Will levels of distress in the U.S. CRE market
continue to rise?
Lender response to distressed real estate has played
out quite differently from the 1991 to 1994 period. In the current cycle,
lenders have minimized fire sales, especially for quality assets, thus limiting
large-scale opportunistic buying and frustrating many vulture and opportunity
funds. In 2009 and year to date through the third quarter, more than 80 percent
of the distressed property sales were under $5 million. In the third quarter of
2010, new additions of troubled assets totaled $13.7 billion, a 61 percent
decline from the same period last year, and were offset by $11.3 billion in
workouts and restructured loans, minimizing the net increase in outstanding
distressed assets to the smallest in two years.
Approximately $281 billion of commercial real estate
properties were classified as distressed assets in the most recent cycle; of
those, one-third have been restructured or liquidated. About half of those
resolved culminated in restructured or extended loan terms, with the remainder
completed through new financing or sale. The balance of known outstanding
distress is estimated at $158 billion, while the inventory of lender REO has
reached approximately $34.3 billion. Opportunities
exist in different forms of distressed acquisitions, ranging from note sales to
sourcing fresh equity to restructuring deals;
however, it requires far more work,
sophistication and networking to identify and
take advantage of distressed situations.
Currently, more than 20 percent of
outstanding commercial
debt is held in tranched commercial mortgage-backed securities (CMBS), adding a
level of complexity to the ownership of
underperforming assets. This dilemma has
resulted in limited offerings and,
consequently, the broader commercial real
estate market resetting at a slower pace. A ‘suspended animation’ effect has fostered gradual price rediscovery,
especially when compared to the 1991 to 1994
period, which was marked by massive and highly discounted disposition of
commercial property by the U.S. government
vis-À-vis the Resolution Trust Corporation.
Core, quality assets fetch a true premium in today’s
market, while lesser-quality and more illiquid properties in secondary or
tertiary markets remain hindered by risk-averse buyers and lenders. Sales
velocity, although substantially improved since its mid-2009 bottom, has been
and will stay sluggish for a while as a result. Generally, lenders remain less
inclined to sell under-performing debt and assets, delaying the deleveraging
process. The redistribution of noncore, distressed and revalued commercial real
estate will eventually occur, but over a two- to three-year period as loan
maturities roll, lenders gain financial strength and space fundamentals
improve.
What types of transactions will close in 2011?
Notwithstanding the institutional and REIT acquisition
volume resurgence in 2010, 93 percent of transactions in the four major property
types were below $20 million, and 87 percent were below $10 million, reflecting
the importance of private investors in the marketplace. Institutional debt
sources share common criteria, including a preference for low-risk,
high-quality assets and larger transactions with strong sponsors. This mandate
leaves the majority of the transaction bell-curve, that being sales of $5
million to $20 million in the B-minus to C-quality range, with limited
financing options. That is not to imply deals in these categories cannot get
done, but the process and qualifications remain far more exhaustive and driven
by the strength of buyer and lender relationships.
Risk aversion will persist for the foreseeable future.
The sparks needed for broad-based easing in financing conditions include
several consecutive quarters of solid job growth and sustained improvement in
corporate capital expenditures. Current conditions suggest this will not
materialize until mid-2011, resulting in more seller financing, loan
assumptions and fresh equity injections to restructure existing deals.
Well-capitalized buyers will have an array of opportunities, but they must be
willing to move down the quality spectrum and assume more risk for the most
competitive valuations, as stable assets in strong markets will not trade at
discounts
What message would you like to deliver to all types
of real estate investors in 2011?
In 2011, investors should take stock of two
fundamental points: the worst is over, and capital markets have improved faster
than expected. Higher returns require the appropriate degree of risk-taking,
and approaching 2011 with the same tenor of wariness present a year ago will
likely lead to lost opportunities. Many investors failed to pull the trigger
over the past 12 months, expecting an RTC-style, deeply discounted property
market or prolonged deterioration of the U.S. economy. The odds of either
occurrence have further diminished. The low-hanging fruit may be gone, but
attractive investment opportunities exist that may not be available a year from
now. That is not to say investors should throw out caution. Economic and market
risks remain and must be assessed; however, this year’s improved data points
and lenders’ ongoing strategy to prevent fire sales on quality assets highlight
the need to reset expectations and adjust strategies.
John M. Leonard is a first
vice president and regional manager of the Atlanta office of Marcus & Millichap Real Estate
Investment Services. Contact him at [email protected]
or (678) 808-2700.
