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06/09/2010

Distressed Real Estate Assets on the Rise—And So Is Investor Interest


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The quantity of distressed commercial real estate assets (properties and loans) in the United States will continue to increase as the deleveraging process unfolds over the coming years. The implosion of the global financing market coupled with the longest and deepest economic recession since the Great Depression has increased stress on both properties and their owners. A shutdown of the securitized lending market (CMBS market) is increasing the demand of properties needing to be refinanced, but the dislocated financing market is limiting the supply of new loans available. 

Real estate market fundamentals continue to worsen in light of the economic recession and anemic economic recovery placing significant pressure on the ability of buildings to generate sustainable cash flow. The majority of assets purchased during the 2005–2007 period were underwritten with very aggressive lease-up and rent growth assumptions. If a property owner purchased real estate in this 2005–2007 period, he or she likely overpaid by a significant margin. Corollary to this point, if a lender provided financing in this 2005–2007 period, it likely overlent. The current economic downturn has put a number of loans in default of their interest coverage covenants.

Downward pressure on asset values due to rising risk premiums (i.e., cap rates) and deteriorating fundamentals are placing significant stresses on borrowers needing to refinance loans at the lower LTV (loan-to-value) ratios available. Portfolio lenders continue to provide new loans at lower LTV ratios; however, the bulk of their lending activity is focused on existing clients, legacy loan books, and primary markets with an aversion to secondary/tertiary markets. Lack of new CMBS issuance has halted conduit originations, creating a glut of maturing CMBS loans that will struggle to be refinanced given the limited appetite and stricter underwriting standards by portfolio lenders. As a result a number of loans sold into the CMBS market will enter various stages of distress and will likely be foreclosed upon over the next few years, with a second wave occurring in the peak maturity years of 2016–2017.

The amount of problem deals has increased materially in recent quarters, especially in the CMBS and banking sectors. Outstanding distress at the end of January 2010 was $163 billion of property in default, bankruptcy, foreclosure, or REO (real estate owned). Since 2007, $207 billion in properties has fallen into distress, while $45.3 billion has exited distress through restructuring/modifications of the mortgage or via sale or recapitalization. Recent data show that the volume of properties entering distress is increasing on a monthly basis, but so is the volume of resolutions leading to lower monthly net additions. For example, the recent monthly net increase in distress was $3 billion, which is below the $10 billion monthly increase average in 2009.

Given the likely increase in distressed opportunities expected to occur over the next 12–24 months, it is not surprising that there has been increased interest from investors seeking to exploit this. It has been reported that $30 billion was raised in private equity funds globally during 2008, with investment plans targeting debt and distressed debt opportunities in the United States. As fund-raising in the segment continues, this wave of capital will likely help reduce the funding shortfall and, in due course, competition among investors seeking to close on distressed opportunities will intensify.

–Mark K. Bhasin, CFA, FRM, CAIA, teaches the course "Investing in Distressed Real Estate Assets" for NYSSA.

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