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Distressed Property Sales Remains a Hot Little Market Unto Itself

While Distress Property Continues to Shrink as Part of Overall Sales, Bargain Hunters Remain Active as Banks Clean House
March 12, 2014
Based on CoStar’s tracking of more than 125,000 repeat sales since 1996, the percentage of total observed paired CRE property sales that closed in January 2014 and were classified as distress sales dipped below 10% of all sales; this is down sharply from a peak of 35% in October 2010.

Importantly though, this doesn’t mean the market for distressed property sales isn’t active unto itself. As the Great Recession fades further from view in our rear view mirrors, investors continue to pick up distressed properties left in its wake. However, the surge in non-distressed property sales has resulted in distressed sales accounting for a smaller percentage of the overall sales volume.

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In the current environment, characterized by historically low interest rates and inccreased investor interest in commercial property of all types, banks and special servicers have been cleaning up their books of distressed properties.

So too have the early-buyers of distressed properties, who have now started putting those properties that have stabilized back on the market. And buyers have been eager to scoop them up, driving up the average price of about $50/square foot in mid-2012 to nearly $80/square foot at the end of 2013, according to data from CoStar COMPs.

Increasing leasing activity and rising occupancies have helped stabilize net operating incomes across a growing number of markets, resulting in a large net reduction in the number of forced sales. This trend has been a positive force for commercial real estate pricing. But it also helps account for the declining portion of distressed sales to the overall investment market.

“When demand is hot and your 'gift card' (loss sharing) is about to expire, it’s time to clean out the closet (distressed properties) so you can buy new clothes" (make new loans), said Fred B. Córdova, III, executive vice president of Kennedy Wilson Brokerage Group in Beverly Hills, CA.

Banks & Financing Are Extremely Conducive to Deals

Cordova rattled off a slew of reasons for the continued strong interest in the distressed property market:
• Loss share agreements are expiring;
• Investor fear is dissipating;
• Buyers are bullish and pushing further out on the risk curve to find yield;
• The market is awash in capital. Foreign money is flooding into the US and
• Short term interest rates remain low, allowing for inexpensive value-add financing.
• Lenders are more accommodative to value-add plays.

The increase in sales volume is also being driven by necessity, according to Patrick Mahoney, CEO of NAI Realvest in Orlando.

“The over $1 trillion in real estate loans originated from 2003 to 2008 are maturing from 2013 until 2018," Mahoney noted. "Due to inflated property values in the bubble years, the vast majority of these loans are in some kind of distressed state, forcing action. In most cases that action is a distressed sale. Additionally, money is flowing back into the market as commercial real estate investors feel more confident in the overall economy. This increased willingness to buy is pushing prices out of the basement, thus you’re seeing the increase in price per square foot."

Andy Little, principal of John B. Levy & Company, Inc. in Richmond, VA, said banks are returning to profitability at least in part by reducing their loan loss reserves.

"This is a reflection that the 'extend and pretend' strategies many banks adopted in the wake of the Recession wasn’t pretending at all," said Little. "We are seeing an uptick in transaction activity from banks selling deals that they have had in REO for a number of years. While many argued back in 2008 and 2009 to pull the Band-Aid off and sell all the bad assets (at the bottom of the market), banks selling assets today are actually making money beyond the written-down level of the loan,” Little said.

CMBS Special Servicers Receptive to Restructurings, Recapitalizations

Jay Maddox, principal of Castlegate Partners, and managing director for Kibel Green, a Santa Monica-based firm that specializes in financial restructurings, said the distress property sale numbers may not accurately capture the financial impact of additional recapitalizations and restructurings.

“Strong demand from distressed investors has enabled us to source "rescue capital" for many borrowers, helping them to recapitalize assets and delay or avoid potentially devastating tax consequences, while retaining an interest in future profits,” Maddox said. “Banks and special servicers have been receptive to creative restructurings and recapitalizations, which have also helped to mitigate losses.”

Who Is Buying?

Jeff Sellers of Montgomery Bros. Commercial Realty in Elks Mills, MD worked with a regional bank in the Maryland area for 27 months to assist in liquidating OREO and distressed properties. In that period, he helped facilitate the sale of 104 properties.

“The buyers that I dealt with over the last two years have been waiting out the interest rate dips and believe they are now at the bottom and want to jump in before rates start inevitably inching upward,” Sellers said. “Their patience is also netting them a lower price on these distressed properties due to the banks/owners frustration and unbalanced asset portfolios.

"I am seeing some foreign investor interest but that seems to be pretty consistent even before the boom. The larger buyers, such as REIT's, private equity funds and private investors, are able to pay cash and forgo the pain of financing these properties,” Sellers said.

Mark Kennedy, director of operations for Turning Point Commercial in Frederick, MD, doesn't expect the heightened interest in distressed sales to go on forever.

“This transaction volume for distressed will most likely start to fade by the second quarter of 2015, and only due to the inability of lenders and special servicers to properly price the remaining product,” Kennedy said. “We are watching for a compression of the spreads between buyers and sellers on tertiary market property. To date, they are still very far apart. If these deltas do not show signs of improvement, a lot of the distressed money may wait and see what new opportunities are available in more desirable markets when the next wave of resets start to occur in 2015-2017.”

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