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   ARTICLE   |   From Scotsman Guide Residential Edition   |   July 2013

Making the Most of Your REOs

Mortgage banks should consider partners to help move distressed assets faster

Handling real estate owned properties (REOs) can be a drain on lenders’ human and financial capital. It is a difficult balancing act for mortgage bankers and lenders to manage REO expenses while also maximizing their recovery.

Some innovative mortgage bankers and lenders, however, are pursuing a new strategy when it comes to taking full advantage of their REO properties: Teaming up with a partner to improve their properties and their potential profit margins. Mortgage banks that consider this partnership can help increase their returns and reduce their REO carrying costs, as well.

Background

Decades ago, mortgage banks would hold real estate on their books for investment. In some instances, banks over-inflated the value of their investments in real estate to cover poor lending decisions or bad projects. Regulators eliminated these hidden losses by forcing banks to accurately price their real estate and to liquidate their REO supplies as quickly as possible.

This resulted in the mortgage industry coming up with a foreclosure value, which morphed into a liquidation value. By the late 1990s, not only were banks rated on the elimination of their nonperforming and REO debt, but loan servicers also were rated on their turn times in disposing of this REO debt. The pressure to convert assets to cash resulted in pressure to put assets on the market and sell them as quickly as possible — all the while without actually repairing the distressed assets.

As part of the National Association of Realtors’ monthly Realtor Confidence Index (RCI), real estate agents are asked to provide the percentage below market value at which a hypothetical house would sell given its condition. According to the RCI released this past April, foreclosed properties in “well below-average” condition were discounted 27.4 percent and properties in “above-average” condition were discounted 13.6 percent.

Real estate investors have been the big winners in the move to liquidate REO properties quickly. Investors have been willing to price and repair distressed real estate to make a nice return for their work. Even Wall Street is buying homes. For instance, the hedge fund Blackstone reported that it already has spent $2.7 billion on REO housing, as of this past February.

Several other hedge funds also have moved to buy assets, repair them, and then rent or sell them. To a large extent, the mortgage-banking industry has not maximized the value of its REO properties because of the pressure to sell those assets and the unwillingness to invest money to repair them. Consequently, the investor community has stepped in and picked up the money that effectively has been left on the table.

Finding a solution

The solution to this is simple: Mortgage bankers and lenders should consider repairing their REO assets if at all reasonable. To determine if an asset is reparable, lenders should consider the following simple formula:

  • Take the as-is value of the asset.
  • Add the repair cost.
  • Add the cost to hold the asset while it’s being repaired.
  • Add the selling cost.
  • Compare that total cost against the repaired value and determine if the repaired value provides a satisfactory return.

At a time when so many REO properties have not been repaired, fully repaired assets can be unique properties and often sell faster — and at a premium. Fully repaired assets attract more buyers because they can move in and start enjoying the house right away.

In addition, repairing an REO asset takes the guesswork out of setting a value on a house so that an appraiser can feel more comfortable giving the asset its full market value. Finally, a repaired property simply will make many lenders more willing to provide a loan for the given house.

A new partner

Mortgage bankers would do well to at least consider fully repairing some of their REO assets. That said, there are several hurdles that banks often face in investing in REOs.

The first hurdle is having the time and money to invest in these properties. With the new Basel III requirements coming into effect, mortgage banks have more pressure than ever to get REOs off their books. Because of this, the justification for investing in an REO may decrease, as lenders may have difficulty reconciling the additional investment before there is a recovery (i.e., before their assets actually are sold). One way to overcome this, however, is to find a partner who is willing to invest in the real estate. A popular approach that’s gaining traction is for a bank and another financial partner to agree on an as-is value of an asset. The partner then pays for property preservation, repair costs and holding costs until the property is sold at its as-repaired value. The net proceeds of the sale of the REO asset are divided as follows:

  1. The bank recovers the as-is value.
  2. The partner then recovers the property preservation, repair costs and other holding costs.
  3. The remaining proceeds are split between the bank and the partner (typically at 50 percent each).

With this strategy, a mortgage bank does not have to put additional money into the asset once it owns the property, but the bank nonetheless reaps 50 percent of the net profit on the REO, an undeniable victory for the bank. The partner has to pay for the real estate preservation and other costs, but that partner does not have to buy the asset itself and still makes 50 percent of the net proceeds, an undeniable victory for the partner, as well. 

Mortgage professionals should be aware that a second hurdle remains, however: Regulators arguably do not like mortgage banks investing in REOs other than to preserve the real estate until it can be converted to cash. This is an understandable position, given that a few banks previously hid poorly performing assets. Even so, many regulators may be willing to entertain this proposal for banks to pursue joint ventures with a partner because, in this case, a bank is not using its own money and is not hiding loan losses.

One stipulation, however, is that a bank cannot be the lender to the partner to carry the asset. Although there is no clear endorsement or probation to this approach, a mortgage bank’s best approach still is to run the concept by its regulator before proceeding with any such endeavor.

Finding the right fit

This system will work for residential and commercial assets. The key, however, is selecting the right assets. Properties in move-in condition or those that your organization was already going to repair obviously are not candidates for the shared-revenue approach. Neither are nonreparable properties, as defined in the mentioned formula. That noted, all other assets should be considered for such a program

One final question remains: What should mortgage bankers and lenders look for in choosing a partner for such a venture? In short, the right partner is one who has experience, is willing to provide a detailed repair cost upfront and will provide all the supporting documentation for the work being done

Some loan-servicing and property-preservation companies have begun to offer this service, as are some independent investors. Often, once the first REO asset is sold under this shared approach, the following sales become easy. Through this joint-venture program, mortgage banks can avoid the out-of-pocket expenses of holding a property and can rest assured that their partners will have a vested interest in maximizing the deal’s net return in as short a time frame as possible.


 


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