Tale of Two Markets

By all indicators, the U.S. economy will continue riding a “recession-recovery roller coaster” into 2012. The banking industry’s woes are well known, and of course, the recovery requires a solvent and competitive banking sector – we all remember TARP.  Less publicized is the distinct impact the lending practices of the banking industry have made on the commercial real estate segment, in particular as it relates to investment by institutional players and REITs.

Indeed, as commercial property demand rebounded during the first three quarters of 2011, we saw a “tale of two markets” unfold: One “market” lifted by institutional transactions in primary metro areas.  The other “market” depressed by community banks’ bloated portfolios of distressed properties everywhere else.

Land of unequal opportunity for CRE recovery.

By September 2011, overall commercial real estate sales of $143.5 billion had already surpassed the full-year 2010 total, according to Real Capital Analytics Inc. (RCA).  This rebound story was true primarily in core metropolitan areas, such as New York City, San Francisco and Washington DC, where capital sought out the best quality stabilized assets, particularly multi-family, and where cap rates and purchase prices neared pre-recession levels.  The rest of the country tells a different tale.

In distressed markets, fundamental demand for space has still not returned.  Recovery in smaller markets is also constrained by less availability of institutional capital – i.e. commercial mortgage-backed securities (CMBS).  The domestic CMBS market imploded from a record $230 billion in 2007 to a mere $11.5 billion in 2010.  For the ten months ending October 2011, total domestic CMBS issuance totaled $27.7 billion.  Industry experts are already jittery about 2012 with issuance estimates ranging from only $20 to $35 billion. This uncertainty has meant fewer bidders and lower offers in secondary markets such as Minneapolis; Austin, Texas; and Raleigh, North Carolina, according to CBRE Group Inc., the largest global commercial real estate brokerage firm.  CBRE reports there have been fewer bidders and lower offers, and CMBS conduits have been important in making deals in primary markets.

We believe this “tale of two markets” pattern will persist into the coming year.  Even as commercial real estate property-level fundamentals continue to improve, deals will flow to choice tier-one markets and only for select property types.  In secondary and tertiary markets, only highly scrutinized and handpicked property types will attract financing.

“Banks’ unresolved distressed loan portfolios will delay a full-fledged commercial real estate recovery,” acknowledges Jack Mullen, Founder of Summer Street Advisors.  Mullen believes 2012 is the year for banks to become more proactive in cleaning up their balance sheets.  “Banks need to get back to the business of CRE lending, but it can’t be business as usual, especially outside of core markets,” says Mullen.

CRE banking faces tough reality.

As levels of uncertainty wax and wane for the foreseeable future, how should distressed CRE assets and loans be addressed so banks can start getting back to lending?  To answer this, we first need to recognize that the banking sector is still far from the stability and liquidity of past economic expansions.

• FDIC data for 2010 shows mergers absorbed 197 banking institutions, while an additional 157 failed – the largest annual number of failures since 1992, when 181 institutions closed.  Through the first half of 2011, FDIC records 48 bank failures (2 absorbed by mergers), and identifies 865 more “problem institutions” with $372 billion in assets. (See Chart)
• The rate of banks’ non-current loans and loan losses has been declining steadily since the end of 2009.  However, $320 billion in distressed loans remain on the books, and almost 20% are CRE loans.
• 40% of all bank loans are CRE loans, and small commercial banks hold almost two-thirds of that total, according to the Federal Reserve Board. 

“This situation with smaller, community and regional banks can’t be underestimated,” offers Mullen.  “They are living the tale of the geographic markets that the 2011 CRE rebound didn’t reach.  And when a local economy has tanked, some properties can’t be liquidated at any price.” 

Can banks compete?

During 2011, Fitch Ratings, Inc. reported that commercial real estate financing commitments by life insurers (such as MetLife and Prudential) grew sharply, with second quarter commitments at $15.7 billion compared to $5.9 billion during the same period in 2010.  Recent insurance mortgage deals have averaged about $20 million, with average LTVs around 60%, according to Fitch.

“Insurance companies enjoy a cost of capital advantage as well as reduced execution risk vs. banks.  These factors favor insurance-financed CRE deals,” says Mullen.

For real estate investment trusts (REIT), the participation of insurance companies in secured lending during the financial crisis ensured access to capital at a time when refinancing needs were substantial and unsecured borrowing costs exceeded 10% for even the strongest credits.  Although REITs do not face large scheduled maturities in 2012, the continuing participation of insurers as lenders will provide critical support to the market.

Economic recovery always moves through a period where astute investors find opportunities to acquire assets at a discount.  The coming year may very well be a good time to invest, with a large number of troubled loan portfolios from community banks likely to come to market in 2012.  Banks, especially the smaller ones, may not realize how critical valuation and due diligence are to competing successfully.

“Institutional equity is accustomed to having transparency, and that aspect is often missing from community bank assets.  Standard underwriting and valuation alone will not be sufficient to reveal the nuances investors need to know on a transaction.  Every deal needs to be carefully reviewed” advises Mullen.

Many institutions may still face the worst days of the downturn as some figure out how to stay solvent, while others try to make money on commercial real estate while their local economies are still suffering.

“We need to understand and appreciate that a lot of small, community banks are in unfamiliar waters, and there’s genuine fear about what’s going to happen.  But they will have to move past fear and trust professionals that have done this before to help them,” recommends Mullen.

Get back to fundamentals.

Despite economic uncertainty, the principles of sound finance have not changed.  While it won’t be easy, distressed banks have an opportunity to move forward with back-to-business plans based on fundamentals.  A prudent course suggests three imperatives:

• First things first: clean up the balance sheet.
• Second, banking executives have to step forward with a new vision to attract capital based on good market analysis and lending practices. 
• Finally, if the numbers dictate, some leaders will be called to shutter their organizations – many community and regional banks will only remain solvent through merger or acquisition.

“Right now, banks are a risky investment,” Mullen emphasizes.  “Every bank needs a viable business plan, one that makes sense for its investors.”

Banking executives can do more than any other group to move their industry forward, starting with due diligence – and the realization that the future may never again look like the past.

For more information, contact Jack Mullen, Founder and Managing Director, 203.293.4844.

More on this topic: Know What You Don’t Know: The Unique Challenges of Community Bank Distressed Debt Portfolios

Download a PDF of this article.

Commercial Real Estate’s “New Normal”: No Wiggle Room.

Proper valuation and due diligence is essential to a successful investment strategy.  We thought it would be helpful to share our insights on how best to mitigate some of the risks associated with making bank portfolio acquisitions in a rapidly changing market – and perhaps provoke some thought and discussion along the way.  That is why Summer Street Advisors is sponsoring a series of articles examining various aspects of underwriting and valuation.

As commercial real estate enters the second half of 2011, perhaps somewhat oppressed by fears of European debt contagion, the US government’s games of partisan “chicken” over debt limits, and slow recovery of fundamental demand, it is difficult to determine what it will take to thrive in or even survive this “recovery”. Core markets and gateway cities have experienced enthusiastic and competitive bidding over the past 18 months, and stabilized assets are reaching pre-recession pricing – despite anemic occupancy growth and a recent report from the Bureau of Labor Statistics pointing to a small rise in the unemployment rate to 9.2% (See Chart 1).  

On the other hand, value-add investments such as - development, repositioning, and non-core markets - seem scarce.  Banks remain reluctant to lend; their balance sheets are still laden with plenty of troubled assets, thus leverage continues to remain low.  Life companies and pension funds might be satisfied with low leverage and small yields on stabilized product, but the balance of the market needs a little more in their juice box.

Is there any hope for the “business plan” investor?  Who else besides large institutions can succeed in this “new normal” of the slow recovery?

One area of brightness has been the return of Commercial Mortgage Backed Securities (CMBS).  In hibernation for a couple of years, originators came roaring back this year.  But as we have seen, change is inevitable and CMBS investors appear to be putting the brakes on. After $20.8 billion of U.S. securitizations with rapidly compressing spreads, a recent decrease of investor demand has pushed the spreads paid for the bonds back up.   As reported by Commercial Mortgage Alert on July 22nd, “The spread on the benchmark triple-A class of an offering led by Wells Fargo and RBS priced yesterday at 170 basis points over swaps.  That was 35 basis points wider than initial price talk and 40 basis points wider than the comparable class of the previous transaction.”

With a good amount of loans currently warehoused, waiting for securitization and presumably losing value every time the spread widens, CMBS originators are understandably losing their unbridled enthusiasm of previous months.  Citadel Securities, after predicting at the beginning of the year that they would originate $600 million of CMBS debt in 2001, recently announced that its lending program is on hold.  And they are not alone.  By no means does this mean the nascent CMBS recovery is over.  According to Commercial Mortgage Alert, although the heat seems to be turned down a bit, $12.4 billion of securitizations are still scheduled before year end.

Is this cause to be alarmed?  Or is it simply a rational correction caused by an inexorably slow recovery?  There are plenty of reasons to be concerned.  Even if one discounts European insolvency or an unthinkable US government default, the slow rate of recovery and an abundance of distressed assets in the system would give even the most fearless of investors reason to pause.

Real Capital Analytics reports that despite the disposition of $15.6 billion in distressed commercial real estate in the first half of 2011, outstanding distressed assets still total a whopping $180.4 billion (See Chart 2). New investments in the second quarter were double that of a year before at $55.6 billion, but most deals, excepting multi-family transactions, were confined to the top 10 markets.  Despite a steady inflation rate reported recently as 3.6% and continued historic low interest rates, there is little room for error in this market and rashness will likely be punished.  

Bidding in core markets on stabilized assets has pushed pricing to the point that, according to Jack Mullen, Managing Partner of Summer Street Advisors, “The economics of recent trades doesn’t quite make sense at the level they are trading.”  Is it any wonder that CMBS investors have pulled back the reigns on originators?  In order to compete with institutional money, CMBS began to push their underwriting standards again and was even starting to work with property outside of core and gateway markets.  This correction may simply be a reminder to everyone engaged on any new deal, in this market, that nothing can be taken for granted.

According to Mullen, “This market is priced so tightly right now that there is less room for mistakes – and we can’t rely on a surge in employment growth to make up for any miscalculations. Class A tenant demand may be changing fundamentally – in office, retail, even industrial – how and where they use the space, what their demand is and how it works with their changing businesses is evolving (See Chart 3).  Yesterday’s trophy asset might be closer to extinction than anyone realizes.  That’s why gateway cities and other core markets are the only “safe” plays right now.  Tenants will put up with a slightly obsolescent building in New York City or Washington D.C. – and demand promises to keep those fundamentals strong.  In a secondary market, however, obsolescence is more of a threat.”

“In this kind of environment, knowledge, fundamentals, and strong business plans are more important than ever.”  Mullen points out.  The opportunities are there, but they need to be understood, as there is little to no margin for error.  Now that banks have raised more capital and values have started to stabilize and recover, they are stepping up their methodical clearance of troubled assets.  Jack continued, “This is a time for the specialist:  those who know enough about the markets, about the product type and about the business plans will find the opportunities.  Those who rely on pure capital muscle may be disappointed.”

On the other hand, the specialists are starting to get busy.  “Some are finding off-market deals, putting some money in, making capital improvements and then achieving improved occupancy and NOI as a result.  But they must really know what they are doing to succeed.  Institutions and the smaller players have to make sure they run a thorough underwriting process.   They need to really understand the deal, the risks, and the market and have to be good at the old-fashioned task of due diligence and asset management.”

The “new normal” of today’s commercial real estate market has very little wiggle room. For now, at least, those with the know-how have an advantage over the merely fortunate.

For more information, contact Jack Mullen, Senior Partner, 203.293.4844.

Download a PDF of this article.

CMBS 2.0: Is It Safe To Get Back In The Water

Proper valuation and due diligence is essential to a successful investment strategy.  We thought it would be helpful to share our insights on how best to mitigate some of the risks associated with making bank portfolio acquisitions in a rapidly changing market – and perhaps provoke some thought and discussion along the way.  That is why Summer Street Advisors is sponsoring a series of articles examining various aspects of underwriting and valuation.

The Commercial Mortgage Backed Securities (CMBS) market is back!  Is that a good thing?  How should investors approach CMBS this time around?

The investors themselves may have changed a bit since the last go around; life companies used to be the big buyers of senior CMBS securities but the money markets are doing the driving now.  “B” piece investors are pairing up with mezzanine investors who are qualified to own and operate assets, or entering joint ventures with strong REITs.  Whichever way investors come to the market, with $30 Billion of new originations predicted for 2011 (See Graph 1), there should be ample opportunity for solid investments in the recovery.  But how can the new “B” piece buyers be certain about what they are getting into?  Has CMBS really learned the lessons of the past?  Or are we destined to repeat our mistakes?

After three hard years of frozen capital markets, for commercial real estate investors, owners and operators gladly welcome the return of the CMBS market.  CMBS issuance, which hit a high in 2007 of $230 Billion, collapsed to only $3 Billion by 2009.  In 2011, the capital has come back from every source, and transactions have started to build momentum.  According to Real Capital Analytics, transactions exceeded $30 Billion in the first quarter of 2011, surpassing first quarter 2010 levels.  An additional $11 Billion in transactions were reported in the month of April.  Bank and insurance company debt accounts for about two-thirds of that activity.  With capitalization rates settling into the low end of their range, commercial real estate is starting to catch its breath (See Graph 2).

But at the same time, fundamentals are stubbornly weak (especially true in non-core markets), absorption rates are bad, job creation is painfully low and there are still all those pesky defaults hanging over our heads.  According to a special report titled U.S. CMBS 2010 Loan Default Study which was issued by Fitch Ratings in May of this year, cumulative defaults of CMBS conduit fixed rate loans reached 10.60% ($57.58 Billion) by the end of 2010 (See Graph 3).  Despite a slight slowing of default rates in recent quarters, “Fitch expects the cumulative default rate will exceed 12% by the end of 2011.”  And yet, despite the very recent scars, investors are getting back into the water and deals are getting done.  Reports abound of CMBS having learned its lessons, implementing stronger underwriting standards and putting the excesses of past years behind us.  But those reports may be a bit premature.  According to Jack Mullen, CEO of Summer Street Advisors, “the competition for core product has pushed CMBS to stretch again.  There’s plenty of talk about getting more coverage and taking on less leverage – ideally investors want 50% of CMBS deals to be in core markets – but that’s not what we are seeing.  By necessity, originators are funding transactions in non-core markets.  Insurance companies, pension funds, foreign capital and REITs are so competitive for product that it is pushing CMBS out of core once again.”

Mullen’s concerns are well founded.  In a recent report by Standard & Poor’s (S&P) it was noted that the U.S. CMBS market has already experienced, “a somewhat swift evolution between late 2009 and early 2011, as single-borrower transactions gave way to a market characterized by relatively larger, more complex multi-borrower deals.”  Some structural features have already loosened and certain property valuations may be overly optimistic.  According to S&P credit analyst James Manzi, “We continue to see instances where we believe that valuations are questionable, especially within the larger loans for certain property types, particularly office and hotel, in primary markets.  This is probably attributable to the fact that lending is very competitive in these types of markets, where insurance companies, pension funds, foreign investors, and REITs could be bidding alongside CMBS issuers.”

Bob Farina, a frequent consultant for “B” piece investors and former CMBS originator agrees that careful due diligence is required.  “You are not buying an insurance level bond when you buy CMBS.  By definition, CMBS has to go a little farther on proceeds, on structure, on market, on underwriting, or on execution risk than insurance company debt.

Therefore, it’s essential to understand what’s inside the individual deals.  There is more conservatism today generally and more cash in the deals, but when there is execution risk, there has to be more structure baked into the loans to account for that risk.  In effect, quite often we are exchanging leverage for other risk.  An example might be an interest-only 10 year deal in a tertiary market – but with only a 50% loan-to-value.  The deals are not cookie-cutter, but that’s not to say that they are bad deals.  There is rollover risk, there is market risk, but with a combination of careful structuring, as well as a thoughtful investment approach, these can be good deals.”

Mullen added, “It may be better structured, there may be better amortization, and maybe better performance – but the question continues to be how much will leverage creep up?  How much will appraisals creep away from reality?  How soon before CMBS doesn’t look as good as it should?  There’s no question in my mind that in order to avoid the mistakes of the past, “B” piece investors will have to look a lot closer than before.  They need to put people on the ground to examine the individual assets in the portfolio – not just take the ratings on faith.”

That need to look closely may drive a tendency towards larger deals in CMBS today than in years past.  According to Farina, “B piece buyers have to look closely at the product, but B piece buyers have limited resources.  This is all driving a trend towards bigger and lumpier securitization.  At the same time, smart investors will bring teams of underwriters in to perform the required due diligence.”

Mullen added, “as long as the “B” piece investors continue to pay close attention at the asset level, the worst excesses of CMBS are likely to be avoided.  It’s imperative, however, that they hold on to a high level of skepticism.  Appraisals, for example are already starting to get more aggressive.  We’re seeing a 30% differential in some cases between what we see as value and what the appraiser reports.  CMBS is an essential component of a healthy commercial real estate sector and there will continue to be good deals for “B” piece buyers, but in-depth and critical due diligence is a requirement for any investor, now more than ever.”

CMBS 2.0 will continue to evolve as the recovery continues, but the competitive factors that drove CMBS up the risk curve still exist.  Tough loans will be made and it is up to the investors to understand where the risks actually are – and how best to mitigate and profit from them.

For more information, contact Jack Mullen, Senior Partner, 203.293.4844.

Download a PDF of this article.

Solid Commercial Real Estate in Uncertain Times: The Quiet Strength of Good Management.

Proper valuation and due diligence is essential to a successful investment strategy. We thought it would be helpful to share our insights on how best to mitigate some of the risks associated with making bank portfolio acquisitions in a fast changing market – and perhaps provoke some thought, discussion and insight. That is why Summer Street Advisors is sponsoring a series of articles examining various aspects of underwriting and valuation.

The persistent phenomenon of the economic recovery continues to be that of two separate markets. On one hand core metropolitan areas, especially coastal gateway cities are witnessing cap rates and purchase prices on par with pre-recession levels and a kind of bidding war for the best quality stabilized assets, particularly in multi-family. The rest of the country, especially in secondary or tertiary markets, continues to exist in a state of limbo, with little interest from capital and continued distress as the fundamental demand for space has not returned.

Despite the bifurcation of the market, we seem to be in a real recovery. Led by core metropolitan areas, first quarter of 2011 showed an increase in sales, stabilizing rents and slowly improving employment. According to Real Capital Analytics, the first two months of sale as shown by the bar graph to the right in 2011 totaled $17.6 Billion. For January and February 2011, sales volume based on price increased 57% over the similar period for the prior year.  According to the FDIC, defaults in the 4th quarter of 2010 actually fell from 4.36% to 4.28%.

According to a recent survey by Kingsley Associates and Institutional Real Estate Inc. (IREI), North America’s largest tax-exempt institutional investors expect to invest more than $30 billion in commercial real estate in 2011. Commercial real estate almost by default has become one of the best asset classes for risk-adjusted returns compared with U.S. and international equities, fixed-income, venture capital and private equity investments. However most of the activity and enthusiasm so far has been limited to core metropolitan markets. The velocity of real estate economic recovery elsewhere has been much slower. The lack of liquidity in non-core markets and weak economic employment fundamentals has discouraged institutional investors from returning to those markets too quickly. However, at this time, due to overheated pricing in core markets, resulting in limited opportunities for meaningful yield, investors may be willing to look beyond those for higher returns. According to a recent article by the National Real Estate Investor, “… with heightened tensions in the Middle East, foreign capital pouring into the United States and prices reaching pre-recession levels, institutional investors are hoping to achieve higher returns by exploring opportunities in America’s heartland.”  This is where the market starts to get interesting, and where executing the correct level of due diligence becomes imperative.

Summer Street Advisors recently completed a successful engagement on a national multi-family portfolio where the ability to understand the collateral and evaluate the property operations/management was crucial to the overall analysis.  In today’s market, it is not enough to just glance at a property’s income and expense statement. Investors need to understand why a property is meeting with its success or failures.  Is it an overall market condition, or how the property is being managed?  Recognizing the difference is critical in determining how a property will operate going forward.

Given the quick return to pre-recession cap rates in core markets, this recovery is unlike previous recoveries in that discounts on distressed assets are simply not deep enough to allow for investor mistakes. The worst of the recession may in fact be over and prices in some markets are again heading upwards.  While this may be good news for banks and the state of the economy as a whole, it has not made the investor’s job any easier. Compounding the difficulty of assessing investments are the various uncertainties that still hang over the economy. Even if there is no double-dip recession, the specter of potential inflation in the years ahead as well as rising interest rates will surely impact the ability to meet return expectations; no matter how well a property performs. Furthermore, possible changes in the role of Fannie Mae and Freddie Mac in the commercial real estate market should raise questions about any exit strategy in the next five years.

James Sellinger, an independent asset manager and workout consultant recently commented, “In this recovery, you cannot rely on the general market to push up all values to pro-forma, but there are properties out there, in core and secondary markets that will continue to consistently perform.  Location, as always, is crucial to a property’s success, but more than anything else, it is the quality of operations that determines the success – even though it is easy to overlook during periods of market expansion.”

Sellinger continued, “Investors have to understand that commercial real estate – and multi-family in particular - is a very management intensive business. And independent of the current state of capital market interest in a given market, it is the quality of that management that makes the difference between a successful and a failed asset.”

Jack Mullen, principal of Summer Street Advisors agrees, as much of his recent work with investors has focused on determining the quality of management and operations in prospective investments. “In an uncertain market, the quality of the operator becomes even more critical. If you don’t have a solid understanding of the market/property and just clip the coupons – even with a seemingly stable asset, you stand a better chance of getting hurt by the external factors. That is why investors, especially as they are forced to move away from their original investment thesis and towards areas of less liquidity, have to make sure they assess property level management carefully. Management is what will create your leasing stability, which in turn is what’s creating value in good times and bad!” According to Sellinger, “Too many buildings can look good from the street or on paper, but due to weak management, end up becoming a problem.” That is why both Sellinger and Mullen recommend that investors pay close attention to the following five key factors when underwriting the operators of a property:

1. Does the operator have an in-depth understanding of the sector and the market?
2. Does the operator have a good financial position? How heavily leveraged are they?
3. Does the operator have a long-term strategy for the asset?
4. Does the operator have an intensive and systematic process for managing tenants and properties?
5. Does the operator have a deep local knowledge, including neighborhood, demand drivers, and in the case of multi-family assets, schools?

There are certainly outstanding opportunities in a recovering market like today, and in a few years many investors will be pleased with their decisions from 2011. It is important to keep in mind that success over the next few years may very well be determined by a willingness to take a longer view. According to Mullen, “Slow and steady will most likely have an advantage over impatient money. The operators willing and able to build relationships with their tenants, to invest time, expertise and even capital in the long term viability of an asset will fare better despite any new changes in the market. No matter what happens with interest rates, inflation, Fannie and Freddie – good management on the ground will not only mean survival, but success over time.”

For more information, contact Jack Mullen, Senior Partner, 203.293.4844.

Download a PDF of this article.

Know What You Don’t Know: The Unique Challenges of Community Bank Distressed Debt Portfolios

Proper valuation and due diligence is essential to a successful investment strategy. We thought it would be helpful to share our thoughts on how best to mitigate some of the risks associated with making bank portfolio acquisitions in a fast changing market - and perhaps provoke some thought, discussion and insight. That’s why Summer Street Advisors is sponsoring a series of articles examining various aspects of underwriting and valuation.

Despite the difficulties of the Great Recession, there is some consolation:

1. It could have been worse;
2. There are selective opportunities to invest in distressed debt portfolios.

With the worst days of the downturn seemingly behind us, investors, lenders and principals are starting to pick up the pieces. It may very well be a good time to invest, with a large number of troubled loan portfolios from community banks likely to come on the market. But these opportunities do not come without risk. They require a careful, nuanced and strategic approach - standard underwriting and valuation alone will just not tell you what you need to know.

The U.S. economy, where recovery always leads to opportunity for new investment capital, is moving into a period where astute investors are able to acquire assets at a discount. After a number of extensions, modifications and renewals of matured obligations, the more troubled community institutions are taking the necessary final steps to divest their devalued portfolios.

The opportunities are considerable. According to the Federal Deposit Insurance Corporation (FDIC), there were more bank failures in 2010 than any year since 1992. If one combines the value of all the assets of failed banks between 2007 and 2010 it totals over $643 billion. Large as those numbers seem, there is still more to come. The FDIC's most recent quarterly report (2010 Volume 4, Number 4) identified 860 banking institutions on their problem list out of the more than 8,000 they insure with assets valued over $379 billion. Many of those institutions are community banks.

Jack Mullen, Managing Partner at Summer Street Advisors, (a company that provides valuation and due diligence services for financial institutions and investors who purchase distressed assets and debt), likes to point out that, "It is important to understand that the opportunities available during this recovery are unlikely to be easy or safe. The right kind of due diligence is critical for any prudent investor." A lack of immediate pressure for banks to divest troubled portfolios allowed many to potentially recover some value and therefore discounts are unlikely to be deep enough to protect investors from hidden surprises. Compounding matters even further, some community banks may have less consistency, transparency or clarity in their record keeping than one would want and many of the best due diligence efforts will have difficulty uncovering all surprises. According to Jack, "The biggest risk facing investors is, you don’t know what you don’t know."

Investors should take extra care when approaching the distressed portfolios of community banks. "Many look at portfolios from an institutional perspective and assume there is enough data in the documentation to understand a group of assets and their collateral, but a community bank is more complex and often less transparent," Jack warned. "Imagine, as an example, a 300 asset portfolio. In a community bank, those 300 assets can represent as little as 100 relationships - meaning every loan in that portfolio is connected in different ways to a number of other loans and entities. They may be cross-collateralized, or cross-defaulted, but not always. Most loans are made to single purpose entities (SPE’s) and guaranteed by a variety of guarantors. Understanding the total exposure of those guarantors is sometimes difficult to pin down, but imperative, as any problem with one asset can cascade into other assets and relationships throughout the portfolio. You have to be able to map out the inter-relationships, understand the larger exposure that every ‘small’ loan has, and build a granular understanding of the portfolio. You just can’t make broad assumptions based on macro market information."

Stephen Soler, a senior advisor to Summer Street’s bank advisory group agrees that the challenge for valuations and underwriting of community bank portfolios is significant. "It’s difficult, in that your underwriters need to have direct experience with these kinds of assets and, at the very least, have had that experience through at least one major down cycle. They have to know what to look for, and even the best finance and valuation guys will miss the issues if they don’t have direct experience with these kinds of portfolios. A misstep on any one relationship could seriously impact the value of the entire portfolio."

The relationships become even more complex when there is a connection to the board of directors or senior management of community banks. According to Jack, "Things can get a little more blurry than they seem on paper. In addition to the complex relationships of multiple loans to single entities, loan approvals could be influenced by board members or senior management. You have to understand who’s on the board and in the management team, their relationship to the borrowing entities and their interaction with the bank."

At the asset level, problems can be too obscure, unique or small to be picked up by standard valuation practice. Steve pointed out something he had recently seen in a small bank he valued, "One of the bank relationships owned multiple gas stations in a region - which is a common investment found in community banks. The valuation of these assets is based on the amount of gas that is sold through that store on a weekly basis, even though most of the profit comes from the attached convenience store. Gasoline sales drive consumers into the convenience store and in return drives store revenue and hence the value of the property. In this case, each gas station was valued in excess of $1 million. On the surface, these were relatively safe investments, all environmental issues had been identified and dealt with, the leverage seemed appropriate to asset value. But when the economy crashed, the local major employer laid off workers and created an unemployment increase in the area. As a result, no one was driving by the gas stations, a lot less gas was sold and convenience store revenues plummeted. Property value dropped by 60% almost overnight - and unless you understood how these businesses work and are valued, you would have missed it."

Steve added, "You have to understand the business, the real estate, the credit and the relationships at a street level - which is much different than your typical institutional approach. Given the impact of a mistake on identifying the potential risk, there isn’t much room for on the job training."

Underwriting these portfolios require a level of granularity that most institutional investors aren’t accustomed to. Those that can understand the actual value quickly and accurately will have a clear advantage. It’s important for underwriters to have direct experience with the dynamics of smaller loans found in community bank portfolios. If they haven’t seen it before, they won’t know what to look for. As Jack pointed out, "Many of these banks lacked a well defined credit process and well documented files, but the acquiring institution is forced to address the available resources (i.e. Half-baked credit files with borrower and financial information that might be six months out of date). You need to be able to know what you don’t know. And you need to do it fast."

There are tremendous opportunities coming to the market from community bank portfolios in the next two years, but it is essential to mitigate the risk of not knowing what you don’t know. There is more complexity and less transparency than one might expect. It’s important, then, to select a due diligence team that can work strategically in this area, has in-depth experience with these kinds of banks, who knows where to look, understands the relationships, risks and challenges of community banking and can work quickly.

Download the PDF of this article.