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CRE Finance World, Summer 2012

Faulty Pricing? As one can see, pricing for NPLs as a percentage of appraisal A back-of-the-envelope analysis, for investors seeking mid-teens value has increased significantly since 2009, and now represents leveraged returns net of promotes and management fees for only a small discount to current appraised values. Why have prices NPL investments, implies a target gross IRR return of high-teens, increased? We see four main reasons: assuming 50% leverage at a 5% rate. Assuming an 18-month collection period and 10% transaction friction costs (legal, carrying •Leverage on loan purchases became more common in 2010 costs, property protection expenses, brokerage), a prudent investor and is now widely available to NPL purchasers. needs to buy at roughly a 20% discount to liquidation value to earn •Optimistic assumptions about time and cost to collect. these targeted returns. •Optimistic projections of future property values. For purchases at 100% of the current appraisal, a 25% appreciation •Declining yield hurdles for risk asset classes. in asset value is likewise necessary to achieve desired yields, again assuming only an 18-month collection and liquidation process, Unleveraged CRE NPL and REO purchases in late 2009 and and normal transaction friction. Many factors, such as borrower early 2010 were priced to a high-teens unleveraged internal rate cooperation, can impact individual loan pricing. However, we submit of return (IRR) using conservative collection, leasing, and capital that imposing such a large value increase requirement to earn base expenditure assumptions with little market growth underwritten. case returns requires excessive optimism. If our assumptions about Today, NPL loan sales are priced to low double-digit unleveraged collection periods, transaction costs, and economic prospects IRRs, with low cash multiples due to their short weighted average are broadly correct, then our math indicates a high potential for life. This decline in NPL unleveraged target yields, coupled with the disappointing returns for distressed RE debt investors from late optimistic pro-forma assumptions, has resulted in loan purchase 2011 and early 2012 vintage transactions. Absent a significant values rising from approximately 65-70% of appraised value at the economic recovery or extraordinary value-add executions, the time of purchase in 2009 to approximately 95-100% today. lenders who have sold assets at these levels will have been on the right side of the trades. An investor should know the critical drivers of an investment, and how many assumptions need to have positive outcomes for Authors: acceptable returns to be achieved. Will collection timing and costs Sam is a Partner, and Rich Krumholz and Casey Nelson are Analysts, at be better than they were in 2009, with clogged courts in certain The Baupost Group, L.L.C. Baupost is a Registered Investment Advisor judicial foreclosure jurisdictions? Should projections assume the in Boston, Massachusetts, with $25 billion in equity under management. same or further interest rate reductions, or a broad rebound in Baupost invests in loans and real estate among other value asset classes. operating fundamentals in the short pro-forma period, given the 1 Data from Morningstar excludes loans sold with less than 2% severity uncertain state of the US economy, weak job growth, and potential fallout from Europe? Should leveraged equity deliver a premium return to account for the increased risk and volatility to the down- side when optimistic assumptions do not play out? Considering these questions, a prudent investor should assume a conservative case with respect to market growth and asset level performance when testing the acceptable bounds for returns. A publication of Summer issue 2012 sponsored by CRE Finance World Summer 2012 27


CRE Finance World, Summer 2012
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