The real estate vultures have been circling for nearly 2 years, their sharp eyes peering from high above the devastated landscape, ready to feast on dead decaying buildings and development projects. According to conventional wisdom, the ground ought to be littered with foreclosed hotels, shopping centers, office buildings, and apartment complexes to devour, yet surprisingly, the vultures have found the pickings slim.
Anyone paying even slight attention to commercial real estate knew that virtually no property that was financed between 2005-2008, at a loan-to-value ratio above 75%, would be able to qualify for a conventional refinance when the loan matured. How could they when property values have dropped by more than 40% and lending standards have tightened? The coming wave of foreclosures would be measured in the hundreds of billions.
Over the last 2 years, financially sound real estate investment trusts, and well heeled private equity groups have been gearing up and raising mountains of cash to take advantage of the inevitable and impending carnage. REITS, for example, have recently issued stock totaling more than $20 billion (over the last 2 years) in preparation for a buying spree. They include big players like Boston Properties (BXP), Regency Centers (REG), Simon Property Group (SPG), and Vornado Realty Trust (VNO) among others. Private equity and the investment banks that sponsor them have about $200 billion earmarked to buy troubled commercial real estate and bad debt on commercial real estate.
The plan was that banks would take the properties from the borrowers and the vultures would take the properties from the banks at mere pennies on the dollar. But something has gone awry; the inventory of distressed commercial real estate is just not there.
With $300+ billion in commercial mortgages coming due every year through 2015, we know the distressed asset pool is massive. We know for sure that it hasn’t been refinanced and we also know (for the most part) it wasn’t foreclosed on. So the question becomes: “Where is all the distressed commercial property”?
The answer is that we are in the middle of some sort of weird, slow motion, delayed wholesale restructuring and a quarter of a trillion dollars worth of problem loans and the real property that back them are in limbo while all the players try to get their heads around the problem.
The-fact-of-the-matter is that banks have just not foreclosed at anywhere near predicted levels. By some estimates, less than 10% of defaulted commercial mortgage loans have resulted in lenders taking possession through traditional foreclosure. And an even smaller percentage of distressed asset sales have taken place for loans facing imminent default.
Instead, lenders have granted extension after extension, delayed taking decisive action and reworked any loan to any borrower who still has two nickels to rub together. Cynics have taken to calling the practice “delay and pray”. I find the term “extend and pretend” more appropriate because I see a-lot more disillusioned bankers pretending the problem isn’t there than I see praying for a rebound that they know won’t come.
The bottom-line for banks is that taking back the real estate means fully writing off the loan and, for many institutions, writing off the loan means statutory insolvency. Federal regulators know this and that’s why they have not pushed banks to resolve or even be realistic about their delinquent commercial mortgages. The FDIC, the Fed and the Comptroller of the Currency have all signaled that they are not going to question even questionable loan restructuring. In fact, according to recent guidelines found in October’s Policy Statement on Prudent Commercial Real Estate Loan Workouts, they recommend a “balanced approach” and are urging mortgagees and mortgagers to “work constructively together”. Our government watchdogs are looking the other way so our banks can do the same.
Though they would never admit it, the FDIC is stressed to near its limit. Forcing banks to reflect the true value of their distressed CRE loan portfolios (which is approaching $0.00) would likely trigger a giant wave of bank failures. They can’t handle that and neither can the US economy.
So we find ourselves at a frustrating impasse. Lenders, property owners, and investors want to begin the clean up in earnest but they can’t. Property owners struggle to salvage unsalvageable deals, lenders, fearing insolvency, won’t write off loans and put buildings on the market, and investors refuse to pay prices they know are not real. The built-in price correction process has been short circuited and the result has been lackluster deal flow in what should be a spectacular distressed commercial real estate market.
Some people have proposed the bankruptcy courts as a place to sort it all out but, with most commercial real property held in single entity LLCs, bankruptcy would do no good at all. Bankruptcy judges will not be as accommodating as the FDIC has been; the law says they can only accept reorganization plans with a “reliable chance of success”. Apparently, judges are not allowed to pretend.
So, to answer the original question regarding the whereabouts of all the distressed commercial real estate; it’s still out there. All that nonexistent equity has to be subtracted from the various balance sheets where it currently resides and all that debt has to be converted into real equity. Then, and only then, can that equity be exchanged for the billions of dollars of cash that is in the hands of the still circling vultures.
The distressed property wave is still coming, it has just been delayed. Little by little, month by month the financial situation of banks improves and more and more will be able to handle the real, true write downs that they face. As they do they will foreclose and dump the real estate onto the market driving down the prices of all underperforming assets.
Savvy investors, including REITs that invest in troubled properties and bad debt, will eventually benefit when things normalize. Two that individual investors might want to investigate are Apollo Commercial Real Estate Finance (NYSE: ARI) and Colony Financial (NASDAQ: CLNY). FBR Capital recently (August) upgraded ARI from “Market Perform” to “Outperform” and both RBC Capital and JMP Securities have CLNY at “Outperform”.
The distressed commercial real estate market is not for the faint-of-heart and not a place to store the grocery money, but then again, it never really was.
Note: This article was written by Vincent Remealto, a commercial real estate valuation analyst for MasterPlan Capital LLC
Disclosure: Officers / Directors of MasterPlan Capital LLC Long: BXP, SPG & ARI. Also the firm may have occasion to do commercial real estate finance business with SPG.
