More Deals, More Financing, More Competition Is the Outlook for Distressed Investing
If conditions in
commercial real estate have indeed hit bottom, then an increased amount of distressed assets could hit the market this year -- and values could also begin to tick up. That is the general consensus of industry professionals that CoStar Group interviewed for their outlooks on distressed investing in 2011.
Contributing to this expectation is a change seen in the dynamic among lenders. Up until very recently, banks have been reluctant to foreclose on distressed loans because they would be forced to take huge write downs - i.e. losses on those assets. So a policy regarding under-performing loans on commercial real estate that has come to be called "extend and pretend" has become prevalent in banking for the last three years.
But if as industry players now suggest that values have stabilized, then the uncertainty that bankers have faced on valuations will begin to clear up.
"We think that the distressed CRE market will continue to see increased deal flow in 2011. As the broader economy recovers, banks are more capable of accurately assessing value and realizing a more clearly defined exit from nonperforming loans which bank balance sheets are now able to handle," said Kevin Brands, managing principal of Holt Lunsford Commercial in Addison, TX. "Thus, the banks see a bid ask spread narrowing and will show progress in concluding their "extend and pretend" strategy and push the distressed assets onto the market."
Editor's Note: This is one of a series of four stories published this week on distressed investing. Please checkout our other coverage:
Three Deals That Capture the Current State of Distressed Investing
A Statistical Picture of Distress Levels
Regulators on Whether Bank CRE Distress Has Hit a Tipping Point
A commercial real estate bottom will also help restore confidence to investors in more properties besides the best properties in the best markets, Brands said.
"As economic growth returns and supports investor confidence in future absorption and lease rate recovery, investors will place value on vacancy and near term renewals. Thus, investors will be more aggressive in bidding down cap rates in less stabilized assets to a more historically accurate discount to core properties," Brands said.
"Similarly, while multifamily was the first product type to see recovery due to its short lease duration profile and more stable occupancy levels, industrial and office will benefit in 2011 from capital migration up the risk spectrum as the broader economy restores confidence and capital actively seeks to be put to work in higher yielding product," Brands added.
For the rest of this story, we'll let industry executives do the talking.
Upward Pressure on Pricing
With banks and other lenders better positioned to dispose of excess real estate as financial conditions improve, lenders will increasingly liquidate distressed assets in 2011. In fact, the fourth quarter of 2010 marked the first period this cycle where distressed sales outpaced additions to distress, resulting in a net decrease of $8 billion to distress in the market.
A majority of the distressed sales, however, will be concentrated in low-quality assets in tertiary locations with limited discounting. The wave of premium properties that many investors and opportunity funds anticipated appears increasingly unlikely.
Because much of the distressed property will be lower quality assets in secondary or tertiary locations, often with substantial vacant space, these investments will naturally carry higher risk. With average cap rates among top-tier properties in primary markets already beginning to compress in 2010 and the expectation that this trend will carry to secondary markets this year, distressed assets offering favorable yield potential will require hands-on engagement.
The substantial pool of buyers searching for these opportunities, however, will place upward pressure on pricing in the coming year, so the deep discounts anticipated by many will not materialize.
Al Pontius, senior vice president and managing director of Marcus & Millichap in San Francisco
Half of All Deals are Lender Directed
I have closed 30 multifamily transactions in the past 24 months in multiple markets around the Midwest and Southeast. About 50% of that business has been lender-directed, whether REO sale or pre-foreclosure (deed in lieu). With most offerings generating 10 to 15 offers, we have seen about a 20% to 30% premium in price if the existing lender is willing to finance the buyer. The rule holds true for large institutions all the way down to small community banks.
David N. Gaines, senior associate National Multi Housing Group of Marcus & Millichap in Chicago
Easier To Find Financing
Distressed lending is the most competitive end of the market. Many new funds have raised capital for high yield debt investments and are competing for a limited number of opportunities. We have been successful in finding both bridge debt and, in a few cases, debt coupled with preferred equity so that an owner can obtain the leverage necessary to not just refinance a project but to properly recapitalize it as well.
We are bringing in either higher leverage debt or gap funding to help owners recapitalize a property or quickly seize a discounted payoff opportunity. Owners can then lease up the property, get it stabilized and then lock in longer term take-out financing from a CMBS or a life insurance lender.
Marcus J. Mollmann, president of Reliquid in Greenwood Village, CO
Debt Pricing Converging; Property Prices Unrealistic
There is a tremendous amount of capital chasing so-called "distressed deals." There is an uptick in the amount of deals hitting the market with bank or special servicer control. We find pricing to be unrealistic, and it seems several buyers (mostly those who have raised capital with a dire need to deploy it) have amnesia.
These days, distressed debt has less mystique about it, and the pricing for debt is converging with the true value of the underlying real estate.
Aasif M. Bade, president of Ambrose Property Group in Indianapolis, IN
Blinded by the Discount
Prices are moving upwards based on the large amount of capital chasing yields. There are too many uneducated capital investors who do not fully appreciate or understand the industry segment they are just looking at the discount from the "high point."
There is still too much vacant space inventory and some lenders are actually funding new development, which is irresponsible in areas where lenders have too many defaulted loans, pretend and extend deals, and municipalities are getting hit with property tax assessment challenges based on too much vacancy. It just forces more properties and loans into the hopper
Chuck Breidenbach, managing director of MDC Retail Properties Group, an affiliate of Mountain Development Corp. in Clifton, NJ
Path of Least Resistance
Debt investing has been the path of least resistance for distressed owners. Given bank balance sheet issues and overall real estate intrinsic impacting CMBS, direct equity investments have been limited, pushing more people to debt purchases.
Institutional investors have pulled back on the risk scale and are willing to pay higher prices versus taking on "market" risk. For other investors, taking on risk is their "game" so they don't see it as taking on "more" risk.
There is just not enough money out there to refi everything, so you should continue to see a steady flow of distressed real estate.
Eric Paulsen, vice president acquisitions/dispositions at LNR Property Corp. in Newport Beach, CA
Dynamics in Place for Increased Deal Velocity
There is an abundance of opportunities, particularly in the mid- to small-sized CRE properties. We will continue to see an uptick in REO sales from regional banks and healthier community banks, as they look to bring in new capital or reposition. Bank failures will continue throughout this year and into next, and the acquiring banks will be motivated to offload distressed assets at current market prices. We have reached the point where the gap in seller and buyer expectations has been bridged enabling deal velocity to pick up.
Some buyers were burned by purchasing distressed debt often with more challenges and issues than were evident. Savvy buyers who know the market and product type will feel more comfortable just buying the underlying assets, which are somewhat "cleansed" through foreclosure.
Multifamily will continue to be sought after, but sales of other well-located income producing assets (industrial, retail, and office) will pick up as well. REO land sales will continue to be slow, and only very isolated and specific new development will pick up in the second half of 2011. The products that are located in areas that stretch the boundaries of suburban Atlanta will be the most challenging to sell and reposition.
Rush Bradley, REO services for Lavista Associates Inc. in Norcross, GA
The Race is to the Nimble
I still feel there are many opportunities out there for cash-buying entities that are nimble enough to offer short due diligence time frames and quick closings. High net worth individuals or their small affiliated groups with local marketplace knowledge can utilize this advantage. These "local" investors find very low rates of return on their cash from lending institutions and project large potential returns on the backside with projected 5- to 10-year holds. This is especially true with blocks of commercial and/or residentially zoned lots or acreage where there are low annual carrying costs and there are fewer problems that can arise from vacancy, non-paying tenants, or troublesome leases that occur when dealing with improved properties.
Craig Hiser, owner / broker of CMJP Properties Inc. in Columbia, IL
2011 Will Bring Resolutions To Many Properties
For a buyer (whether an institutional type investor or user buyer) that is strong financially there are many opportunities. However, from recent experience for the smaller office and industrial properties there is still a gap between what buyers are willing to pay and what sellers anticipate. But there may be less risk in general because the bottom of the market for commercial property types is behind us in 2010. My guess is that distressed properties that did not get resolved in 2010 will be resolved in 2011.
Peggy Gallagher, president of PG Commercial Real Estate | ITRA in Springhouse, PA
Staying Away from Low Growth Areas
I believe it will be more investment in properties as some banks will let go of OREO because the market has inched up a bit.
For us it's distressed debt [that holds the most interest] it has higher potential returns, especially when you cannot leverage CRE enough to get the close or similar returns. We stay away for states with declining or low population growth and little future employment opportunities.
Orlando Garcia, president of Casa Properties in Miami, FL
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