Lead Bank – Special Servicer

• Sole member vs. Multiple Members

• Problems – Transfer of all Tranche/Syndication Interests into SPE – Partial Note Foreclosure Issues

62

Alternative Transaction Options

• Alternatives to Foreclosure – Deed in Lieu of Foreclosure – Title Subject to Competing Liens and Other Defects

• DIL and then foreclosure strategy can be useful

• Consensual Foreclosure – Permits a Lender to “Clean Up” Title, And Can Speed Up the

Process

• Consensual Bankruptcy – Risk Of Competing Creditor Interference – 363 Sale has Broader Effect on Creditor Claims

63

Common REO Issues- Regulatory Considerations • Holding Period

– Only Applies to Regulated Institutions – 5-Year Maximum – Regulatory Drive to Sell Within 12 months

• Appraisals – Valuation for Foreclosure/Bidding Strategy – Hold vs. Sale Considerations

• Property Inspection – Use, Repair and Maintenance Issues

• Environmental Audit – Foreclosure Review – Use, Repair and Maintenance Issues – Alternative Remedies – Personal Liability Under Indemnity

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Survey and Title Considerations

• Use of Prior Survey – Update or Re-Certify Survey – Alternatives – Title Company Products (Plotted Easement

Map, Etc.)

• Title Policy – Binder if Foreclosing Owner – New Title Policy for Purchaser

• Potential Problems – Easement, Setback and Parking Issues – Mechanics’ Liens, CC&R Assessments

65

Survey and Title Considerations II: Emerging Title Issues • Creditor's Rights Issues

– Consideration for Upstream and Downstream Guarantors – Solvency Representations/Source of Equity

• Broken Priority – Financial Statements From Borrower/Guarantors – Signed Indemnity Agreement from Borrower/Guarantor – Construction loan agreement

• Cost Break Down and Loan Budget – Cash Deposit/Letter of Credit

66

Land Use Considerations

• Entitlements – Unstarted Project – Beware of:

• Moratoriums, • Changes in Developments Plans, • Expiring Development Agreements, and • Replacement Bonds

• Rent Control – Typically Survive Foreclosure

67

Successor Liability

• Leases – Review Liability Under SNDA:

• Past Defaults, • Defaults During Ownership, and • Post-Assignment Liability.

• HOA/CC&R Defaults and Assessments – Typically Do Not Survive Foreclosure

• Profit Participation/Marketing Fees – Controlled by Agreements and Subordinations

68

Project Development Challenges

• Stepping Into Former Project – Bonds need to be replaced – Broken Subdivisions

• Gaining Control of the Declarant’s Rights – Expired Entitlements and Development

Agreement - Moratoriums – Fee Credit issues - Reimbursements?

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