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As CRE Loan Stress Peaks, Debt Investment and Modification Strategies Change

CRE Loan Delinquencies Leveling While Severity Remains High Changing the Nature of Workouts and Deals
June 15, 2011
The level of commercial real estate loan distress appears to be at or nearing its peak - a welcome sign that the worst of the Great Recession may have passed. And with this new phase, the market for distressed commercial real estate borrowers and investors is also undergoing major changes.

Statistically, at any given point in time at least, the Great Recession has wreaked havoc on less than 10% of outstanding CRE debt to date. Overall though, the percentage of damaged CRE debt has been higher when factoring in outstanding loans that have been modified and reverted back from delinquent into current status.

The overall distribution of the troubled loans has by no means been even. For example, the overall CMBS delinquency rate remained relatively flat in May at 9.2%, after reaching all-time highs in 20 of the previous 25 months, according to CoStar Group.

Delinquency rates for other groups peaked at levels lower than seen in the last major real estate downturn during the early 1990s - some by large margins, according to the Mortgage Bankers Association's (MBA).

Between the fourth quarter of 2010 and first quarter of 2011, the 90+-day delinquency rate on loans held by FDIC-insured banks and thrifts remained the same at 4.18%. The 60+-day delinquency rate on loans held in life company portfolios decreased to 0.14%. The 60+-day delinquency rate on multifamily loans held or insured by Fannie Mae decreased to 0.64%. The 60+-day delinquency rate on multifamily loans held or insured by Freddie Mac increased to 0.36%.

Together these groups hold more than 86% of commercial/multifamily mortgage debt outstanding.

Still, the amount of CRE loan delinquencies represents hundreds of billions of dollars in damage - hence value-add opportunities.

However, the delinquency numbers don't take into account the level of severity among the delinquencies.

Tiandan Wu, a debt analyst with CoStar Group, and John O'Callahan, a capital markets strategist for CoStar, recently looked at the severity and timing of delinquencies. CoStar created a Delinquency Severity Index (DSITM) to capture the spectrum of severity within overall delinquencies and to provide a more meaningful indication of periodic change, such as whether conditions are improving.

Although the rise in the delinquency rate began to taper off in early 2010, the Delinquency Severity Index has not begun to taper off until much more recently.

If the pace of resolutions and liquidations increases in 2011, the Delinquency Severity Index could begin to turn down later this year as the more highly weighted, longer-term delinquent loans leaving the pool outweigh the newly delinquent additions, according to Wu and O'Callahan.

Year-to-date in 2011, new delinquencies totaled $12 billion with CoStar predicting total new delinquencies in 2011 of approximately $42 billion.

In another analysis CoStar debt strategist, Mark Fitzgerald and Steve Miller, CoStar's director of U.S. debt and risk research, examined the "extend and pretend" strategies of troubled CMBS loan modifications.

Early in the recession cycle, special servicers relied almost exclusively on maturity and interest-only (IO) term extensions for their loan modifications. From first quarter of 2009 to the first quarter of 2010, more than 93% of modifications utilized one (or both) of these techniques.

However, beginning in the second quarter of 2010, while the rapid ascent in the overall number of modifications continued, principal and contract rate reductions began to take up an increased share of modification activity, the two found.

"For the CRE industry, the increase in the number of 'true modifications,' as opposed to simply extending the maturity or IO term of the loan, is likely a welcome sign as it helps to speed along the deleveraging process and assist distressed borrowers," the two reported. "While loans generally received term/IO extensions in 2009 and 2010, the treatment of those same loans in today's environment would likely be more varied - with many loans finding a more receptive environment today than existed in the eye of the storm."

"The 'extend and pretend' moniker, while true, did not really measure the degree of 'pretending,' as the overwhelming majority of loans got similar treatment. Now we see differential approaches," the two reported. "Despite the obvious opposition from many servicers and CMBS investors to reductions in principal and/or rate, the realization that impairment is permanent for many of these loans has led to increased 'true modifications.' Principal/rate reductions have increased despite the fact that the costs are onerous and have actually increased slightly since 2009."

Fitzgerald and Miller concluded that initial modifications were short-term solutions and logical given the economic uncertainty and the relative confusion regarding special servicers' culpability and latitude in seeking solutions in the best interests of all constituents.

"The market is now morphing into the next phase, better distinguishing the winners, also-rans and outright losers. Loosely translated: Winners, if needed, will likely get more time; also-rans will likely get rate or principal reductions that should allow them to become creditworthy loans again; and outright losers will be foreclosed and sold, or result in hefty discounted payoffs," Fitzgerald and Miller noted.

Just as the market is morphing for borrowers, it is also morphing for debt investors, according to accounting firm Ernst & Young.

In a report summarizing the results of its 2011 Distressed Debt Investor Survey, Ernst & Young says the CRE debt market has sprung to life but with a changing set of investors.

"Delve into the market for distressed real estate loans today and you'll find two categories of investors: those who have slowed or stopped their search for investment opportunities and those who continue to actively pursue them," E&Y reported. "If they stay active in the game, investors are finding more success."

The slowdown in activity may result to some extent from a pullback by some individual investors or groups of smaller investors that typically pursue smaller deals in their local markets, E&Y noted. And some investors may have decided there is too much competition for a relatively limited supply of distressed loans coming on the market. Miller and Fitzgerald of CoStar also note that some investors express concern over "deal fatigue" - pursuing large pool of auctioned assets require substantial commitment of resources that can be fruitless if they do not win the bid.

Meanwhile, other investors including large real estate companies and institutional investors continue to pursue buying opportunities, E&Y noted. More than two-thirds of respondents to the latest survey reported that they have bought or tried to buy loans.

The respondents to E&Y latest survey included real estate investment and opportunity funds, private equity firms, institutional investors, investment banks and real estate developers and other investors.

"While some of these investors are less active in seeking to buy distressed real estate loans, other investors are forging ahead. They have stepped up their efforts to try to acquire distressed real estate loans from the pool of loans that banks offer for sale," E&Y said. "Investors expect regional U.S. banks to be most active in selling loans this year, followed by the U.S. government and money center banks."

NAI Global in a corporate blog published this week, also noted the increasing trend.

"As we round [into] the third quarter of 2011, we are seeing that lenders are increasingly willing to sell notes/assets to clear up their books. With the real estate recovery under way, more sideline capital are chasing the few opportunities on the market and the increased demand is prompting distressed debt owners to place more of their inventory on the market," the company said.

NAI Global noted that LNR Partners and CIII Capital Partners are selling a tremendous amount of product through a large auction now and the FDIC has another $700 million portfolio to be sold in the third quarter of 2011.

"We believe we are at the tipping point towards a more normalized market where new originations will commence in early in 2012 reflecting normal CMBS output and lending patterns similar to 2005 and 2006," the company said. "Though 2012 will see more distressed debt opportunities we see an overall slow down as the economy and its recovery finally impacts real estate positively."

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