COVID-19 Opportunity: Invest in Distressed Assets and Unique Gaps in the Private Lending Market
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The COVID-19 outbreak could be scary for ourselves as humans, and for our economy. But there are silver linings and opportunities in every economic downturn. Distressed assets, including nonperforming loans, became a high-demand asset class as the crisis continued to affect our economy. If you are an investor, a fund manager, or a lender with dry power, this webinar is for you.
During this webinar, our expert attorneys discussed:
1. The legal issues and solutions surrounding distressed asset strategies.
2. Practical aspects of pursuing these strategies.
3. The viability of these strategies considering the volatility of today’s market.
Kevin Kim, Esq.:
Alright, good morning everybody. Welcome to the Geraci LLP webinar for the COVID-19 Pandemic on opportunities. We're just going to wait a little bit for the attendees to file in before we get started. Matter of housekeeping. Real quick, guys, this is a Zoom webinar format, so if you've got any questions, if you click below in the toolbar, there should be a Q&A function. Click on that to type in your questions. We're going to make sure to try to get to all of 'em today. Try to keep from typing in questions into the chat box just because it can get a little cluttered and I can't track whether I've answered them or not.
So we're just going to wait a little bit for the more attendees to get in before we get started. Okay. All right, I think we should get started now. Make sure we're respectful of everyone's time. So good morning everyone. This is Geraci LLP Covid 19 Pandemic Response Webinar on investment opportunities. This particular webinar is focused on investing in distressed assets. I'll be your host. I'm Kevin, Kevin Kim, partner here at Geraci. With me today is Associate Tae Kim. So today we're going to talk about opportunities in the space associated with distressed assets. Lemme introduce myself. For those of you who don't know me, my name is Kevin Kim. I'm here, a partner here at Geraci LLP. I manage the firm's corporate and securities division, nationally recognized expert and fund formation in the private lending space. I've basically advised and prepared hundreds and hundreds of funds across the industry. I'm also the lead instructor for the American Association of Private Lender Certified Fund Manager Course. I'm teaching hundreds of fund managers throughout the United States and abroad on securities regs, fund formation, fund design and compliance. te, why don't you introduce yourself to the audience?
Tae Kim, Esq.:
Sure. Hi, my name is Tae Kim. I'm a corporate securities attorney here at Geraci Law Firm. I work very closely with Kevin Kim, the partner here at the firm as well as other colleagues. We specifically design and structure and assist our clients, specifically the fund sponsors for preparing the offering documents. We work with mortgage funds, real estate acquisition funds, syndications, REITs, and opportunity qualified funds, and today we're definitely going to be talking about the NPL funds as well as other investment opportunities in relation to COVID-19.
Kevin Kim, Esq.:
Alright guys, so just to make sure we revisit the housekeeping before we get started. So for those of you who just filed in, this is a webinar format, so if you've got questions, please type them into the Q&A function below. So below in your toolbar, you should see a Q&A button. Click on that to type in any questions, we'll make sure that we try to get to all those at the end of the webinar. Try to avoid typing your questions into the chat because it's hard to track and make sure we've answered them. Feel free to chat if you'd like. So let's get started. So today our focus is definitely talking about the opportunities that come from an economic downturn associated with this COVID-19 coronavirus pandemic. Before we even get started on this, I don't want to be insensitive to our listeners.
Our hearts and minds definitely go out to the world right now suffering because of this unprecedented and unforeseen pandemic. We're all sheltering in place and we're all doing what we can here at Geraci LLP to social distance, but it would be remiss if we did not educate our industry and we would not be surveying our industry properly if we didn't educate the industry on opportunities that come from a down cycle. As many of you know, Geraci LLP was founded during the last cycle in 2007 and we really grew significantly during the economic downturn or the great financial crisis of 2008 and 2009 and here we are today seeing similar, I guess impacts on the real estate and real estate finance industry in a different, I guess format or different means of course, but still important to discuss. So that's the focus of today. Once again, our hearts and minds do go out to those suffering with this terrible disease and we are doing what we can to support the industry the best we can through education and advocacy.
So the focus for today is really talking about distressed assets associated with the private lending space. The first and obvious topic that comes to mind is non-performing loans. Definitely a large industry in and of itself and a lot of opportunity there, but we're not just going to talk about that. We're also going to talk about distressed companies. It's also a very important opportunity to discuss and also talking about distressed real estate. The focus for today's webinar is going to be talking about mostly legal. You have two attorneys on the call today, so we're going to be talking about legal guidance associated with pursuing these strategies, the main ways you'd go about pursuing these investments, and that's why you have two fund attorneys on the webinar primarily talking about securities and corporate issues, fund formation issues and fund design issues. We're also going to talk about market trends as it pertains to these investments, which will impact the way you pursue them.
It's not necessarily the same strategy we all saw back in 2008 and 2009, and we're also going to talk about some of the common pitfalls that we see in this space. Things that you can really easily fall into, a lot of risks associated with it. So definitely want to talk about that. So first off, let's get started with is this opportunity real? I've had several calls with lenders and fund managers and capital markets professionals in the past few weeks, and some are very bearish on this market right now. Some are saying it's temporary, but the agreement across the board is definitely the opportunity is real. There is going to be opportunity to invest and primarily going to see distress assets and certain gaps in the marketplace. And we definitely know that this disease and its impact in the United States is really feeding economic distress. I mean massive unemployment is definitely top of the news these days.
Definitely headlines everywhere about that. And all of you who are on the webinar today who are lenders know about the non-existent liquidity on Wall Street and the margin calls from the institutional secondary markets, basically eliminating the opportunities to purchase loans or sell loans, I'm sorry, to the secondary market. But what you're not seeing also is banks are tightening up credit, banks are tightening up everything they can to make less loans as possible, they're being more conservative and you're also seeing a increase in forbearances defaults and modifications outside of our industry, mostly in the conventional space, but it's starting to creep into our industry. We just passed it April one, a lot of payments have become due. It's something to think about as playing a huge role in feeding the, I guess you'd call it the opportunity bucket. But on top of that, we talked about earlier in the intro about other opportunities that are coming our way besides non-performing loans or NPLS as we call them.
Also in the distressed business sector, you are looking at all, you had all the precursors in place prior to the COVID-19 pandemic. You had massive corporate credit over levered businesses, businesses that were struggling to produce reach, profitability now suffering more than ever. And it does create the interesting opportunity to purchase a distressed business and reperform it and make it more profitable. So all of these factors and many, many more are stressing the balance sheets of these companies to their limit. And of course what's going to happen and what already is happening is a sell off at a discount and this is what the opportunity is. Now this webinar is not only focused on talking about the specific issues associated with NPL, but also we talked about earlier Aetna distressed businesses, distressed real estate. What I like to also talk about is not necessarily distressed assets, but just discounted assets in the webinar kind of intro or the promotional materials.
We talked about unique gaps in the market and this is a unique gap in the market in and of itself as well. Another opportunity that's presenting itself is performing loans or loans that have a little bit of dust or scratches or scratch and dent opportunities are coming to the market at a discount they're performing, they're perfectly fine. There may be some delays, but they're not necessarily in default or non-performing, but they're coming to the market at a discount as well. So it's something to think about from an opportunity perspective. So before we get started, I want to talk about the common investment strategies now. So one of the things that we always talk about when we're talking about investing is how do you pursue the investment? What structures are the commonplace strategies? And I want to make sure that everyone understands that just like any other investment, usually sponsors will pursue investor capital to acquire these assets.
Now the modeling is a little bit different, but the strategies remain the same. So we've got direct investment. So you've got asset by asset acquisition. You see a lot of that in the real estate and in the distressed business sectors. You have closed end funds, which are you have specific target amount of capital you're going to raise on a specific horizon timeline and you're going to continue until you reach that and then close the securities offering. And then of course you have the open-ended funds, which we see a lot of in the performing debt space in the mortgage space where you have ongoing capital raised to fund a balance sheet of loans which will ultimately pay your investors. Now as you can see, the strategies remain the same. What the big difference is is in the design, the accounting and the deal sourcing, the methodology in which you pursue the deals and purchase the deals is very different from a performing loan or mortgage fund or real estate fund.
And also the accounting is dramatically different, but the most important thing is the design, the return to waterfall, the expectations to investors and the risks are all very different. So we're going to talk about those in depth later in the webinar, but these are the common strategies or structures you're going to use to go after these investment opportunities. Now quick mention on deal sourcing. Deal sourcing is very dependent on the asset class as you all know. We're talking about non-performing loans. Typically those loans are sold in tapes they're sold. Very rarely do we see them sold off as one-offs, although there are opportunities that present themselves usually from balance sheet lenders to move off loan by loan as they start to enter default or enter a potential non-performing scenario. Vast majority of the loans are acquired in wholesale format.
The non-performing loan industry is much more, I guess robust or heavy, heavier set on the conventional consumer purpose residential mortgages, because those loans are longer term, they're usually serviced by a national servicer and there's more volume of that. It does not mean that there are not the same opportunities in our sector. We believe that there will be the same type of wholesale tapes being sold or portions thereof being sold of loans secured by residential real estate for business purpose. And so it's something to look for. The source of these typically come from secondary market aggregators, sometimes pension funds that have them that need to move them off their books. Same with some of the reads out that they're purchasing these mortgages, but also balance sheet lenders as well, seeking to move off risky assets from their balance sheet to reduce risk. Now on the other side of the world, we have non-performing businesses.
Typically speaking, those are driven by the brokerage community. There are a lot of business brokers out there that are presenting those opportunities. And also you have a lot of m and a brokers out there that are shopping those opportunities as well. In the real estate, it's the same. The brokers in the real estate, there are those that specialize in distressed real estate and also you also have this coming from balance sheet lenders as well. It's important to keep your eyes open. It's important to keep your networks open. Thankfully in our space, a lot of us already have these networks in place. We have deep networks in the private lending community that can also help source these deals if you're interested in investing in these assets. One thing also to note is that top, we talked about it earlier, there are also tapes of loans that are being presented that are not necessarily non-performing or in default, but we call 'em Scratch and Dent, or not even scratch and dent.
They're perfectly fine mortgage loans that are performing just fine, but the lender can't keep 'em on the balance sheet for whatever reason and they're being sold at a slight discount. So thinking about that as well as an opportunity and a source of a way to source the deals. So the first topic, first methodology for strategy is direct investment. Direct investment is in the world of distressed assets. It's the same as performing assets asset by asset acquisition, right? So not conducive in the NPL space because typically those loans are sold in wholesale format, but it is commonly used for distressed real estate and distressed businesses and also for discounted performing loans. What's commonplace for direct investment though is that the investment is pursued as a syndication, meaning that a syndication is a single asset investment, but the sponsor will go out there and raise investor capital typically under some kind of special purpose vehicle to go out there and raise the money.
That strategy can also be pursued in purchasing a wholesale loan tape from an NPL broker or seller and the capital strategies are going to be the same. Now, what's important to consider though is that one thing that's commonly overlooked is that syndications themselves are not viewed as securities offerings. A lot of sponsors out there think they can bypass a lot of the securities rules because they're raising money from a handful of investors, maybe they call it friends and family, so on and so forth. But the best way I can drive this home is that regardless of whether we are raising money from friends and family, or it doesn't matter if it's less than 10 investors, securities rules apply no matter what. And it's important to consider and consult with securities counsel when you're going to go out there and raise money to pursue these investments because not only because of the basic securities rules that require you to give disclosures and comply with the necessary exemptions, but also because these investments have a lot more inherent risk to them.
It's not just the fact that you're pursuing, you're just pursuing a investment in performing asset, which alone has its own risk, but you also have the downside risk in these non-performing assets. Thereby best practice is going to dictate that you have documents put together to disclose these risks. Now for the NPL sector, what we would strongly recommend is to pursue tape acquisition but still pursue a closed end strategy. So to go to the fund formation discussion, I do want to hand it off to Tay Kim, my team. He's been doing a lot of these with our clients and so Tay talk about fund formation issues in the distressed asset sector.
Tae Kim, Esq.:
Sure, thank you Kevin. So when it comes down to the fund formation, as you may know in terms of the securities laws, generally when we are setting up a fund, you either have to register the securities with the SEC or rely on one of the exemptions that it allows for you to sell securities to the investors. And one of the most popular exemptions that are reliant out there by the fund sponsors are under reg fee rule 5 0 6 B or 5 0 6 B. These are what we call a private placement exemptions. Just a quick review here when it comes down to the 5 0 6 B versus 5 0 6, 5 0 6 B, you can raise money up to 35 non-accredited investors and unlimited number of accredit investors. You can't advertise this fund. You have to stay with them to make sure that the investors that you have are going to be what we call having a preexisting substantive relationship.
On the other hand, on the 5 0 6 C, you can advertise to the public and you can in fact advertise in any medium, including Facebook, social media, print media, newspapers, radio, television. You can just advertise wherever you need to do in order for solicit money and capital from investors. However, you can only accept money and admit members or investors into your fund that they are accredited investors and you have to verify that they are credit investors. There are smaller other less popular, but still available exemption that are out there is a red a, this is a 50 million raise, but subject to the qualification with the SEC. So you have to go through multiple rounds with them to make sure that the fund is in fact qualified with the SEC before offered to secure to the public. You can't solicit this to everyone and anyone. You can't accept money from both the non-accredited as well as accredited investors.
But there are also additional compliance requirements that you have to go to qualify the Reg A and any of these exemptions that you have to rely on, you have to get a, what we call an offering documents private placement memorandum or an offer in the reg A realm. If we are raising money from an equity, if it is raising money from equity, then we have to get either an LPA or limited partnership agreement or an operating agreement as well as subscription agreement. Of course, the entity has to be filed as well as a certain notice filing that is required for both the federal level as well as the state. So now that you determine what type of exemption you want to rely on to offer these securities to the public, then it comes down to the structuring of this fund. When it comes down to what we call an NPL or non-performing loan funds, you have to make sure, you want to make sure what type of offering you want, what type of structure you want to put together when you're offering insecurities.
Two prevailing thoughts out there in terms of the structure will be closed and fun or an open end fund as Kevin mentioned prior, when it comes down to a closed end fund, you have a very specific project raise that you want to raise money off of. And once that money is raised, you close that offering, you deploy the money for the purposes of operations. So in a scenario of purchasing npls, what you do is you raise the money, you close that offering, you deploy it to purchase NPLS as well as other distressed assets and in certain cases definitely the distressed businesses. And then you perform it or modify it in terms of the NPL or you go through the foreclosure process and have this clear exit strategy and plan as to how you guys want to exit this fund. So once you have a certain business plan that has been executed, the close end fund typically dissolves and you can rinse and repeat the strategy on a continual basis and continuing on in terms of the deployment of capital, once you raise money from a close end fund with the investors, on the other hand, on the open end fund, it's a continual raise.
You see this in a typical mortgage fund where you have a large or an unlimited max offering amount and you raise on an ongoing basis as you accept money from an investor you typically get and then you get that money and then you deploy it on a queue and on a rolling and an ongoing basis. One thing about the closed end fund that you want to think about is that the raise is typically a little bit lower. We typically see around one to about 5 million raise. It can be high as 10, but part of the reason for having a lower offering raise is so that you can mitigate risk from one, you want to be able to deploy the money as quickly as you can, but at the same time you don't want to have such a large money inside your fund. It's such that you purchase these tapes on a massive scale. In order for you to reperform these things or modify or even go through the foreclosure process and to return that money back to the investors on a highly manner is simply the key to doing a closed-end fund. On an open-end fund, the accounting is a little bit more difficult to administer and we'll talk about that a little bit later when we're talking about phantom income as well as other parts when it comes down to the offering raise.
Next slide please. Okay, so now we're talking about specific investing in discounted assets. Specific issues here when we're talking about from a fund perspective and an operation wide, when you're purchasing distressed assets, you have to think about the working capital. It is going to take more work, right? You're already buying a distressed debt or distressed asset and you have to make sure that this thing is going to perform and it's going to operate and generate income whether through interest payment or through capital gain. So in that, then you have to hire attorneys. If you have to go through the closure process, you have to manage these tapes to ensure that they produce money. You have to analyze the probability of success and re performance through either modification or extension or whether it makes to go through the foreclosure process. You have to contact the borrower and negotiate who are already in distress.
And so these more an additional working capital and the additional cost that comes into play when we're setting up an NPL fund is very important to consider when you are engaging this in the fund for more formation. Other thing that you have to think about is that there is going to be a delay in cashflow. Think about this, when we're purchasing an NPL, the typical timeframe for a reperformance or a modification typically goes around the six to eight months, but it can even be longer than that. For example, 1.1 and a half years is one of the longer terms that I have seen for the reperformance. On the other hand, when you go through the foreclosure, that in and of itself is also it takes a while for that to get it to basically go through that foreclosure process. And once you even go through the foreclosure process now you're not even sure whether that's going to be sold at the portfolio auction or not. And so you may even have to take it back in the form of an REO and even then you have to figure out how you're going to take care of this REO, whether it's going to be through rent and you get the income from the rental property management for the cashflow that comes from property management and from tenants, or are you going to sell it and get the cash proceeds from the res?
And so there in that, there is going to be a delay in cashflow and you have to make sure that you account for that delay when you're structuring the fund. And we typically see that the fund is going to be delayed in cashflow. And so you have to either structure that either through what we call a delay or a deferral in terms of a payment, or you can either do a cumulative prep or a certain type of income so that you ensure the investors that something is coming back from the delay that it's going to occur based upon these purchase of npls. And another thing that we have to consider is adjusting for realization of phantom income and additional gains. And I just want to talk a little bit about what the phantom income is. So when we see these NPLS that's being purchased, you typically purchase these on a discount between 50 to 80%.
And lemme just take a simple math here and say you want to purchase an NPL at 50 cents of the dollar. So it's a $200,000 unpaid principle balance. You're purchasing it off of a hundred thousand dollars and you're remodify it and you reperforming it and you're modifying it such that and the borrower decides to make payments on it on an interest payment. And there's substantial evidence to show that this loan has been modified. And once that has been modified, at least from an accounting perspective, is that you take the entire unpaid principal balance. And so implicitly there is a gain there between the purchase price that you have made and the reperformed loan up to. And so in this instance will be a hundred thousand dollars. But the issue is that on that unpaid principle balance and the difference between the a hundred thousand dollars, you got to pay tax on that or there is a taxable event that occurs on that, but yet there's no interest income, there's no sale proceeds and there's no money that is being distributed off of that, that reperformed loan.
And so you have to account for that gain that comes, which can be a taxable event. So implicitly in there is that there is a difference. It varies widely between a cash event and the taxable event that you have to account for when you're putting together this type of fund. And of course lastly is the absorption of higher possible risk. It's an NPL or a distressed asset. These asset classes are generally of higher risk, and so you typically see a higher return when you're structuring an NM PL, but it's a boom or bust, right? So you either can win big and make a killing off of it and you lose out of it. And so because it doesn't perform and you've got to liquidate this thing out off of your balance sheet, but you can't really do so and so you may either have to sell it off of even further discount than the purchase price that you have made.
And so there is going to be an absorption of higher possible risk from a legal perspective. You also want to think about the risk profile, the investor disclosure to tailor fits to these asset classes in the offering documents specifically on the private placement memorandum you are going to put in there that you intend to primarily engage in the purchase of these npls. When you're doing that, there is going to be a different credit box. It's going to be based off of the unpaid principal balance as opposed to NLTV ratio that we typically see on an underlying collateral. You have to figure out and think about the various capital waterfall structure, how you intend to repay these investors as just as I mentioned before in terms of how are you going to repay these investors, whether it's going to be through delay or cumulative. Cumulative return in the lockup period of course is also a lot smaller.
I mean a lot longer. It's typically between about 24 to 36 months simply because from an operational perspective it takes a while for these capital to reperform and also you have to consider additional compliance risk that comes along when it comes up to mpl. And we're going to talk a little bit more about the lending compliance aspect a little bit later. But when it comes down to these tapes, a lot of them can be purchased in the owner occupied consumer lending spaces. And you have to consider a couple of these lending compliance laws including hoppa or Federal Home Ownership and Equity Protection Act, federal Truth and Lending Act, fair Debt Collection, practice Act, credit Reporting Act amongst others that you have to disclose to these investors that these are some of the risks that you may be taking in putting together these MDL funds.
Kevin Kim, Esq.:
Alright, a lot of stuff there guys. So let's talk about real quick moving on. So there's a lot talk about in the NPL market itself and working in a fund strategy. So first of all, if you are a private lender and you are thinking about pursuing investing in non forming loans, it's not just something you can just jump into. If you go to these seminars, they very rarely discuss a lot of the compliance issues that we as private lenders deal with on a daily basis. And a lot of them are ignorant to it because the way the industry works is that you have a servicer attached to things that tell you, Hey, we'll take care of everything. But the reality is is that investing in this space, there are state by state legal restrictions and licensing restrictions associated with the purchase modification and performing of loans.
So when you're thinking about pursuing these investments, you have to make sure you have your framework in place and also it's important to have your box in place, right? Decide what your credit box is going to be. Typically speaking when we're talking with NPL investment fund managers, the marketplace in which they want to play is the residential space, but not necessarily limited just to residential rentals or fix and flip. It's broader. The vast majority of the opportunities are coming from the consumer space and it's a different type of investment strategy. You're going be going after consumer loans, but because of the current, I guess outset of the market, whether you can purchase at a discount deep enough to earn a significant gain will also dictate your strategy. And so until today, the vast majority of NPL investors have been pursuing a acquire at a discount and reperform eventually sell or refi out to another lender because the discounts weren't deep enough and also because of the national restrictions that are vary state by state when it comes to modification and consumer protection.
And so we do want to consider all of that when we're going to be entering the sector. You are also going to, typically, when we talk about funds in general, we don't always recommend a third party servicer, but with NPL, it's very, very important to think about bringing on a servicer that has expertise in NPL. It's got a good distressed asset desk, may be able to help you with foreclosure work, has a national understanding of this. Very important. Also talking about the issues that come with acquiring loans for the purpose of foreclosure or modification can result in dealer status. Dealer status is a very nuanced, very fact or circumstantial based analysis. You want to make sure that you are avoiding this because you do not want gains to be taxed ordinary income. So one of the things that we talk a lot of our clients about is how are you acquiring these loans?
And if you're acquiring them, how long are you taking to transact, to foreclose, to modify, to do whatever you need to do and how long are you holding the real estate for? All of these different aspects will impact the IRS's assignment of you being a dealer. This is very material for fund managers out there who want to pursue NPL investing through a reit, which we'll talk about later in the webinar. Other things you want to consider when you are forming an NPL investment vehicle is really the key thing is thinking about the strategy, right? We talked about that a second ago. So reperform versus foreclosed, right? And so foreclosed makes a ton of sense if you are in a state that is more conducive to do so from a legal perspective if you're in a non-judicial state versus a judicial state. Factors to consider, right?
Timelines in general. Before the COVID-19 crisis was timelines to foreclosure to sale a property, but also now with the COVID-19 pandemic, even after this is lifted, you have a backlog of foreclosures, you have backlog of the courts are just backed up in general, what was seen as a typical 18 month to 20 month foreclosure process in a judicial state may extend out even further. So that will also inform your strategy in going after these assets combined with the fact that you have to account for a discount, right? So if you're buying at a discount at around 90 cents on the dollar as compared to 85 to 80 to 65, that's going to dictate which type of strategy you're going to pursue, the different fee incomes and also it's going to dictate the waterfall and the targeted returns for your investors. So all of that comes into play when you're designing these vehicles.
It's really important you consider these things with counsel because the last thing you want to do is see other NPL funds quoting out 25% returns, but you're going out through a reperform model and you may not hit that because your discounts aren't deep enough. So really considering all those factors and working with council and accounting to design that out also, you have to understand where the market's at right now. So we have not hit the bottom yet. A lot of folks are waiting for the bottom the floor to bottom out, and we saw that in the oh 7, 0 8 0 9 financial crisis. I can tell you from a market perspective, based off of the institutional, I guess data aggregator, Quin, about 140 billion, which is a ridiculous number, 140 billion in dry powder has been accumulated since December in the private equity and private debt market by these specialized funds.
And so that just tells you they're getting their dry powder ready to go after these assets. And so if you are thinking about this, this is the time to prepare because when we start to face the bottom, we start to see the long-term ramifications of this crisis. You will be ready to do so. And also we also want to encourage folks who are thinking about pursuing an NPL investing vehicle to broaden your horizons a little bit, broaden your box into owner occupied or consumer purpose because you're going to see more volume there. That's compared to the private lending market, the fix and flip market, you've got shorter term loans there, you've got less volume comparatively speaking. And an interesting note we saw in the news today is that the non QM market is suffering dramatically and so there may be some opportunity there as well.
So let's talk about fund design. So Tay was hitting on the issues of closed end versus open end and whether you're pursuing a closed end fund or an open-ended fund. Regardless, the design issues are very different to a traditional mortgage or debt fund, which a lot of you on the call today are very accustomed to managing or already have. The return structures are typically going to have some type of delay to 'em because you have a significant delay to cashflow when you're sourcing and acquiring the tape of loans or acquiring the asset in question. The negotiation timeline may be a little bit longer than what you're used to seeing with just regular performing assets, but also after you've acquired them, there's going to be time you need to spend and money to convert the asset into a cash flowing position. So that means for a loan, either it means to negotiate and reperform the loan and get it positioned to sell or it's going to be to foreclose on the real estate and either complete the project or improve it and then prepare it for sale.
If you're going after the ladder for foreclosure, it may also dictate that you hold it a little bit longer as the market making these time to recover. So with that in mind, you'll need to account for that to investors and also set those expectations. This is the biggest issue that we see with NPL investors and NPL fund managers coming to the space is they're not used to this or they're not accustomed to this is they're used to doing a coupon that goes out to the investor right away. We have to make sure they understand this. And this also goes to the question of can I have a fund or a close end or open end that pursues multiple strategies? And while you can, you have to really think about the timelines to cashflow and try to figure out a common denominator that's going to minimize the risk to you and not obligate you to hit a certain coupon by a certain date.
What I mean by that is, let's say for example, we have a lot of fund managers that want to pursue just an opportunistic investment vehicle. They want to be able to go after distressed real estate. They want to be able to buy distress companies. They want to also be able to invest in nonperforming loan tape. Now each of these asset classes have different timelines to cashflow and even in the NPLsector itself, you've got foreclosure versus we perform depending on the asset class there, depending on the type of loan, different timelines. So we have to model the fund out, the investment vehicle out to try to find a timeline to cashflow, to distributions to the investors. That doesn't put you at risk of missing it because oh, you miscalculated your timelines based off of the fact that maybe the distressed business aspect takes longer to get to cashflow or the real estate is taking longer than that you thought to sell or what have you.
On top of all of this, now we have to add the extra layer of the discount recognition. So Tay touched on this, right? Phantom income, you have to worry about how you're going to account for that and how are you going to recognize the discount. It's really, really important. There are two primary ways to recognize the discount and it really depends on how you're raising the money, which is why it's really important to have an accountant or a CPA that's well experienced in distressed asset accounting to join in and talk about designing the fund, especially if you're new to the space to make sure that you're accounting for that phantom income and gain and also that you're recognizing the discount in a proper manner because the last thing you want to do is to account for a discount. I recognize a discount in different means throughout the entire lifecycle of the fund, creating issues for audit, creating issues for investors ultimately because a lot of these vehicles are passed through.
So there was some questions earlier today about REITs. I want to touch on this and then we'll get into the question and answer part of this webinar. So for those of you who are currently managing a debt fund that converted to a REIT earlier this year or last year, pursuing an NPL strategy or distressed asset strategy is not impossible with a reit. It's definitely doable. You are seeing a lot of them happen. A lot of the Wall Street and publicly traded REITs go this direction, but buying and selling distressed assets can jeopardize the REIT status. And so you want to make sure that you're navigating all the pried transactions, understanding what the safe harbors are. This in and of itself can be a webinar series. So the short answer is definitely you can do it through a read strategy. You may have to adjust if you're doing a sub read strategy with a performing debt fund, you may want to consider whether you can do this or not in your primary PPM for your debt fund to see if this is even within the cards for your investors.
If it's in the cards to pursue and it's disclosed. It's really a question of making sure that you don't violate the rules associated with acquiring a distressed asset, phantom income, additional gains, but also the issues associated with dealer issues for the reit. The last thing a REIT wants to be is considered a dealer because it's designed to be a passive investor. So gains recognized generated from discounted acquisitions can also be a major issue if not accounted for properly. And so really it's it's going to require a heavy consultation with both your REIT CPA and your attorney to make sure that whatever strategy you plan on pursuing, you are understanding the impact of the PRI transactions rules as it pertains to REITs, but also understanding the safe harbors because if you can fall within the safe harbors to pursue your strategy, then you can kind of pursue things without as much headache and actually definitely increase the returns for your investors.
So if you're interested in doing that, if you have a reit, definitely contact us to go through the issues there. We'll open your CPA if you are thinking about creating a REIT just to do this, definitely make sure that you have a very well experienced CPA who understands the NPLaspect of things, but also understands the compliance issues and the private transactions issues. Now before we move on to the question and answer, one little point of housekeeping is to make sure you asked your questions in the Q&A feature, not in the chat feature. I know we did not talk too much about distressed real estate and distressed businesses. We definitely focus on the NPL suite. I do want to touch on that really quick. So distressed businesses typically require a much longer timeframe to reperform. The discount is not negotiated, there's no par value.
You're basically going off of ebitda. Now, one thing to note that a lot of people that we spoke with in investing in distressed operating companies in our sector is that there's no clear valuation methodology. There's no multiplier to EBITDA in our sector because all of these businesses operate so differently and they have significant relationships owned by the operator owner. And so it's definitely a negotiation, which is why we expect distress, distress business acquisitions in the sector to be a little bit slower to cashflow. And when it comes to distress real estate, the obvious strategy right now has been commercial real estate, hospitality, retail, but a lot of investors are looking at this sector on the residential side as well. So keep that in mind. Those asset classes typically will require some type of foreclosure process because there is debt on the property. If you're applying commercial real estate, there also may require you negotiate down any other additional financing on the project that's not real estate related.
For example, if there's Mez lending on the property, if there's a pay loan on the property, you will have to negotiate that down and that may cause delays to your cashflow capability. So keep that in mind. But definitely we're keeping eyes on a lot of data aggregators in the space and there is a lot of activity. So if you are interested in pursuing this strategy, please contact us. Let's get into the questions now. So we've got five questions from the audience. Feel free to add questions as you come along. So the first question here is can you please talk about the forbearance versus deferment? So the forbearance versus this is really more of a question for the defaulted loans team or our foreclosure team. Most of our clients right now are going through a lot of forbearance negotiations. The only understanding that I have is any differentiation between the two would be a deferment would be more of an informal forbearance of the term of art and you enter into a for agreement, rich, you does a restructure work for distressed real estate debt absolutely does work.
Once again, you have to make sure that you keep those issues. We talked about phantom income, capital gains from distressed assets, dealer issues and prohibited transactions associated with the sale of real estate from a foreclosure. All major issues you want to navigate. So it's really important that you go through these issues with your CPA and your attorney, but also making sure that you have a strategy long term mind because if this is going to be a continued pursuit, then it's better to have a cookie cutter process to go after the assets. Next question comes from an anonymous attendee. The phantom tax, which is incurred when you buy a discounted note for the discount received tax on note face value less the discounted no purchase price. What tax strategies can one use as there is little possibility of getting all a hundred percent of this discount the NPN buyer receives?
Unfortunately, we're not CPAs on this webinar, so what I would strongly recommend is that you speak with a CPA that understands this. The major CPA firms in our industry all have significant experience in this. If you need a referral, please contact us directly and we're happy to give you one next question on here. Make sure we mark these done from Brian. You mentioned for whatever reasons current holders of these NPLS are selling these loans off without discounts. If there's equity in the property, why would someone can a huge hit and sell these NPL loans off at a discount? Is there a is the main reason cashflow primarily? Yes, cashflow is a big reason and also because they can no longer service the loans, the value of a loan is lower. If a loan is defaulted, if a loan is not performing, if there's no debt service and there is going to be cost associated with recovering it, the value of the asset is decreased, which is hence the discount.
Next question he asked in series was also, what is the average range of returns you were seeing in the NPL space? This varies wildly professionals will tell you, some of them are seeing high double digits in the 20 to 30% return rate. I think that's a little bit excessive right now. It really depends on what the trade discount is going to be, how much volume you are purchasing, and also what you are planning to do with the loans. If a re performance strategy is very different from a foreclosure strategy and capital costs and the longer it takes to pursue it costs more. I do want to let Tay comment on this too. Tay, we just finished a handful of these NPL funds. So what are the range of returns that you're seeing with clients coming to you?
Sure. So in terms of the average range of returns that I typically see is between about eight to 10% coupon, but the expectation is that the investor would like to see a double digit return. Again, as Kevin mentioned, those all vary wildly depending on the strategy that you're taking.
Kevin Kim, Esq.:
Yeah, so it really boils down to how deep a discount you're buying these things at. And also, are you performing the loan or modifying the loan versus going after the foreclosure and all those factors come into play. What local geography are you dealing with? Local laws on foreclosure, what does the market look like? How deep is the discount? Because right now we're not seeing trades happen below 85, 80% on what we say conventional or consumer owner occupied deals In our sector, we're still not hearing too much about discounted sales beyond a slight discount, maybe five points below par, 95%, 98%, something like that. So it's still yet to be seen, which is what we're recommending folks, if you're interested in pursuing this kind of broaden in your horizons, but also prepare right now because that discount as these lenders having to hold onto these assets on balance sheets, longer time equals money.
So there's going to be a longer, they don't want to move these things faster. Next question is about what licensing is required for buying discounted notes. So the question really has nothing to do with discounted notes, have anything to do with buying notes, right? So for a lot of you who are clients of ours, we've talked multiple, multiple webinars and lectures and talks about you need a license to lend on business purpose in certain states. You need a license to lend on consumer purpose in all of these states. Now, for real estate, now, a lot of these states, their regulations associated with lending also have regulations associated with buying. For example, in California, there are certain regulations associated with purchasing loans that will trigger the need to get a license. One state in the eastern markets that comes to mind is Georgia. Georgia requires a license to purchase loans, not just to make loans.
So it's important to consider, it's a state by state analysis. So you want to really talk to your attorney on this. For those of you who are in the NPL sector and coming to this webinar, the NPL sector, a lot of folks actually do not realize they need a license until it's too late. A lot of times they're hiding behind a servicer and it takes a regulator a few question and answer sessions to figure out, oh, the actual owner is somebody else. They're not licensed. So it's important to consider and we should talk about that offline if you're interested in doing so. So next question here, two questions. Can we do an MPA fund to buy business purpose private money loans and non-performing real estate through a Reg D 5 0 4? And can you put an NPL fund in a Delaware series LLC and have one investment strategies as your first question?
Yes, I will. Four is conducive. We don't personally like five oh fours because of the lower dollar amount, it's really limited to 5 million and also 5 0 4 does not preempt state law. What does that mean? That means that I have to go to every state in which I'm raising money and comply with local blue sky regulations. In certain states, it may require us to register a very thorough and painful process, which we try to avoid. So that is why we mostly do Reg B, rule 5 0 6. But once again, yes you can. We don't necessarily find it to be conducive unless you're raising money in one state or maybe two states at most. The second question, can you put an NPL fund in a Delaware series LLC and have one investment strategy in each series? Absolutely, you can from an accounting standpoint and from a legal standpoint, each series LLC is treated as a separate entity and you will have to have a private place memorandum per series LLC.
One thing you want to note though is if you're thinking about going into other states and expanding this operation, there are certain states that do not recognize a series LLCs, even for foreign entities. You want to make sure you navigate those issues, but definitely can you? Absolutely. Yes. And let's talk about it offline if you're interested. So next question, would you recommend the best way to test the waters in this space? But what would you recommend the best way to test the waters in this space before investing in designing an NPL fund? The number one thing is I would start talking to brokers and originators on the availability of the asset class. Talk to a servicer that you are working with or talking or know and talk to them about their NPL desk. It's important to think about that and kind of think about the geography you want to pursue and the type of asset class you want to pursue.
This is, right now we're kind of in preparation mode for a lot of our clients. Once you prepare and you're ready for this, then it's a question of deal sourcing. And that's really a question of networking and hitting the traditional methods. So really kind of going through all the usual steps in any kind of information. Our next question is, could you briefly discuss the recovery period or horizon for different asset classes, commercial residents? So let's talk about number one. If we're talking about loans, commercial real estate, non-performing mortgages. If you're those at a discount and you are planning to reperform them, that's really a question of negotiation with the borrower, modifying the loan, re documenting if necessary. And then the question is takeout, right? Are you planning to provide some kind of bridge to long-term takeout by a financial institution? Are you planning to sell the loan to a financial?
Are you buying a portfolio loan? What is that going to look like? That will dictate your timeline to recovery. Now, the other rationale strategy is going to be foreclosure before we go there. For commercial, when you're renegotiating the loan, you also have to think about in commercial real estate, you oftentimes will have a pace lender senior to the first position lender, which a tax lien kind of strategy. But you'll also sometimes have a mezz loan or a preferred equity loan or some type of junior debt. You have to keep that into mind. You have to make sure you negotiate with all of them. You may have to pay them off residential, kind of same strategy, same timelines, right? The timeline it takes, it's going to be how long it takes you to negotiate and modify the loan. Now for foreclosure, it's really dependent on where what state you're in.
Every state is different on timelines to foreclosure. I can tell you generally speaking, if you're in a judicial state versus a non-judicial foreclosure state, non-judicial foreclosure is much faster than judicial foreclosure, which means you have to actually go to court and litigate the foreclosure. We can't tell you exactly because foreclosures, for those of you who have been through foreclosure, you may be in a non-judicial state, but if the borrower goes to bk, now you've got, it's going out much, much longer than you expected and you're litigating and so on and so forth. So there is no specific timeframe that we can quote, but these are fact patterns that you think about, right? So foreclosure right now in a nonjudicial state can oftentimes in a judicial state, can take anywhere from 18 months to two years with the impact of COVID-19. That could be extended for maybe longer than that.
Plus the fact that you have the risk, the borrow may go bk on the non-judicial states, it can take anywhere from six months, six months to a year. Now you got to think about BK risk as well, all of that if you're foreclosures. So yeah, the timelines are not exact, which is why it's important to think about timelines to cashflow and also working capital. Next question here is, can you recommend using a trust company format to work best with state licensing regulations? Trusts are the only trust that we're aware of that going to pursue. This is a Delaware statutory trust, and that's kind of anecdotal at best. We've seen a mixed reviews from very, very aggressive states. This is a common strategy you use in the NPL sector. If you're going to do this consult with licensing council, because this is actually more of an anecdotal thing in some states.
In some states, absolutely, you're okay. It really depends on who the trust company servicing, the trust, the DST is going to be. So definitely make sure you consult with licensing counsel that we do licensing consult all the time. Please contact us if you'd like to talk about this in more detail. What state in the current cycle do you believe we are in, and when would you expect the apex to be? In terms of flow of discounted notes, it seems likely that it would take at least six months for most lenders, sellers to reappraise and take the writedowns necessary to offer discounts. Brandon, I don't have a crystal ball where I can tell you what I'm seeing. I can tell you what we saw in the last cycle. I can tell what we are expecting, but I'm not going to commit to anything just because it's really hard to tell because this is all caused by this COVID-19 pandemic.
So it's a different type of fact pattern that we really cannot predict what's going to happen. But based off of experience, I'll try to answer the question the best I can. So definitely we are kind of at the point of preparation right now. We are starting to see a lot of aggregation of capital, a lot of dry powder being prepared. Experts believe that we're going to see an increase in default in mortgages and distressed debt hitting the markets starting now. The discounts are being discussed. So anywhere between 95 to 85% depending on the market and depending on the loan you're dealing with. And then that typically goes down and down and down as the longer these balance. These are held on balance sheet because there's more cost to them, but also has to do with valuations of real estate because there's no clear indication as to how long it's going to take for real estate values to dip.
If anything though, the reaction, the impact to the market in this crisis was a lot faster than the last one. I was discussing that with a former hedge fund manager client of mine. He was talking about in 08, 09. It took us several months to get there, almost a year to get there from 07, 08 here. It's happening in a matter of months. So it definitely feels like a much more accelerated cycle when it comes to these. Now on the traditionally pursued asset class in the consumer space, we're not quite sure how it's going to impact because of the fed's stimulus into the MBS markets. I would imagine that that's going to result in significant amount of long-term you're going to pursue maybe within six months to a year from now. You're going to see a lot of opportunities come your way in the form of those loans and also non QM loans because those are being held on balance sheet right now and are probably looking for a home.
So that's the last question we have. For those of you who do not know me, you can reach us right here. My email and phone number right there, Tae's email and phone number right there. Those are our direct lines. You can reach us by email or you can call us with any other questions. This webinar will be recorded and we'll be available to the public later down the line. So feel free to go on our website, geracillp.com for more content. And keep in mind, we are going to be producing much more COVID-19 relevant content in the future next week, Tay. And I'll be presenting on fund management and issues there and so on and so forth. So we're looking forward to seeing more of you guys on the webinar for Geraci LLP. Thank you very much. And that's the webinar. Thank you. Thank you.