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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   October 2012

Whatever Happened to Distressed Properties?

Brokers must understand the market dynamics controlling distressed loans

After the dramatic 2008 economic crash, there were predictions that the commercial real estate market would be awash with distressed properties that could be snatched up for pennies on the dollar. Bargains would be everywhere, ripe for the picking, and all you had to do was amass your capital and be ready. Many investors are still waiting for the deluge, however, and wondering about the reasons for the delay.

This wait may soon be over if recent trends in commercial property values, which are a direct reflection of these properties’ ability to generate income, hold. A property’s income largely is a function of its occupancy rate and rental rate. In the aftermath of the financial crisis, vacancy rates across different commercial property types spiked and rents dropped. Previously stable, profitable properties were no longer generating enough revenue to service their debt obligations. As a result, property values spiraled downward and many more properties were soon upside down on their loan-to-value (LTV) ratios.

Focus on small businees

In the aftermath of the financial crisis, many banks have been cash-strapped, partly because of the reserves they must maintain on distressed real estate loans. As a result, they have cut off credit lines or have been unable or unwilling to provide financing to businesses — even to those with good credit ratings.

Many may not realize that small businesses rather than large corporations make up the overwhelming number of American businesses. The Small Business Administration’s (SBA’s) Office of Advocacy research shows that small businesses represent nearly 99.7 percent of all U.S. employer companies. Lenders play a critical role in helping the SBA achieve its mission of assisting small businesses. This current prolonged economic situation, however, is new to many banks. A bank may be sitting on a wealth of property, but lacks the expertise to effectively bring these assets to market. In addition, a small bank may have a desire to handle SBA lending, but the niche is specialized, and full of regulations and high costs to start such an operation.

Either way, this creates business opportunities for brokerages that specialize in SBA lending, which can help those lenders and jump start the economy at the same time. This is clearly a win-win situation for everyone.

By some industry estimates, distressed properties have lost as much as 52 percent of their values since the market peak. This, of course, depends on the property’s location and asset type. For instance, property values were hit worse in Las Vegas and Florida, where they had increased faster before the bubble popped. Multifamily assets have stabilized in many markets and are trading near pre-crash levels in some areas. This stabilization stems from a number of reasons, including substantial single-family home foreclosures and little new construction.

High vacancy rates also have plagued the nation, particularly in the office market. Currently, the national average vacancy rate for office space is 17.6 percent, according to Reis Inc. There are scattered signs of stabilization and slow recovery, but the office sector isn’t out of the woods yet.

With many property types still struggling and downward trends in income and property values continuing, will the long-anticipated wave of bargain properties finally arrive? This may depend on whether loans coming to maturity will be able to refinance or modify their existing loans.

Maturing loans

Adverse trends in property values, rental rates and vacancy rates have severely hit the commercial real estate market, but the greatest threat to the market is the impending wall of maturing loans. More than $2 trillion of commercial real estate debt is set to mature through 2015, according to a report from Morgan Stanley. The loans that were written during the 2005-to-2007 market peak are reaching maturity this year and in the coming few years. The majority of these loans were written at 75 percent to 80 percent LTV ratios.

With property values significantly depressed, these loans’ LTVs now could be 130 percent or higher. In other words, not only has the property owner lost all of the equity, the owner now has a debt liability that greatly exceeds the value of the property, and to complicate matters even further, this debt will not qualify for refinance upon maturity.

When a loan hits its maturity date, there are several actions that can be taken:

  • The borrower can refinance the obligation, either with the current or a new lender, but probably with more cash down because of falling values; 
  • The borrower and lender can agree on a modification of the note; 
  • The lender can sell the note, probably at a discount, and let someone else deal with the problem; or
  • The lender can take the property back through foreclosure or a deed in lieu of foreclosure.

Loan-modification obstacles

One would think that a loan modification would be preferred by both banks and borrowers, but loan modifications have proved unsuccessful in general. There are several hurdles to modification, including:

  1. Banks are not at liberty to unilaterally modify a loan’s terms because of the securitization process. A bank must seek investor approval. In some instances, this can be almost impossible given how mortgages have been collateralized, chopped up and sold to multiple investors. At this point, the bank is just servicing a note that is owned by parties that can’t even be readily identified. It can be easier for the bank to declare the asset as nonperforming and engage in recovery than it is to secure investor approval for a loan modification. This process was written into the loan origination and servicing documentation and does not require any investor approval. Unfortunately, when these notes were written, no one anticipated such a massive scale of defaults and falling property values.
  2. The perception by some banks that modification creates a “moral hazard” by incentivizing borrowers to default on their payments and seek modification. When a bank writes down a note’s principal for the benefit of the original borrower, the bank’s perception may be that it is the only one writing down the loss. On the other hand, if the bank recovers the asset and sells it on the market, then the bank and borrower have suffered equally in the exchange. This can be considered short-sighted, but no one wants the perception that they are being treated unequally in the sharing of a loss.
  3. Many banks do not have the resources to modify such a tremendous volume of nonperforming loans. In his testimony before the Congressional Oversight Panel in February 2011, Patrick Parkinson of the Federal Reserve System stated that only 5 percent of the outstanding commercial real estate loans were restructured to that date. The industry hopes that it can increase this effort to as much as 8 percent, but such a modest effort won’t make the slightest dent in the impending wall of defaults expected in the next three years.
  4. The guideline on prudent loan workouts is perhaps the most important factor in the delay of loan modifications. The Guidance on Prudent Commercial Real Estate Loan Workouts issued in October 2009 by the Office of Thrift Supervision (OTS) (currently the Office of the Comptroller of the Currency) was meant to allow lenders to avoid an adverse federal classification of nonperforming debt by claiming they were engaged in loan workouts with the borrowers. Some consider the requirements imposed by OTS to qualify a loan for exemption were minimal, and therefore led to what can be called “extend and pretend.” The practice also is seen as a cause for the massive backlog of nonperforming loans that have been withheld from the market. Loans that should have been removed from lenders’ books have been allowed to remain and fester. This backlog now is swelling much faster than institutional lenders could dispose of it, even if they were to effectively modify or foreclose and market these properties under their historical loss- mitigation strategies.

Given the volume of impending maturities, the floodgates eventually will be forced open. At this point, investment opportunities will open up to more investors, and banks will start to clear inventory. This in turn will bring the remainder of legacy problems to the market to be resolved.

• • •

Real estate cycles are relatively slow moving, and because of loan issues and the sluggish rate of economic recovery, it is likely that the industry will be faced with problems for a few years to come. Until the cycle turns in the industry’s favor, commercial mortgage brokers must be aware of the dynamics that control the market to better advise investor clients who have been waiting for distressed-market bargains. 


 


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