The Trouble with Troubled Assets

Overall, commercial real estate sales are on an upswing. According to Real Capital Analytics, national sales volume for 2011 should top out near the $200 billion mark. Although that is only a third of the 2007 peak, it is significantly higher than 2010’s $120 billion.

Meanwhile, signals regarding the sale of distressed commercial property are more mixed. A variety of factors are affecting sales volume, including property location, type and the availability of financing. To understand the dynamics of this sector, the Center consulted several Texas-based commercial real estate professionals.

Distressed Asset Flow

Investors have been raising money for several years in anticipation of the next “RTC event.” Expectations were that bank regulators would flush distressed properties out of the banking system, selling them at steep discounts. This has not occurred.

The FDIC did conduct several auctions and a large number of structured sales during 2010. Structured sales are joint ventures or partnerships between the FDIC and private sector investors designed to facilitate the disposal of assets from failed banks and thrifts. The FDIC retains a financial interest in the assets after their sale while transferring day-to-day management responsibilities to the private sector.

“The FDIC was able to unload more than 5,400 commercial loans with a total unpaid balance of almost $7 billion in structured transactions during 2010,” says Bruce Nelson, chief operating officer for the Houston based Situs Companies, a full-service real estate advisory firm. “But the flow of assets out of the FDIC slowed considerably in 2011.”

Russell Ingrum, managing director of investment sales in the CB Richard Ellis Houston office, notes that a consistent 22 to 23 percent of their company’s commercial valuations have been for distressed properties, but that has not translated into sales.

“CB completed about $12 billion in sales during the first half of 2011. However, less than $1 billion of those properties were distressed,” says Ingrum.

Nelson says he is seeing an increase in sales from both troubled and healthy banks offering a select number of assets culled from their loan portfolios.

“Although these portfolios are smaller than some of those marketed by the FDIC, we are now beginning to see a more steady flow of deals,” says Nelson. “I expect that trend to continue in 2012.”

“For the more institutional-grade properties our company deals in, we haven’t really noticed an increase in volume,” says Dallas-based Sam Gillespie, executive vice president and chief operating officer of Behringer Harvard Opportunity REIT I & II. “We have noted that the quality of distressed properties coming up for sale has improved.”

“What I’ve seen in 2011 is a bit different from the three or four previous years,” says Carlos Vaz, president and founder of Conti Organization Real Estate Investments. Vaz’s company deals exclusively in distressed Class B and C multifamily properties in the major Texas metros. “Much more capital has become available, both equity and debt,” he says. “As a result, more investors are competing for distressed assets, even in Class-C properties.”

Vaz also believes that the special servicers working with distressed CMBS (commercial mortgage-backed security) properties are now starting to part with some of their worst-performing properties. “They are a huge liability,” says Vaz. “They realize they must feed these properties like crazy if they hold them.”

“In the CMBS world, liquidations of distressed loans have begun increasing while loss severity is starting to trickle downwards,” says Nelson, whose firm also acts as a CMBS special servicer. “However, modifications and extensions are still about 70 percent of current resolutions. So you are seeing more product from the bank sector and less from the FDIC. With more loan maturities coming and originally modified loans not being able to get refinanced, we can expect more distressed opportunities coming from CMBS.”

“Most of the lenders I deal with are commercial banks,” says Reid Wilson, attorney with Wilson, Cribbs & Goren P.C. and CRE, Houston. “Healthy banks are being more aggressive in removing their bad loans. The stronger the bank, the tougher they are on their borrowers. They also are feeling pressure from their regulators. Alternatively, struggling banks are continuing to extend and pretend because they just can’t take the losses.”

“One thing to note is about a third of loans held by CMBS special servicers are experiencing maturity default and not monetary default,” states Will Holshouser, commercial mortgage banker with San Antonio-based Trinity Mortgage Finance. Maturity default occurs when an owner cannot secure refinancing.

“They are unable to meet their loan maturity balloon payments, and it is taking a great deal of time and effort to find a replacement lender,” Holshouser explains. “As a result, some borrowers are being forced to accept terms they really don’t want.”

Distressed Property by Type

Multifamily properties have been one of the most prevalent property types in CMBS transactions. Though they were thought to be safer than some other property types, they are now showing up in distressed sales.

“Multifamily deals, particularly Class-C apartments financed through CMBS, were having performance issues before this recent crash even began. So it’s no surprise that we have seen a lot of apartments,” says Nelson. “We are also seeing a lot of distressed land on the books of banks. In CMBS, distressed loans are more or less evenly split between multifamily, retail and office with a lesser amount in hospitality.”

“Land is where many assets have decreased in value, and owners are having to feed them,” says Ingrum. “So they have to make a decision to keep feeding until the market comes back or let the property go because land generates no income.”

Ingrum adds, “A vacancy event will often trigger a default in retail properties. Losing an anchor tenant can be catastrophic in retail. Luckily, there has been comparatively little distressed industrial space because it is largely a low-leverage product.”

Distressed Asset Pricing

The prices that FDIC received for distressed assets early on were quite low. According to Nelson, one early FDIC bulk transaction traded in the 20-cent range while several others were in the high 30s on the dollar. Prices have gone up since then, although the price can vary greatly depending on the composition of the pool.

“On the one-off FDIC deals, we are seeing an extremely wide range of prices,” Nelson continues. “CMBS assets that have actually been liquidated are experiencing losses in the 40 to 50 percent range. That’s consistent with losses occurring in auctions as well.”

Vaz states that in the last three months, “The market has changed more than in the last two years. There are deals that we have made that were maybe 20 percent of the note value. You just don’t see that discount anymore. That gap is closing.”

Location is also a factor.

“During 2011, I know of four Dallas transactions that sold lower than a five-cap. That’s never happened before,” says Vaz. “I had someone in New York ask why I would want to go to Texas to pay a five-cap. So something will need to adjust, but I don’t know how it’s going to happen.”

A large disconnect has occurred between the way distressed and nondistressed commercial real estate is being priced.

“I see two distinct valuation scenarios depending on whether the property is distressed or not,” says Pat O’Connor, MAI and president of O’Connor & Associates, Houston. “For non-distressed assets, pricing is based on the property’s capitalization rate. You are looking at how much money you could have put in the bank in the last three months or the last year. So trailing three- or 12-month income is what’s being used to calculate the price.”

O’Connor believes that pricing for distressed assets is now being done “by the pound.” In this case, by the pound means buying small quantities at the cheapest price possible.

“Appraisal theory generally doesn’t apply in price-per-pound deals,” he says. “Sales price is determined by how desperate a particular owner is to sell. So pricing is determined on a caseby-case basis.”

O’Connor notes that some of the distressed prices being paid are extremely low.

“I have seen as little as $4k to $8k per door paid for Class-C distressed apartments in Houston. A combination of tight financing and limited buyers was most likely the reason,” he says.

Investor Expectations

Economic conditions affect investor expectations, and the Texas economy continues to outperform much of the country.

“It’s important to distinguish between the Texas recovery and the national recovery,” says Vaz. “Interest is high from outsiders. For distressed Class-A and -B multifamily properties in Texas, I am seeing local, national and international buyers.”

“Texas is doing better, but we are still in a risk-averse environment,” notes Ingrum. “In 2007, loan committees might meet for 15 minutes on a large deal. Today, they are spending much more time understanding all the ways they could lose money on an investment.”

Ingrum states that “gateway” markets such as Washington, D.C., or New York all have significant barriers to entry. “Coming out of the recession, you want to look at markets that have shown a proven ability to grow, and Texas fits that description well.”

There is still more capital and more aggressive bidding for distressed assets than any other property profile.

“I see a definite bifurcation between high-quality core properties, opportunistic distressed properties and the vast wasteland of assets in the middle that nobody is interested in at the moment,” says Gillespie. “It is truly mind-boggling to see cases where high-performing assets are trading for less than a building that is half-leased. Some distressed buyers are obviously purchasing the hope that they can do a better job than previous management did.”

“There is always the question of whether now is a good time to sell,” says Vaz. “Owners of Class-A or -B assets may want to consider holding out for a better price. In the Class-C distressed apartment segment, our main objective is to secure cheaper debt for a future sale.

“Fannie Mae recently offered us 5.25 percent nonrecourse money for ten years on a refinance deal. The loan was also assumable. Depending on what happens to inflation, two years from now you may not find such attractive debt financing being offered. So we are hoping to earn a premium for our assets that have secured cheap debt,” Vaz notes.

Financing Distressed Assets

Bridge financing is making a comeback because of the comparatively low loan-to-value (LTV) ratios available today.

“We are seeing mezzanine financing being offered again,” says Ingrum. “However, this time around the money is coming from hedge funds or debt funds that are much more sophisticated than in the past. They are only offering funds if they really like an asset.”

David Carter, principal with Colliers International in Houston, is also seeing the return of mezzanine and second loan financing. “If you have a 60 percent LTV, you need the gap filled,” he says. “However, mezzanine funding rates are 12 to 15 percent right now. So it’s not cheap.”

Vaz explains that his firm generally needs bridge financing to obtain enough debt until it can improve the properties enough for Fannie’s financing standards.

“High LTVs are rare for Class-C distressed apartments,” he says.

“A key factor driving the increase in available financing during 2011 was the increase in overall sales,” says Holshouser. “This provided lenders with more information about where commercial values are. And that has made lending easier.”

Challenges with Distressed Assets

“The biggest challenge today is getting a deal done,” says Ingrum. “The trick is to pursue deals that result in a market sale. About 20 percent of time but only 8 percent of revenue is coming from distressed deals out of my office.

“Timelines for everything (such as due diligence and loan agreements) are compressed with distressed assets, mainly because of the level of competition for them. This is especially true for properties greater than $10 million in value.”

Carter agrees. “Funding is generally not an issue if you are bidding. It’s mainly timing and due diligence. You need to move quickly. Sellers demand that you do your homework ahead of time. And once the contract is signed, they are not allowing changes.”

What Lies Ahead

Real Capital Analytics reports that about $1.2 trillion in commercial real estate assets were traded nationally between 2005 and 2007.

“For the most part, these assets are still being held by those purchasers,” says Ingrum. “As a result, many of them will come up for sale in the next four years, depending on holding period, market conditions, and so on.”

These properties could represent $200 billion per year in transactions. Many of them will be in the distressed category because of when they were purchased.

“If you are a broker, you should consider focusing on what traded back then,” says Ingrum.

The quicker distressed assets get resolved, the better. “They tend to slowly deteriorate due to lack of tenant improvements and deferred maintenance,” notes Ingrum. “You can defer for one to two years, but after four or five years, it’s too long. We are pretty near that five-year window for a significant amount of product based on the 2007 start of this downturn.”

Dr. Hunt ([email protected]) is a research economist with the Real Estate Center at Texas A&M University.