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Impact of CRE Distress Varies Widely Market to Market

If you are looking for the story Some Leveraged CRE Owners Beginning to Find Rescue Capital for Troubled Assets Please click here.
June 16, 2010
While the amount of CMBS loans falling delinquent and/or defaulting continues to escalate, doubling almost every six months, the damage inflicted on property values and deal volumes varies widely across local cities. Some metro areas are being ravaged while others are being spared, according to an exclusive analysis of local distress compiled for CoStar Group.

In Lansing, MI, for example, where CMBS loans back more than 50 properties, nearly 1 in 5 loans are in the process of defaulting. But in Wichita, KS, or San Luis Obispo, CA, where CMBS loans also back more than 50 properties, the default rate is less than 1 in 100.

The data was compiled exclusively by Investcap Advisors LLC and QuantumRisk LLC for CoStar. Investcap Advisors provides surveillance data on the CMBS market and QuantumRisk is a registered investment advisor in Colorado. The two firms analyzed more than 85,000 properties backing more than 52,000 loans and developed a probability of default ratio and loss severity calculation for 405 U.S. markets.

Even looking at the 25 markets with the most properties backed by CMBS loans, the disparity between individual markets is vivid.

For example the hardest-hit major metro areas of Las Vegas, Phoenix, Detroit, Orlando, Tampa and Atlanta all show probability of default ratios of 10% to 14% and loss severities on loans of 8.6% to 15.4%. While the major metro areas of Orange County (CA), Washington DC, Boston, San Diego, New York, Los Angeles and Seattle, show defaults and losses are running at less than 4%.

In a tandem analysis of distressed property sales compiled by CoStar Group, there is clearly a direct correlation between the results. The percentage of distressed property sales to total sales in the last five quarters is highest in the worst performing CMBS markets and lowest in the better-performing markets.

In Atlanta, Orlando, Tampa and Las Vegas, distressed property sales account for 27% to 44% of total sales activity. However, in New York, Los Angeles, Washington DC and Boston, distressed sales account for just 6% to 11% of the activity, according to the CoStar analysis.

The same discrepancy that shows up between markets across the country also shows up within each individual market.

Distressed Office Properties Widespread

While the tidal wave of troubled office assets that many investors hope for has yet to flood the market, distress has been rippling through the system. In fact, distressed deals accounted for nearly 19% of U.S. office transaction volume from the beginning of 2009 through March 2010, according to CoStar Group data.

"By and large, these distressed transactions have been in suburban submarkets," said Stephanie Hession, a real estate economist with CoStar Group. "Since the beginning of 2009, suburban assets accounted for 63% of total office sales volume but 75% of distressed volume. CMBS delinquencies show a similar trend, with the delinquency rate for suburban office loans at about 7.5% versus a little more than 4% for CBD offices."

"There are several reasons why CBDs are dodging distress better than the suburbs," Hession explained. "CBD office submarkets have structurally lower vacancy rates, at 11.5% in the first quarter, versus 13.3% for the suburbs. Construction has been much heavier in the suburbs, with the suburban office inventory increasing by 7.4% over the past five years, versus a 2.6% increase in the CBD inventory. Because suburban landlords have more competition from new product, it is harder for them to retain and attract tenants."

In addition, Hession said more valuable properties (which are often CBD towers) also have lower delinquencies; so stricter underwriting and more workouts for larger loans may also be a factor in the lower CBD delinquency rate.

"While more distress will emerge in the coming years as net operating incomes deteriorate - in both CBD and suburban submarkets - investors that need to place capital and are looking for bargains (and willing to take on a bit more risk) should check out suburban submarkets," Hession said. "With more distressed assets and less competition from foreign and institutional buyers, they will present more opportunities to buy on the cheap."

While the data and numbers tell a story of local distress across the U.S., they don't tell the whole story. For what distress looks like from the 'front lines' and how it is impacting commercial real estate investment and brokerage activity, we turned to professionals across the country. Their comments that follow reveal more at the gut level of what distress feels like.

A Classic Bifurcated Market

Ironically, the distress that my firm is encountering lies is the fact that purchase prices and investment returns (cap rates) for stabilized trophy and class A office buildings in the DC CBD that our German and Swiss clients want have not only not gone down but have actually gone up in certain cases. This is making it extremely difficult for us to get the returns our clients need, especially closed-end fund clients.

The situation is not quite so difficult for open-end funds because they can put a low yielding, brochure-quality trophy in a fund together with higher-yielding properties already in the fund and blend the returns to an acceptable level.

There is simply too much money chasing really good office properties in the DC CBD (and in the CBDs of NYC and Boston, in particular) and, therefore, the few really good properties that are available are very expensive with yields only in the 5% and 6% range. Our clients need returns in the 7s.

What we have is a classic bifurcated market. Some deals are available on certain stabilized B- and C buildings in the CBD and A and B buildings in the suburbs, as long as one's clients want those kinds of properties.

In regard to other cities, we have done deals for clients as far away as Miami, and last year in Boston, where we did get an acceptable return for a client on a Class A waterfront building in the financial district. But quite recently there was a feeding frenzy for a Class A office building in Boston and the winner of that deal had to buy on a return in the 6s. The deal we did in Boston last September was considerably higher than that, but that was 'so last year.' "
Benjamin B. Lacy, Chairman, Lacy Ltd., Washington, DC

Foreign Investment… Manhattan's Ace in the Hole

Various sectors of Manhattan real estate have fallen approximately 40%-60% from the 2007-2008 peak. Real estate sales activity has likewise plummeted. If you live or work in Manhattan, unless you've been living in a cave, you're now quite familiar with all of the "For Lease" signs that traverse the city's landscape, and in particular Madison Avenue.

As we start to look around the corner towards a "slow and prolonged recovery," or as some say "a jobless recovery," it is important to revisit some of the economic realities that are peculiar to the Manhattan marketplace. Wall Street firms will eventually rebound, and with that increasing residential prices are likely to ensue. Slowly, stalled condo projects will transform themselves into rental apartment complexes, and vacant stores will gradually become occupied…. albeit at significantly reduced rental rates.

Furthermore, due to the weak dollar, international capital is now beginning to flock to the U.S. in ways reminiscent of the early 1990s when Japanese and European investors flooded the Manhattan office markets. A Central Park West penthouse unit recently sold for $37 million to a Russian investment fund; and an Israeli fund purchased the HSBC bank's headquarters building in Manhattan for $330 million.

Russian investors have been particularly active with Mikhail Prokhorov purchasing an 80% share in the New Jersey Nets basketball team and a 45% stake in Atlantic Yards, a real estate development in Brooklyn where the team is expected to play within the next few years. With real estate transactions crossing international borders, foreign investment may just well be Manhattan's ace in the hole towards recovery.
Jon Fischer, Managing Director, NAI Global, New York, NY

The Funds Are Not Letting Assets Hit Bottom

I am a commercial land buyer in the Dallas/Fort Worth metroplex. I was looking forward to the imminent buying spree that I was sure would surface this year. In the late '80s, we were spoiled by many 10-cents-on-the-dollar opportunities, but this down cycle is very different.

I have made three earnest efforts to acquire some so-called "distressed land" this year. I have been unsuccessful. My favorite was a lender-owned 12-acre multifamily parcel, I was sure I would be the logical buyer for its acquisition. I was the first one on the scene and owned property in the immediate area. I felt I knew more about the submarket than anyone, I needed no financing and I could move fast but… I came in 6th out of 12 offers.

Turns out there is so much competition out there from "distressed" property funds, that they are crawling all over each other just to buy something. Every big shot REIT, investment bank, hedge fund - (you name it) has a fund for acquisitions of "distressed" properties. Each fund has people who are hired to acquire this type of asset and the competition is fierce.

The multifamily tract sold for very close to the lenders asking price and for all cash, which was about 25% below where the asset was there years ago. I told one of my listing brokers to put the word "Distressed" on one of our marketing packages and the funds would probably break the door down. The funds are not letting the assets hit bottom. I don't think we are going to get to see the glory days of 10 cents on the dollar in this cycle.
CW Kendall, Owner, Kendall Land Corp., Richardson, TX Showcase Listings

2 Out of Every 3 Deals Will Be Distressed

As you are keenly aware, Florida is one of the leading markets for distressed real estate. As such, the majority of investors are looking for "distressed" deals because of the perception of extremely discounted prices.

Transactions in 2009 were few and far between, but we have seen a modest increase in activity thus far in 2010. This is in part because the groups that are getting deals done are typically able to come in with better terms (i.e., 15-30 days of due diligence, followed by 15-30 days to close) and have the ability to close all cash. Many of these types of deals usually take place with an owner that is being foreclosed on or a lender that already owns the property.

There are other groups that are choosing to purchase the non-performing note, with an eye on getting a hold of the underlying real estate. We have closed a couple of note sales thus far this year and one of them has already produced a "friendly foreclosure" with the investors taking title to the real estate.

While there are no hard and fast rules, it seems like these transactions are getting discounts of 40%-60% of the face value of the note depending on the property type and condition. We have had many groups contact us regarding the purchase of notes in 2010 versus 2009 and expect this to continue moving forward.

Our business model moving forward anticipates nearly two-thirds of the transactions we will complete will be distressed in some way, shape or form.

Based on the conversations I have had when traveling across the country to meet with bank executives and executives from special servicers, it seems like the general consensus is that dealing with distressed properties will account for the majority of transactions for the next 3-5 years.
T. Sean Lance, Managing Director, President-Troubled Asset Optimization, NAI Tampa Bay, Tampa, FL Showcase Listings

Distressed Properties Are Fringe Properties

Most, if not all of the distressed properties, are fringe properties in tough submarkets where the risk is high. All offerings are full of deferred maintenance, non-performing tenants in some cases, and are in competitive areas, again, very high risk. I am often asked, "Do you have any well located distressed deals?" "Yeah," I answer, "I keep them next to my heard of unicorns."

Apartment owners I cultivate for the list side have suffered in their operations. These last six months have been the leanest for operations in my six-year career as a broker. So many owners are not making money, can't keep good tenants, fight the concessions and rising expenses, and are forced to lower rents because the investor who bought the distress deal down the street is at a lower basis and trying to get full occupancy.

This summer is critical and as we go into the busy leasing season, we hope to emerge in the fall with a better trend than the trailing six months. As I push value for owners who feel it is time to exit, I have to price a deal with the market constraints we all face: higher cost of debt, lower amortization schedules, more money down, higher debt service coverage, and find that yield is the most important factor, plus room for upside. Second is the push on my part to take to market offerings that have some form of assumable debt or seller financing because the loan dollars are on the table and not much confidence is placed now with lenders. Seldom will a seller go under contract with a financial contingency.

Buyers are everywhere, but most with experience are holding out for better locations and not getting sucked in on the low price per pound distress in the market. It is still a game of leverage, so many would prefer not to shoot all of their bullets on a deal.

As a listing broker, I help owners exit. If it is a distressed deal that has been repositioned and put out for sale, it is not well received no matter how attractive the return is.
Brian Janak, Senior Associate, National Multi Housing Group, Marcus & Millichap, Houston, TX

No Confidence and No Stomach for Risk

Basically properties are distressed because there are no tenants to lease up vacant space. It is compounded by owners whose other sources of income have also been hit and reduced or eliminated by the recession. Rents may have to be deferred or adjusted temporarily to keep tenants from failing completely, but loans, taxes, insurance, utilities, and other operating expenses are not so easy, if not impossible, to defer or adjust.

What good is a distressed property that can be acquired at a low price, if there is not enough cash to invest to buy it, impossible financing requirements, and no tenants to occupy it anyway?

Needless to say investment activity is minimal, as buyers and sellers are too far apart on price and terms, and no one is confident enough to take a risk because the recovery is still nowhere in sight or no one knows if the recovery signs are true or false.
Wesley K. Firkin, WTA Real Estate Management Co., Philadelphia, PA Showcase Listings

No Room for Old School Ideology

In San Diego County the current market is not getting better in terms of filings, however, we are seeing more commercial properties either having the NOD being filed by the lender, the note going to Trustee Sale (NTS), and eventually the note either going back to the bank as OREO. In the time frame of Jan. 1, 2009, to Dec. 31, 2009, there were 31 properties, which had a NOD/NTS or became OREO. Of the 31, 13 are OREO. In the time frame of Jan. 1, 2010, to June 14, 2010, there have been 240 NOD/NTS or became OREO. Of the 240, 55 are OREO.

We are getting busier every day. The investors we deal with are predominantly focused on distressed assets, whether it be pre foreclosure note sales or REO. I would say that the market for non-distressed investment is very soft. The asset has to be in "hot water" to really get a lot of interest from the people we deal with.

We study NOD's, NTS and call banks! We don't deal with borrowers who need to get bailed out; we go straight to the decision makers. In today's market, as you know that is the banks or the FDIC. This is where the brokerage business has changed in the past five years. Guys that are resistant to this new way of getting business are going to get left in the dust. There is no room for old school ideology. There is going to be a ton of money made and lost over the next five years and guys that are resistant to change are going to get left out.
Steven C. Martini, President, QualityFirst Commercial, San Diego, CA

The Best of Educations… Reeling and Writhing

Political uncertainty is killing investment activity for distressed real estate. This is not, as some pundits explain, because investors are still waiting for a bottom. Questions of how taxes and proposed regulations will impact real estate financing and investment returns have virtually closed down transactions. There is simply no way to construct financial models without knowing what Congress will do in efforts to raise taxes to help reduce the huge deficit. Washington's mathematical rationale for taxing the struggling real estate industry is based on the Mock Turtle's (Alice in Wonderland) four branches of arithmetic - Ambition, Distraction, Uglification and Derision.
Susan Lawrence, President, Real Estate Strategies Inc., Winter Park, FL Showcase Listings

Lurking in the Shadows

With respect to distress in the East Tampa industrial submarket points to the amount of shadow space, or space that is not being utilized by a tenant but is not actively on the market. This figure could be as high as 10% and represents another variable in the commercial real estate recovery, both in the Tampa Bay market and nationally.
Jeff Lamm, Director of Leasing, Taylor & Mathis of Florida, Tampa, FL Showcase Listings

The New Optimism: We're at the Bottom, Unless…

To a large degree, beyond the numbers, it's perception. As long as the perception is that the market is dropping, investors are hesitant to invest. Once the perception changes and people believe that we have bottomed out, investors will return. When asked where the markets at, my reply is, "It looks like we have reached the bottom, unless we find a new bottom."
Larry D. Schnepf, Principal, Schnepf Ellsworth Appraisal Group, Mesa, AZ

Persistent Uncertainty

Our research backed by conversations with active commercial brokers suggest the Chicago commercial markets will continue to suffer due to persistent uncertainty in direction for the buyers and sellers, tenants and landlords, driven by weak fundamentals and constrained liquidity. The general economy must improve which means job creation must resume.
Anthony J. Uzemack, Principal, Appraisal Systems LLC, Park Ridge, IL

The New Vocabulary for the Brokerage Business

Due to wild speculation, overbuilding, and overleveraging of all property types in the Phoenix market, the majority of properties will change hands in the next five years. On an individual property basis, the how and when are the questions that are difficult to answer. The great news is that we are seeing the great divide of 2009 between lenders and investors narrow.

The economic freefall of late 2008/early 2009 has subsided. Rental rates and vacancies have slowed their decline, cap rates have stabilized and the marketplace is beginning to come to a consensus of values. Lenders can assess what losses they can take and investors no longer feel like they are trying to catch a falling knife.

Real estate transactions, once a simple procedure of negotiating between buyer and seller, are now a convoluted process with countless decision makers and routes to navigate toward the ultimate goal of acquiring a property. From a simple escrow process to a landscape riddled with note purchases, short sales, trustee sales, receivership sales, property auctions, note auctions, portfolio note sales, loan workouts, loan to own and equity partnerships, this is a new vocabulary for most and consideration of new strategies that must implemented toward the ultimate goal of acquiring a specific asset.

And it is not so simple as to be able to pay the most for an asset. Timing and knowing the appropriate approach for a bank, receiver, special servicer, master servicer, life company, note purchaser, or borrower can be the difference between an opportunity and yet another closed door.

We are in the midst of a period of great opportunity for the well-capitalized and entrepreneurial investor. Though few loans and properties are transacting, those that are trading are trading at a fraction of past values.

At the peak, it was inconceivable how the market could experience a downturn. Now, at the bottom, it seem implausible that we will ever see that kind of pricing again - but we always do! This will create unparalleled buying opportunities for the contrarian investor who is not relying on a precise financial model, but knows whether we are at the bottom, near the bottom or past the bottom. The long-term prospects for commercial real estate are promising.

There is plenty of activity, an abundance of capital, and a limitless supply of buyers. Unfortunately at the moment there is a constrained supply of deliverable inventory. Many investors with access to a few million dollars expected banks and lenders to cater to them, but lenders to date have held their ground. As a result, we have actually seen an increase in values to a degree for actionable notes or properties. Though the inventory will exponentially mount, it will be absorbed quickly.
Ari Spiro, President, Orion Investment Real Estate Solutions, Scottsdale, AZ

The 3 Most Important Words in Real Estate

Growth markets such as Phoenix experience higher highs and lower lows than other major commercial real estate markets, which translates into zero sum game. A winner for every loser!

Three most important words in real estate become "Timing, Timing, and Timing". No one wants to catch a falling knife. Nothing is the first thing that happens in a distressed CRE market. No sales, no new leases, no new development. The real estate growth complex is replaced with the mentality of cut personnel, costs and debt to the bone to allow them to travel through the canal of carnage.

Survival in CRE requires a nose for identifying new opportunities, finding new clients, creating new services to bridge over the cyclical nature of our industry. Locals are the last to get back in the game.
Dan Colton, Principal, Colton Commercial, Tempe, AZ

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