Distressed note purchases have been eyed by many investors as one of the bigger opportunities in the multifamily arena.

As in the conventional acquisition market, though, the lack of distressed notes on the block has inspired frenzied bidding, discouraging many investors. But the opportunities to buy a loan for pennies on the dollar and either collect the remaining debt, or foreclose and own the asset, do indeed exist.

Seeing Traction

Earlier this year, Essex Property Trust purchased a $24 million permanent loan for $20 million, a 20 percent discount. The note on Santee Court, a 165-unit asset in downtown Los Angeles, comes due in October. The seller was an insurance company that grew nervous when the borrower threatened to stop making payments on the note.

“We’re happy to own the asset if the borrower stops making payments,” says Michael Dance, CFO of the Palo Alto, Calif.-based REIT. “But we’re also happy to get a $4 million gain for a six-month investment.”

Like most note purchases, Santee Court was an all-cash buy. Lenders want the assurance of a quick close and are sometimes willing to reduce the price if an investor can strike especially quickly. Those with deals contingent on finding debt financing often are bumped to the back of the line.

Since the beginning of 2009, Alliance Residential has spent about $150 million on six note purchases, with the biggest being for around $30 million. “If you wait for it to be foreclosed, and it goes to a competitive market process, it’s going to drive a much higher price,” says Jay Hiemenz, CFO of Phoenix, Ariz.-based Alliance.

But it’s not just the big REITs that are active in this space. Consider Brand Properties, an Atlanta-based investment group that owns about 1,400 units, all of which it has come into ownership of over the past three years. About 1,000 units alone came through distressed note purchases.

Brand, which is privately held, hired former Lane Co. CFO Derek Kahn last fall to help beef up its multifamily operations. But Kahn soon found that every time Brand bid on a note for a Class A asset, it was routinely outbid by institutional players.

So the company began to focus on loans in the $2 million to $10 million range that fall off the radar of institutional investors. That meant buying Class C assets at pretty steep discounts to face value, mostly in the $10,000 per unit range.

“We’d love to do straight-up asset purchases, but to make good outsized profits these days, you have to assume some of the risks, some of the unknowns, that come with buying the notes,” Kahn says.

Finding the Deals

Many investors found success in the early days of the current recession, before bidding wars became the norm. The Kislak Organization acquired a distressed note through an FHA auction in 2008.

“We paid about $1,500 a unit, and we’re in the process of flipping that out for about $9,000 to $10,000 a unit,” says Dung Lam, CFO of Miami Lakes, Fla.-based Kislak. The previous owner was in the process of redeveloping and ran out of money. “It was 256 units, but only 10 were habitable,” he says.

Since then, the company has put in plenty of bids in online auction sites such as Carlton Exchange and DebtX. “You’re not getting two or three bidders, you’re getting 40 to 50 bidders, and we’ve been about 20 percent off of the winning bid for the past few years,” Lam says. “But we see the bid/ask gap narrowing over the past few months by a pretty good margin.”

Brand Properties also saw some early success on auction sites, buying some loans for just 20 cents on the dollar and selling them a month later for 40 cents on the dollar to build up its balance sheet. “There were some good quick flips, but as more people got more comfortable with the auction sites, a lot of those opportunities dried up,” Kahn says.

So the company turned its attention to working its relationships with local and regional banks. Brand Properties founder Brand Morgan is part of a family that owns a fifth-generation community bank worth upwards of $1 billion, so the company had many connections from the get-go.

“You really have to be very close to the bankers, talking to them almost on a daily basis to find out what their motives and goals really are,” Kahn says. “It changes considerably as you get closer to quarter end—by then, they know how many more losses they can take.”

The relationship between Brand Properties and the family bank pays off in many other ways. Brand has a participating loan program through the bank, basically a debt opportunity fund that provides up to 95 percent leverage to acquire notes. The bank makes the loan to a third-party investor, who guarantees the loan, and the note is bought by a special purpose entity, where the investor is 100 percent owner, “and we’ll take 50 percent on the upside from it,” Kahn says.

When development opportunities came to a halt in 2008, Alliance Residential poured more resources into acquisitions, hiring Russ Kindorf to lead a five-member staff charged with finding note and REO acquisition opportunities. Before joining Alliance, Kindorf served as managing director of JPMorgan’s national housing group.

“Since these financial institutions are more national, rather than regional relationships, we felt we needed people with deep backgrounds in finance to make inroads into those opportunities,” Hiemenz says.

Editor's Note: For a look at the challenges and risks involved in acquiring distressed notes, see our follow-up story, Underwriting Distressed Note Purchases Poses Fair Share of Risks.