Hi Nickolas,
I am not sure if you see my Commercial Observer column, "Concrete Thoughts", each week but I thought this week's article on distressed assets might be of particular interest to you. The article is below. If there is anything I can do for you, please don't hesitate to call. Best regards, Bob
That Distressed Assets Wave?
Hasn't arrived and may never--but a steady flow has clearly begun
It is said that history repeats itself. However, when it comes to distressed commercial real estate assets, that saying needs to be modified by adding "but in different ways".
The NYC building sales market started to feel the effects of the credit crisis tangibly in the summer of 2007. From that time through the fall of 2008, it was tempting to believe that maybe things wouldn't be so bad. However, with the collapse of Lehman Brothers and the fundamental restructuring of Wall Street as we knew it in October of 2008, it became clear that the economic condition of the country was significantly worse than we anticipated.
As it became clear that we were headed into very choppy waters, many people in the industry, including myself, had predicted a tsunami of distressed assets coming to market. This dynamic has not played out as little has happened in the two and a half years since our awareness grew about the pending problems with commercial real estate.
Notwithstanding this fact, current economic conditions have certainly created profound stresses in the marketplace. During the asset bubble-inflating years of 2005 into 2007, there were $109 billion of investment sales completed in New York City. Based upon reductions in property values, and the loan-to-value ratios that existed during those years, we estimate that about $80 billion of that activity, or roughly 6,000 properties, have negative equity positions. This means that the amount of the mortgage is in excess of today's value.
Adding to this properties that were refinanced during that same period, we estimate that there are approximately 15,000 properties in New York City which are in a negative equity position.
We further estimate that these properties have approximately $165 billion in debt and that, if these properties were underwritten using today's standards, a conservatively leveraged market would only have about $65 billion in debt on those properties. This $100 billion of excess leverage is what is creating distress in the marketplace.
It is unreasonable to think that the entire $100 billion of leverage will be extracted from the marketplace due to the fact that several owners have additional sources of income that can support properties which are in a negative cash flow position. If these owners want to own the assets on a long-term basis, they will continue to feed the property. There will also be a substantial percentage of these properties that will simply be worked out between the borrower and the lender.
We do, however, anticipate that by the time we exit this cycle, $30 to $40 billion of excess leverage will be extracted from the marketplace and that will occur in the form of recycled capital stacks, which will create losses.
Thus far in the cycle, very little of this activity has actually occurred, as everything that has happened legislatively has created a disincentive for lenders to deal with troubled assets embedded in their balance sheets.
Modifications to FASB's mark-to-market accounting guidelines, bank regulators allowing lenders to keep loans on their balance sheets at par even if the lender knows that the underlying collateral is worth only 50 percent of that value, and modifications to REMIC guidelines have created a path for banks, servicers and special servicers to do little to get recycling in motion in a substantive way.
Additionally, the Fed's highly accommodative monetary policy, where banks are able to borrow at close to zero and lend at significantly higher rates or, conversely, simply buy risk-free treasury bonds, puts the lenders in a position where they are highly profitable. This advantageous recapitalizing of the banking industry enables quarterly earnings to serve as ammunition to offset losses.
For these reasons, there has been very little activity in the commercial real estate distressed arena up to this point. This has caused significant frustration on behalf of buyers looking to acquire these assets. In fact, the low supply of available assets has prompted bidding wars for those few distressed assets that have come on the market.
We have, however, recently seen a shifting tide of late. Rather than a tsunami of distressed assets coming to market, we believe that this distressed asset recycling process will consist of slow rolling waves over time. They will be created by several factors, including interest reserve burn off, expiration of interest-only periods, conversion of floating-rate provisions to fixed-rate, and, most importantly, mortgage maturity.
In the distressed asset area, properties that are most significantly strangled by excess leverage are those with 2006 and 2007 vintage debt. Most of these loans will mature in 2011 and 2012, creating distressed conditions over the next two to three years.
Other advantageous loan terms, which were common during the bubble years, are often creating land mines in capital stacks.
Interest reserve provisions were typically a component of proforma transaction loans that were relying on significant value-added strategies to increase net operating income. As real estate fundamentals have degraded over time, these proforma increases have been unobtainable, creating interest reserve burn-offs without cash flow levels to service the debt.
Many loans had interest-only periods which were typically not for the entire duration of the loan. As amortization kicks in, the additional cost will typically push total debt service payments to a level in excess of net income.
Additionally, those loans which are floating over LIBOR, which opened Monday morning at 23 basis points, may be paying debt service at a rate below 2 percent. At such a low debt service rate, properties with negative equity may, in fact, still be cash flowing. However, when the rate is reset to a market rate of approximately 6 percent, net income falls far short of being able to service the debt.
These factors are starting to loosen up the congestion in the distressed asset pipeline. This has been particularly evident over the past two to three months.
Going back to mid-2008, Massey Knakal has completed in excess of 1,000 valuations for lenders, servicers and special servicers, giving them an idea of the value of the underlying collateral for their loans. From October 2008 thru October 2009, these valuations resulted in our being retained to sell only 12 distressed assets. Within the past three months, we have been retained to sell 32 distressed assets. This is a trend that many of my friends at other building sales firms have seen as well.
There are four factors that we believe are adding to the motivation of sellers to bring their distressed assets to the marketplace now.
First, the foreclosure process in New York is extremely long and cumbersome. Many lenders and servicers are based outside of New York; and, in almost every other jurisdiction in the country, the foreclosure process is much more streamlined than it is here. Going through the New York system, which is often complicated by bankruptcy filings both on personal and entity levels, can, at times, take two to three years.
As lenders become impatient with this process, decisions are made to monetize their assets now. This is particularly beneficial when realizing that, due to the short supply of availabilties, lenders are able to achieve pricing of 95 percent to 100 percent of collateral value for notes that are being sold.
Second, it is becoming clear that fundamentals will not improve dramatically in the short term. The unemployment rate remains elevated and job losses continue. Given the methodology for calculating the unemployment rate, it is predicted by many economists that the official rate will stay elevated even after job creation occurs, as the participation rate will continue to escalate.
Third, as lenders monetize toxic assets they are able to make new loans which are highly profitable and less risky. Bank spreads, or profitability, two years ago was as small as 30 or 40 basis points based on the competitive marketplace to deploy debt capital. Today, those spreads can be 300 or 400 points over treasuries, creating a situation where each dollar lent is 10 times as profitable as it was two years ago. Moreover, these loans are made with less risk as the amount of the loan is 60 to 65 percent of today's lower value, as opposed to 75 to 85 percent of yesterday's inflated value.
Fourth, it is becoming clear that at some point the Fed will have to sequence an exit from the marketplace and, regardless of the method used, it will have a negative impact on commercial real estate. As discussed in last week's "Concrete Thoughts" column, there are four routes the Fed's exit could take: terminating assets purchases (which is a program that consists of mainly buying mortgage backed securities and is expected to cease in March of this year); draining excess bank reserves in the form of a reverse repos and/or term deposit facilities; raising the federal funds rate in tandem with increasing interest rates on reserves or; selling assets outright.
Numbers one, three and four above will have the effect of raising interest rates, which will put pressure on lenders to either compress their spreads or pass along the increases in the form of higher mortgage rates for borrowers. It is very likely that a small percentage of these increases will be absorbed in the form of compressed spreads, while the balance will result in higher mortgage rates.
The second Fed option, the draining of excess bank reserves, will serve to limit the pool of capital available to be deployed in the form of mortgages. Any of these actions will have a negative impact on commercial real estate values; therefore, waiting to sell assets would appear to have a negative impact, at least in the short-term.
This growing trend is positive for our marketplace as the sooner natural bottoms are allowed to be achieved, the sooner a sustainable rebound can grow. While the huge wave of distressed assets we were all anticipating has not resulted, it does appear that a slow and steady flow of these assets has begun which should continue over an extended period of time.
This will not only create steady opportunities for buyers and brokers but, importantly, will lead to a more fundamentally sound market.
