PDF DownloadThe Use of Real Estate Auctions in Commercial Short Sales
By Celeste M. Hammond and Craig M. Post

Probate & Property Magazine: March/April 2009, Vol. 23, No. 2

Real Property|Trust & Estate

Celeste M. Hammond is a professor of law and director of the Center for Real Estate Law at John Marshall Law School in Chicago, Illinois. Craig M. Post is an attorney and team management director for Sheldon Good & Company Auctions, LLC, and a graduate of the John Marshall Law School in Chicago, Illinois.

Recent real estate problems plaguing lenders and borrowers have turned out to be far more difficult and tenacious than anyone could have imagined. With concern growing over the erosion of equity because of carrying costs and falling sale prices, lenders and borrowers recognize that the monthly carrying costs associated with holding real estate when conventional marketing is used will not be recovered through higher sales prices. This phenomenon is especially true in a negative market fueled by an oversupply of available properties or a reduction in the number of buyers caused by changes in the credit market. Developers of residential properties have been affected by this trend because of the scarcity of construction loans. These problems are likely to be around for some time. Consequently lenders and borrowers are turning to the real estate auction process to facilitate workouts and short sales to sell surplus inventory.

When a Short Sale Is in Order

Both residential and commercial short sales occur when a lender agrees to accept an amount less than the current outstanding mortgage balance, usually through the use of a workout agreement. When a property is listed for sale conventionally, the major problem is that neither the lender nor the borrower knows the price at which the property will be sold; therefore, they must wait until a purchaser makes an offer before a workout agreement can be finalized. This situation is further complicated if the purchaser or broker is unwilling to sit still while the lender and borrower haggle over the terms of the workout.

In contrast, the auction serves as a workout vehicle that can solve the lender-borrower-broker problem. The auction brings these parties together to focus on the issue at hand: the property needs to be sold, and because of carrying costs and a declining market, it is in all parties' interest to sell as soon as possible. The auction allows the lender, borrower, and auctioneer to time the sale of the property, negotiate the terms of the workout before the sale, determine potential deficiency issues up front, and quantify the risk by setting minimum bid amounts and the number of properties to be sold subject to those amounts. For these reasons, real estate auctions increasingly are the method of choice for the sale of real property in general. See Steven L. Good & Celeste M. Hammond, Real Estate Auctions: Legal Concerns for an Increasingly Preferred Method of Selling Real Property , 40 Real Prop. Prob. & Tr. J. 765 (2006).

For new residential housing developments there are four classic patterns in which a lender and borrower find themselves in a potential commercial short-sale situation:

  1. The borrower begins building a development, and during the pendency of the project the market changes and the property's value is less than the debt.
  2. The market slows after a project's sales effort has begun. As a result, the project's carrying costs increase and the developer's equity begins to erode. In this situation, if the borrower and the lender do not take immediate action, the equity and interest reserves may erode completely.
  3. In seasonally specific markets, the season ends. In this situation, the sales are good because the property is "in season." Yet, because of the seasonality of the market, both the borrower and lender are aware that sales will shut down as a result of the season ending.

    The two types of properties affected by the seasonality factor are (1) secondary residences in warm climates and snow skiing locales and (2) resort communities. The secondary residence season is approximately from Thanksgiving through Easter. The resort community's season varies according to the location of the property. Ski destinations, for example, often have a different seasonality than warm weather locations. As a result of the seasonality factor, lenders and developers must understand the costs of carrying the remaining inventory until the next seasonal cycle. This problem is exacerbated if the market is declining or stagnant, and, as a result the next seasonal sales cycle is likely to be worse than the previous season. Carrying costs will continue to accrue and price levels will need to be adjusted even lower in the hope of making sales.
  4. The built property is viewed as marginally acceptable based on either quality of work or location. This situation may include apartment buildings converted to condominium developments that in hindsight were poor candidates for conversion. Properties developed in fringe or marginal locations also fall within this category. In a robust market, both types of properties would be acceptable to the marketplace, but in a slow market they are often highly discounted or rejected outright.

An Example of a Successful Auction

An auction was recently conducted for a condominium development located 20 minutes outside of downtown Boston. The developer offered 204 newly converted condominium units and sold 139 (68%) of the units for between $250,000 and $450,000 at a rate of 12 units sold per month.

During the next eight months, the developer watched the velocity of sales decline to an average of less than one unit sold per month. The developer estimated that the monthly carrying costs for the unsold inventory exceeded $100,000. Despite reducing the asking prices and offering incentive packages, sales were at a virtual standstill.

Faced with the prospect of the construction loan maturing, a worsening market, and the prospect of limitless carrying costs that would further erode the developer's equity position (assuming the equity had not already been eliminated by the decline in the market), the lender and borrower elected to take a proactive approach to the sale of the unsold properties.

As part of a workout agreement, the lender and borrower agreed to conduct an auction to sell the remaining units and resolved potential deficiency issues that would have arisen if the property's value exceeded the outstanding loan balance. The auction also allowed the lender and borrower to quantify their risk by setting a floor for pricing and the number of units to be sold. The lender and borrower agreed to sell 15 of the 65 units subject to low minimum bids from $125,000 to $215,000.

During a 10-week marketing program, nearly 2,400 people inquired about the property and the developer sold all remaining 65 units at an average of 85% of the prior sale prices. Eighty percent of these sales closed within 10 days of the auction, for aggregate proceeds of more than $15.6 million (exceeding the loan amount by more than $3.5 million).

The Auction Short Sale and How It Compares to a Conventional Short Sale

The true benefits of using an auction as part of a workout arrangement are that the lender and borrower are able to control a number of variable factors, including the following:

  • The Date of Sale —In a downward trending market, time is a seller's worst enemy. Conventional marketing offers no defined timetable. As a result of stagnant or worsening markets, carrying costs become limitless and sales prices fall. Auctions may be preferable because the sale and closing of the property occur on specific dates, usually within 60–90 days.
  • Lack of Negotiations —The lender and borrower control the terms of the auction and are able to structure the sale of the property to suit the selling group's specific requirements as they relate to the rules the buyer will be required to follow. In an auction, the owner sets the specific terms of the real estate sales contract that the successful bidder will enter into, and the prospective buyers bid based on those terms. This valuable aspect of auction programming is reassuring, particularly to owners who have had negative experiences with contingency-laden contracts. Most auction deals are made on an "as-is, where-is" basis and require potential buyers to complete all due diligence before bidding.
  • Minimum Prices and Properties to Be Sold —The lender and borrower are able to set threshold bid amounts and determine the number of properties to be sold subject to those amounts. This characteristic allows the lender and borrower to set a safety net for pricing and the amount of inventory sold.
  • Deficiency Issues —The lender and borrower come to an agreement on deficiency issues before the beginning of the auction marketing program. By resolving these issues up front, the lender and borrower are able to focus on selling the property. By comparison, in a conventional short sale, no action is taken by either the lender or borrower until a potential buyer submits an offer. This reactive response can kill potential deals if the lender and borrower cannot come to a timely agreement.
  • Broker Participation —The uncertainty of making a deal in a short-sale scenario also tends to chill interest in the conventional brokerage community because there is no protection for the payment of the broker's commission or comfort regarding the price at which the property will sell. Consequently, many brokers refuse to work on short-sale properties. These problems are avoided in the auction setting because the sales process does not begin until deficiency and other relevant issues are resolved and incorporated in the workout agreement by the lender and the borrower.

Case Studies

Real estate auctions conducted across the country demonstrate the benefits of these short sale transactions. These examples include:

Houston, Texas

As a result of slow sales and high carrying costs, the developer and lender implemented an auction strategy to reduce a large portion of the outstanding loan balance. Over the course of a year and a half, the developer had sold only 13 of the 53 townhomes. As a result of the auction, the developer sold 32 additional units and was able to reduce the carrying costs and debt by more than $7 million.

San Bernardino, California

Because of the strength of the real estate market, the developer converted a 69-unit apartment complex into townhomes. As the market softened and the project's sales slowed, the developer feared that its equity would eventually erode if the remaining 32 units were not sold in a short period of time. To create a safety net for its price, the developer offered to sell at least 15 of the units as absolute sales, regardless of price. During the 10-week marketing program, more than 1,000 people inquired about the properties and more than 300 bidders attended the auction. In the end, all 32 townhomes were sold for an aggregate price in excess of $8 million.

Chicago, Illinois

During a two-year period, the developer of a nine-unit condominium building was unable to sell a single unit. Despite the fact that the owner had no debt secured by the building, worsening market conditions made it clear that the developer's equity was quickly diminishing. An auction marketing program was implemented, in which the developer offered the nine units subject to low minimum bids. As a result, more than 50 bidders attended the auction and every last unit was sold, with seven of the nine units closing within 10 days of the auction.

IssueAuction

Conventional

Timing of the Sale.

60–90 days.

No definite timeline. Limitless carrying cost and potential for worsening market conditions.

Timing of the Workout Agreement.

Proactive—Before the start of the auction marketing program.

Reactive—Only after an offer is received.

Deficiency Issues Resolved.

Proactive—Before the start of the auction marketing program.

Reactive—Only after an offer is received.

Ability to Quantify Risk.

Seller can set minimum bid amounts and the amount of inventory to be sold.

None. No definitive timeline for the sale, questionable carrying costs, possible worsening market conditions.

Payment of Auction/ Brokerage Fees.

Guaranteed.

Not guaranteed and may be subject to reduced or nonpayment altogether.

Comfort to Buyer That Seller Can Sell the Property at a Designated Price.

Guaranteed.

None.

Conclusion

In increasing numbers, lenders and borrowers are finding the structured sale nature of an auction to be far superior to conventional marketing methods as a workout strategy for reducing the cost and risk associated with owning real estate. The increased popularity of the auction sales process can be attributed to the lender's and borrower's desire to quickly exit the market and obtain the best prices available. The resulting certainty that a sale will go through under pre-determined terms of the auction sale entices buyers to participate in the auction. By using the auction, lenders and borrowers are able to time the sale of the property, negotiate workout terms and deficiency issues up front, and quantify their risk for both pricing and inventory sold.

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