With Defaults Mounting, Buyers with Money Line up for Deals; But Lenders Not Willing To Part with Notes at Distressed Price Levels
Increasingly frustrated in their attempts to acquire income-producing property at pricing levels lower than what sellers have been willing to accept, commercial real estate investors have turned their attention to commercial mortgage-related investments. But they're finding sales conditions in that arena are not too different than those for the brick-and-mortar assets.
While it looks like there is a consensus that opportunities exist for debt and mortgage investments, and there is plenty of money to finance such deals, the pricing that sellers are willing to accept isn't matching up with what buyers are offering at this point.
Michael B. Singh, managing director of Jones Lang LaSalle Americas in Los Angeles, sums up conditions succinctly.
"If notes are available at the right price, investors are ready to move," Singh said, but added, "pricing has been a big sticking point as seen in the continued wide bid-ask spread. Lenders generally seek to recover 80% or more on performing notes while investors typically bid sub 60%."
Even at a 60% discount, it is hard to complete a deal, said John T. Fenoglio, senior vice president of Grandbridge Real Estate Capital LLC in Houston.
"We recently marketed an acquisition loan for 60% of the purchase price of the of a power center on an exclusive basis and spoke with 30-plus lenders (life companies, banks and pension funds). We received only one quote," Fenoglio recounted.
But with a spike in CMBS deliquency rates over the past six months and hundreds of billions of dollars in loans set to mature over the next several years, prospective buyers appear to be in no hurry to strike deals at current pricing levels, believing looming loan maturities will make sellers more amenable in the not-too-distant future.
David S. Akeman, director of capital markets of Stan Johnson Co. in Tulsa, OK, told CoStar Group: "There is a market, but I hear that most lenders or note holders typically aren't discounting the performing commercial real estate notes enough to attract buyers. Many I have personally spoken with are still trying to discount less than 10%. One life company is trying to hold out for par on a vacant Stock Building Supply (property) that is no longer paying rent. This will change in the future, but right now the lenders are stressed, not distressed."
Compelling Opportunity
According to data from CoStar COMPS, total office building sales transactions were down 42% in 2008 compared to 2007; retail property sales were down 37%; and industrial building sales down 32%.
And as property deals have fallen off, signs of a growing interest in mortgage-related investments are showing up everywhere. Investment advisors and brokerage firms are stacking up on personnel with experience in the debt market. And new funds are coming together to make such investments.
For example Prudential Real Estate Investors has hired a team of leaders in the commercial real estate debt industry to establish a global high yield debt investment platform that will serve institutional clients worldwide.
Jack Taylor joined PREI as a managing director and head of the group that has offices in New York, London, and Parsippany, NJ.
Current conditions have created a dramatic shortage of debt capital in the commercial real estate markets, offering significant investment opportunities, Taylor said.
"The historic dislocation unfolding in the real estate debt markets, resulting in a capital constrained and secularly deleveraging environment, has created an enduring opportunity for our clients to participate in attractive debt investments," Taylor said.
In another example, this week, Starwood Capital Group, a privately held private equity firm, launched an initial public stock offering for Starwood Property Trust Inc. that will focus primarily on commercial mortgage loans and other commercial real estate debt investments.
Starwood Property Trust offering circular spells out the opportunities.
"We believe that the next five years will be one of the most attractive real estate investment periods in the past 50 years. … Due to the dramatic repricing of real estate assets thus far and the continuing uncertainty in the direction of the real estate markets, a void in the debt and equity capital available for investing in real estate has been created as many banks, insurance companies, finance companies and fund managers face insolvency or have determined to reduce or discontinue investment in debt or equity related to real estate."
"The dislocations in the real estate market have already caused and we believe will continue to cause an "over-correction" in the repricing of real estate assets," the document continues. "We expect to capitalize on these market dislocations and capital void. We believe that there will be a significant supply of distressed investment opportunities."
The Disconnect: Buy Side
CoStar Group contacted a variety of executives on both the sell and buy sides of commercial mortgage-related assets to provide their assessment of the current market and the types of deals out there.
"We are buyers of performing commercial first mortgage notes," said Charles Cecil, partner at OpIn Partners in New York. "The market is very thin for performing whole loans (that do not look like they are about to go non-performing!). During the past six months, we have seen two such loans, both were in the $250 million size, one from a major money center bank and one from an important regional bank. Discounts were at 80% of face. In non-performing commercial loans, where we are loan-to-own buyers, we have seen a bit more action, but the quality has not been very interesting, and the pricing guidance is not in the market. In CMBS, where we are buyers of AA to A4 tranches of fixed rate CMBS, the market is trading at $1 billion to $2 billion a week, which is very thin for the $680 billion outstanding."
Cecil offered the following examples of recent deals he's looked at. There was a non-performing Manhattan acquisition development loan with a $22 million face value priced by regional bank seller at 72%. Cecil said the firm would buy at no more than 50% because of ongoing market uncertainty and related extended maturity for returns. There a Los Angeles non-performing acquisition and development loan with an $80 million face value offered by a money center bank at $45 million. Cecil said he would pay no more than $20 million.
"Banks have resisted the divestiture of their sub and non-performing loans, and pricing has been about as transparent as red clay," said Steven Sandler, CEO of Crosswind Capital LLC in Rye, NY. "The sum is a commercial mortgage market that remains, in relative terms, comatose. It will stay that way as long as U.S. lending institutions believe, rightly or wrongly, that the best bid for their paper will eventually come from the federal government."
"With the serious retrenchment in values across the board, coupled with continuing downward pressure on asset prices, it's difficult to make the investment case for any subordinate debt. Pretty much all of the mezz type loans we see are hopelessly under water and that has been our observation across collateral types," Sandler added. "I can't speak for other buyers of distressed paper, but for our firm, the sweet spot is, and in the near to medium term will be, at the top of the capital stack. Even in the most senior positions, however, pricing is still disconnected and it makes for a challenging investment environment."
According to Alec Schiffer, an investment advisor with Strata Equity Group in San Diego, the time to buy has yet to come.
"The only good deals being done are note sales, but the good ones are extremely hard to find," Schiffer said. "What I will say as an active acquirer of good deals with cash in hand is that it is becoming obvious that banks have not written down their commercial notes performing and nonperforming to a level that would create active investments in these vehicles. It seems painfully obvious that the trouble with financial institutions is far from over and they are in a catch 22. They cannot take more losses, but have to deleverage their books."
"Being that we are in the worst financial crisis since the great depression, which is also entirely focused on real estate value, one should expect that commercial prices have a long way to go and the smart banks should take their losses now," Schiffer said.
Ron Opfer, CCIM, a broker with Coldwell Banker Premier Realty in Henderson, NV, said all asset types are attractive right now from a buyer point of view.
"You just have to use real numbers in your math and make some sort of adjustment for a market that is continuing to fall," Opfer added. "Our investors chop the reported lease rates by 25% to 35%, apply a higher than reported vacancy rate, and use a cap rate that truly reflects the current risks associated with commercial real estate. No longer can you associate the same risks with commercial real estate as you would with a money market account. From an investor point of view, the days of artificially low cap rates are gone."
"It is absolutely essential step to recovery that the CRE assets re-set at current market rates. There are CRE assets all over the country that simply cannot re-lease due to the fact that current market lease rates do not pay the mortgage. These mortgage values have to be re-set in order for the assets to offer the necessary pricing," Opfer said.
The Disconnect: Seller Side
The sellers mind set still appears to be to try to hold on and ride out the volatility until things stabilize. Or as Opfer put it, "banks are having trouble pronouncing the word 'loss.'" Thus buyers are finding it extremely hard to negotiate a deal with banks.
"It is amazing that more stuff hasn't been sold at a steep discount right now," said J. Mark Gibson, a commercial analyst with Proficio Bank in Jacksonville, FL. "I think that banks are holding onto certain assets with the thought that they will be made whole on them if they can hold out until things turn around. Maybe the TARP money is helping with that also, but they've been somewhat unwilling from the beginning of the recession to unload at least from a commercial perspective."
"It feels like at least from the banking perspective that we all still in the wait and see what happens mentality," Gibson said, adding that investors too are still in that mode.
"Potential investors are leery of whether or not they are getting a good deal or catching a falling knife," Gibson said.
Barry C. Smith, president of LoanSaleCorp.com, a loan sale advisor in Scottsdale, AZ, said there is a real need in the market for different types of transactions.
- Banks need to purge troubled loans.
- Banks need to sell good loans. And
- Banks have REO they need to dispose of.
However, Smith said, "many banks today are basically illiquid from a disposition capability. The real issue is capital. They don't have the capital to sell -- meaning if they sell, they basically have to mark to market the asset because they acknowledge the price being offered by the capable buyers (buyers with cash that do not rely on financing)."
Troubled loans and REO also must be discounted to foster a transaction because it is very rare that the loan-to-value on the asset has held up, he added.
"We know of numerous banks that would like to sell 'good" loans,'" Smith said. "This is basically a disguised way of raising capital. The problem with this action also relates to a 'mark to market' issue. Sellers will generally have to discount a good loan in order to meet the yield expectations of buyers. Most of these loans are written at interest rates that would not be appealing at par. Again, discounting means taking a hit to capital; again: illiquidity."
Any transactions getting done are coming from failed institutions because they are the only ones that can afford to sell, Smith said.
In addition to sellers hanging on to mortgage notes, they are also hanging on to commercial mortgage securities, said Anton Qiu, principal of TRI Commercial in San Francisco. But they can't hold on forever.
"There will be huge pools of CMBS loans, as well as bank portfolio CRE loans (not sold, but kept) maturing in 2010 - 2012. Most were funded in 2005 to 2007 near or at peak of the market," Qiu said. "Once these loans are mature and [for which there will be] no take-out financing, then many of them might be forced to be liquidated. We will see much lower valuations in price."
Sampling of Recent Deals
According to Michael B. Singh, managing director of Jones Lang LaSalle, the majority of larger commercial real estate loan sales have been "one offs" or involved small portfolios. Many of the sales have been to the borrowers at a discount or directly to other investors and banks.
"While the few larger auctions have garnered media interest, we are far from seeing a flood of deals transacting," Singh said.
The following are samples of some of recent loan deals that CoStar Group has run across in the past couple of weeks:
- This week, Investcorp announced that its real estate team completed a series of transactions to acquire a senior mortgage loan, a B-Note for a senior mortgage and two mezzanine loans, all secured by commercial property assets, located in the United States, that are performing well. The loans, with a face value of approximately $170.9m, were purchased by Investcorp at a discounted rate. Details of the transaction were not disclosed. The senior mortgage loan was secured by an office headquarters building in Washington, DC. The two mezzanine loans were secured by Class A office buildings in New York and Los Angeles, and were acquired from a private investor. The B-Note of a senior mortgage was secured by four self-storage facilities located in the boroughs of New York, and was purchased from a major commercial bank.
- Winthrop Realty Trust in Boston acquired a first mortgage loan secured by a 19-story, 289,000-square-foot office building at 160 Spear St. in San Francisco, and a first mortgage loan secured by a two-building four-story office complex containing 116,000 square feet at 3737 and 3877 N. 7th St. in Phoenix, AZ, for an aggregate purchase price of $44 million. The 160 Spear loan has an outstanding principal balance of $73.8 million, bears interest at a rate of 6.48215% ($4,850,000 per annum), and matures on June 9, 2012. The Phoenix loan has an outstanding principal balance of $7.2 million bears interest at 9.8375% and matures on June 9, 2012.
- United Capital Corp. in Great Neck, NY, purchased a $13.4 million mortgage note encumbering the property that houses the Bentley Lamborghini Dealership of Long Island from Bank of America. The mortgage is secured by a newly renovated 61,000-square-foot showroom and service center just off the Long Island Expressway in Jericho, NY. The 4-acre property is currently occupied by Champion Motor Group, which recently filed for Chapter 11 protection. The note is non-performing and was purchased at a discount to its stated amount.
- A10 Capital in Boise, ID, provided $4.6 million to an opportunity fund to finance a distressed debt purchase of a defaulted loan with a $22 million face amount for approximately $10 million. The acquired note is secured by a large multifamily complex with more than 85% occupancy.
Download this story and all of the stories in the Watch List Newsletter here. The Adobe pdf version also includes all of this week’s leads of distressed properties and loans of concern, lease cancellations applied for in bankruptcy proceedings, all of the local and national facility closures & layoffs, banks with distressed real estate portfolios and lists of loans approaching their maturity date. Plus the pdf version contains bonus news items not found in these columns or the CoStar Group web news pages.
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