Distressed Debt is starting to make a lot of noise in the alternative investment arena and with everyone jumping on the boat; it might be ready to tip.  I have seen numerous announcements of new distressed debt funds and I think we will keep seeing more down the line.  Here are questions you should be asking; who are going to be the winners and losers and does anyone really know how distressed the debt really is?

The buzz in the investment air went from buying real estate to buying distressed debt.  What I would like to concentrate on here is distressed debt in the form of real estate mortgages.  Being a fund manager of a specialized fund that operates as an asset based lender in the business of alternative financing, we are getting hit almost daily with people looking for money for foreclosure acquisitions.  Everyone is talking about buying foreclosures and the media is again helping to purport the good news/bad news story by publishing articles about investors making big money in foreclosures.   The most favored structure is for investors to negotiate short sales with banks, and the banks are more than happy to oblige.  A short sale for those of you not familiar with the term, is a sale of a mortgage note for less than its face value.  Banks do this because they want to get the bad debt off of their books.  This works well in a good market because it gives the new note holder instant equity in an appreciating asset with the hope of a large gain on an eventual foreclosure.  Granted, in this current market short sale pricing is a little more discounted than usual, but for good reason since the housing market is a bit in shambles.  Once an investor actually does negotiate a short sale and take possession of the note, the long foreclosure process begins.  First off, real estate is not a liquid asset and the foreclosure process makes it even more illiquid, if you are looking for a quick turnaround look somewhere else.  The foreclosure process is not only long and tedious, but if you are unfortunate enough to buy a note for a residential property that is owner occupied, the law is not on your side.  As a rule, commercial property is more of a non-regulated structure that is more of a business agreement then the regulated monster that is residential lending.  In residential lending, the law gives the borrower every possible leniency and time is on their side. Carrying costs like debt, taxes, maintenance, and insurance to name a few,  start to quickly eat into profit, and  a residential owner can stretch out a foreclosure for anywhere between 6 to 18 months,  and depending on the state and depending on how much they fight it, it could go even longer than that. Imagine having to service the debt that was used to buy the foreclosure, and every month the payment to carry that debt eats into the profit.    However, that is only the start of the pain because you also need to add the legal bills that will start piling up and then add the potential damage that will have to be repaired when the borrower leaves (needless to say, evicting someone from their own house brings out the worst in people).  Wrap it all up and distressed debt starts looking less like a slam dunk and more like a dunking tank.

The big question is how certain are the funds betting on this strategy and furthermore,  I am curious about whether or not there is a long term strategy for these funds?   If there is a long term strategy, what is it because  the amount of new loans being made is decreasing and once we churn through the current large volume of bad debt and foreclosures, how much business will there be to support a multi-billion dollar fund.

This is not to say that there aren’t a lot of very skilled fund managers out there with the experience and know how to make this kind of strategy pay off big, but if I had to take a guess, I would say that the Asset Based Lenders(ABL) are going to be the big winners here. Now I am possibly biased, because in full disclosure the fund I co-manage is an asset based lender collateralizing on commercial real estate but here are the facts to back up why the ABL’s are the play here.  It takes cash to negotiate a short sale, and it is next to impossible to get a bank to give you an unsecured line to go out and negotiate short sales. Even trying to get a loan on a commercial property that you already own is becoming a magic trick so these buyers only choice is to go to alternative financing sources and these sources can charge what they want for the simple reason of supply and demand. When I say they can charge what they want I am talking about rates in the neighborhood of 11%-20% on average. Not only can they charge what they want but they can also afford to be cautious. Not only do most of them only lend on commercial real estate, but during the heyday, banks were lending somewhere between 80% to 100% loan-to-value(LTV) while ABL’s were generally lending around a 65% (LTV).   In addition, most good ABL’s are originating and underwriting their own loans and with an experienced ABL that knows how to sift through the numbers and nuances, they know what the end looks like before the start.

ABL’s are doing well but the significant returns are still ahead of them.  One must consider that the ABL’s are probably going to lend around 65% LTV on a note that has already been negotiated down probably between 25%-30%.  In fact, the new norm for responsible ABL’s seem to be below a 60% LTV.  That means that a note that was discounted say 30%, is then discounted by the ABL’s another 40% and clearly the security starts looking a little more secure.  To sum it up, ABL’s are making great money short term with the potential to secure large gains long term through foreclosure. Through this, you clearly have both a short and long term strategy.

So in short, I am saying that there is a huge opportunity in distressed debt. However, the most lasting and secure opportunity is in the hands of whoever is at the end of the end game, and that long end game player is an Asset Based Lender.

Copyright: Dominic Mazzone, Regent Global Funds 2008