WHY BUY THE PROJECT when you can get a deeper discount buying the paper?

That seems to be the sentiment these days, as a growing number of firms take advantage of the opportunity to buy distressed notes at a discount. Experts expect the pace of such deals to continue to ramp up into next year.

As the banking sector returns to profitability, it is able to more readily absorb losses through liquidation. And banks may not have to take too much of a hit. With fundamentals stabilizing and cap rates compressing, the recovery rates on distress dispositions are improving.

“As banks regain their health, they've been more willing to let the assets go out into the market, whether it's a note sale or a discounted payoff,” says Kirk Booher, senior vice president of Chicago-based bridge lender BB&T Real Estate Funding.

There are two growing opportunities in the note space: First-party acquisitions, where owners buy back their own debt at a discount, and third-party acquisitions, where a new owner buys the note and continues the foreclosure process.

Finding the financing to buy back your own debt—or purchase someone else's—is starting to get a little easier. As more lenders dust off their bridge loan programs, first-party note deals will find increasingly competitive quotes in the marketplace than they could just six months ago. And smaller lenders are beginning to step up on thirdparty note acquisitions in anticipation of a growing wave of distress.

Buying Your Own Debt

Most traditional bridge loan lenders prefer first-party to third-party acquisitions.

After all, navigating the foreclosure process and bankruptcy laws in a third-party note acquisition is much riskier and contentious for all those involved.

The rates charged for first-party note deals range wildly, anywhere from 5 percent to 12 percent, depending on the risk inherent in the deal. But in general, these bridge loans are two or three years long, often with options for a year or two extension, and offer loan-to-value (LTV) ratios in the 70 percent range.

BB&T has grown more active in this space of late. The company offers nonrecourse bridge loans with a typical term of two to three years (with extensions for up to five years), currently priced around 5 percent. The lender has seen more opportunity this year in lending on first-party note acquisitions. But just like a straight-up refi, the company requires the owner to put in a significant amount of fresh equity.

“As a general rule, we'll require them to put some new cash in—at a minimum, usually 10 percent of the loan amount,” Booher says. “Anybody can say, ”˜I'll take a discount on my note,' but it doesn't really prove an ongoing commitment to the property."

Though the overwhelming majority of its business is conventional bridge financing, Arbor Realty Trust is also starting to consider first-party note acquisitions.

And when underwriting a note buyback, the company, like most lenders, will take a fresh look at the asset and hold tight to today's values.

“We would look at it as if it's a new acquisition,” says Fred Weber, executive vice president of structured finance at Uniondale, N.Y.-based Arbor Realty Trust. “We're going to underwrite off of today's valuation, and whatever the LTV ratio—75 percent to 80 percent—it's off of the new capitalization."

Third-Party Plays

Often, third-party note acquisitions are all-cash executions. But that's not always the case, and the debt market for third-party acquisitions is beginning to heat up.

There are several hard-money lenders off ering programs that are often shorter term and higher priced than a standard bridge loan. And there are alternative lenders such as Boise, Idaho-based A10 Capital, which opened its doors in early 2008.

A10 has a debt program specifically for note acquisition—and will consider single-loan or loan pool purchases for those looking to foreclose and sell, foreclose and hold, or flip the note to another lender at a higher price.

One of the company's competitive advantages is that its loans are nonrecourse.

A10 will go up to 65 percent of the loan acquisition cost, with one- to five-year terms off ered. All-in interest rates are around 9 percent, comprised of an 800 to 900 basis point spread over the 90-day LIBOR, with two points included in the deal.

The company is aggressively expanding this year to capture an expected wave of distress acquisitions. Since January, A10 has opened offices in the Mid-Atlantic, Midwest, and Los Angeles, and is also mulling plans to open satellite offices in New York and Florida.

“I think the opportunity is going to be huge, not just for next year, but for the next five years,” says Greg Cazel, A10's executive vice president of the Midwest markets.

“We're going to see more bank foreclosures, and on the CMBS side, we're starting to see more deals come out to be sold."

A10 requires full due diligence, including third-party reports, and its typical deal cycle time is between 30 and 45 days from receipt of application. But for those looking for even faster turnarounds, there are options. For instance, BRT Realty Trust, a publicly traded company that specializes in fast executions, has grown much more active this year after a tough 2009.

“We've done quite a number of deals this year where we've financed people buying third-party notes,” says Mitch Gould, executive vice president of the Great Neck, N.Y.-based BRT.

The lender can close in two to three weeks and doesn't require an appraisal. Its bridge loans typically price between 10 percent and 13 percent with two or three points. BRT can go up to 80 percent on leverage, and its loans are typically one-year terms with an option for another year. Significantly, there are no prepayment fees.

The loans typically require recourse, but BRT also off ers a “walk away” guaranty, which gives the borrower an opportunity to give the keys back and walk away with the guaranty getting dissolved.

When it comes to structuring a note acquisition loan, BRT takes a much diff erent approach than it would for a conventional bridge loan. The company buys the note itself and names the borrower a special servicer who continues the foreclosure process and then takes ownership.

“It's a mechanism we came up with to avoid double foreclosure,” Gould says. “If a borrower doesn't pay us, then instead of having to foreclose on him and continuing to finish the foreclosure on the property, we already own the note."