Whether times are good or bad, lenders always have foreclosed properties in inventory. During a recession the inventory may be high. One of the problems that banks and insurance companies have is disposing of this real estate owned (REO). They are faced with the decision of whether they wish to dispose of the property immediately or hold it for a period of time to hope for an increase in value. They would like to see the value of the REO increase to equal the loan amount.
These lenders are not professional real estate investors but money managers. Therefore, they are reluctant to invest any additional money in the properties. This problem is compounded because a troubled property needs more attention than does a healthy one. It would not have been in foreclosure if it didn’t need help.
The solution might be a service joint venture. This type of contract with a real estate firm allows the lender to minimize management fees until the property is generating cash flow again.
Asset Manager As An Agent
The service joint venture is a form of incentive compensation by which the lender retains an asset management firm as its agent, with the firm agreeing to defer a portion of its fees until payment can be made out of future cash flow. The relationship may be a straight principal-agent one, or a new joint venture can be created in which both the lender and the management firm are partners. Some lenders who want to avoid a formal ownership position in distressed property desire this approach.
The differences between the fee structure of a service joint venture and more traditional arrangements are as follows:
• Management fee. In a service joint venture, the agent receives anything from a below-market fee to no fee at all until the project achieves a specified level of net operating income (NOI). After that, the asset manager receives a designated portion (for example, 50%) of the NOI over the threshold amount. By comparison, the traditional management firm receives either a fixed fee or a fee based on a percent of the gross income.
• Lease-up fee. In a service joint venture, the agent may receive anywhere from a full leasing fee to none at all. The variable relates to the type of property involved. In the case of an office building, retail property, or industrial project, the agent normally receives the full market fee because payment is usually a commission rather than a straight salary. On the other hand, for residential properties, the fee often is deferred until a future date.
• Commissions upon sale. In a service joint venture, the manager receives a substantial portion of the sales price over a threshold price, together with a negotiated commission that is slightly below the traditional percentage. By comparison, a traditional arrangement gives the agent a higher percentage of the total sales price but no share of the amount over a designated threshold.
• On-site marketing and management. Here, both the service joint venture and the conventional agent receive a fee as provided for in the property budget.
The value of the service joint venture is that the management company is co-opted because it receives incentives in exchange for fees. In this way, the management company shares the objectives of the lender to maximize net operating income and value as fast as possible.