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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   May 2013

Commercial Properties Face Some Tough Medicine

As loans hit their expiration dates, maturity defaults dominate the trends shaping distressed markets this year

Commercial Properties Face Some Tough Medicine

In the past few years, concerns have  mounted over maturing commercial real estate loans, particularly as the loans made at the height of the market began to reach maturity. Borrowers have scrambled to seek loan modifications and workouts, and this trend is likely to continue for years to come.

Despite the significance of maturity defaults and their impact on the market, they are just one trend among many that shape today’s commercial distressed property market. Commercial mortgage brokers must stay on top of these trends to keep the commercial real estate market from becoming a bitter pill to swallow.

This year, there are five primary themes at play in relation to distressed properties.  These are:

  1. Maturity defaults: They will be significant with the 2003 vintage of 10-year loans maturing along with the six-year and seven-year loans from 2006 and 2007 originations. 
  2. Office properties: Office loans make up the largest share of outstanding distress, and certain markets have worked through only a small fraction of this inventory.
  3. Class-B and Class-C properties: These should be re-priced on a new basis to be competitive in today’s market. 
  4. Re-defaults on loan modifications: Loans that have been poorly restructured or modified are expected to face re-defaults, which will play a larger role in this year’s distress market. 
  5. Debt and equity capital: It is expected to become cheaper in secondary and tertiary markets.

In addition, Federal Reserve policies and interest rates will play a role in the pricing of commercial real estate loans, which also will affect distressed markets. Commercial mortgage brokers should understand the impact of each of these trends to ensure they have proper market knowledge and can advise clients who may be interested in finding a bargain property or looking for workout solutions for a maturing loan headed to default.

Maturity defaults

Maturity defaults have been, and will be, the main storyline for distress in commercial properties throughout the remainder of this year, but that’s not the only story to be told. Real Capital Analytics (RCA) estimates that 57 percent of the $387 billion of commercial properties that have become distressed in this cycle has been resolved.

Although loan defaults and transfers to special servicing of $5.8 billion in third-quarter 2012 were about half the previous quarter’s volume, the majority of these were maturity defaults. This high concentration of maturity defaults as a percentage of new distress will continue as the 10-year loans from the 2003 vintage hit maturity. These properties are not nearly as underwater as the five-year loans from 2007 originations that matured in 2012, but it is expected that many will experience a maturity default.

Jemmet Graph

Based on data from Trepp, it is estimated that nearly $8.6 billion of commercial  mortgage-backed securities (CMBS) loans with a debt-service-coverage ratio of less than 1.1 will mature in 2013.

Commercial mortgage brokers should be aware that when the clock expires on these loans, most are unlikely to refinance. The additional stress of maturity default should further reduce values, which will mean more losses for lenders, albeit smaller ones. As a result, the market has begun to experience a sort of workout fatigue.

Office properties

Some property types have been hit worse than others in terms of loans and properties in distress. The highest amount of outstanding distress yet to be worked out is in office-property loans. According to RCA, there is nearly $42 billion in distressed office loans outstanding. The office sector’s struggles seem to have no end in sight as this segment continues to experience the trend of downsized employee-space requirements and the proliferation of collaborative workspaces — all combined with anemic employment growth for the foreseeable future.

There is a disparity among different regions, however. For example, although the Northeast has worked through about 77 percent of its distressed office inventory, several large metropolitan areas, including Atlanta; Las Vegas; Orlando; Detroit; northern New Jersey; and Sacramento, Calif., have resolved less than 35 percent.

In addition, the breakdown of distressed loans by lender type indicates that CMBS lenders are by far the biggest holder of distressed loans. They also rank at the bottom of all lenders in how far along in the workout process they are, and they share the bottom position with domestic banks in how effective they are at recovering losses.

Secondary and tertiary markets

Although secondary and tertiary commercial property markets rebounded strongly in recent years, investors are likely to be selective within these markets. Secondary and tertiary markets that are well-positioned with key growth industries and population growth likely will find interested institutional and non-institutional investors. That being said, from a capitalization-rate perspective, these markets still trade at 120 basis points to 160 basis points higher than the major metro markets and will bear the brunt of this year’s distress.

Class-B and Class-C properties in these markets will be affected disproportionately because they will continue to experience the “flight to quality” of tenants upgrading their space for almost the same rent that they’ve paid for lower-tier space. Tenants also are extracting significant lease concessions from better-capitalized Class-A competitors. Ultimately, most Class-B and Class-C properties should be re-priced at a lower basis to allow for new capital and should lower rents to attract tenants back to these buildings. This re-pricing eventually will happen either through a loan restructuring with existing owners or foreclosure and new ownership.

Re-defaults on modified loans

Workout fatigue likely will continue to gain traction. There will be an increase in re-defaults of poorly structured loan modifications by banks and special servicers as many of the short-term maturity extensions from 2009, 2010 and 2011 start to expire.

In the CMBS market alone, more than $5 billion in loans were returned to the master servicers from special servicing in 2009, many of which were modified, according to Fitch Ratings. Because many of these owners have given away most of their leverage against lenders as a condition of their first modification, they likely will face additional hurdles in attracting favorable financing and face another capital increase even if they can negotiate with the lender. Unfortunately, many of these properties are expected to be lost in foreclosure.

Capital markets

The return of investors and lenders to secondary and tertiary markets has been driven in part by improvements in the cost and availability of debt and equity. Both have reduced the overall cost of capital to investors and allowed for more transaction activity and higher prices in secondary and tertiary markets.

The Mortgage Bankers Association (MBA) reported that commercial and multifamily originations this past year were 24 percent higher than 2011. In addition, mortgage borrowing and lending activity this past fourth quarter was at its highest level since 2007, according to MBA data.

Across all sources of debt — banks, CMBS, life-insurance companies and government agencies — there were  significant gains over the previous quarter and the previous year. This continued recovery for conduit lending is a critical development for secondary and tertiary markets. According to some estimates, 37 percent of all originations in tertiary markets were CMBS and 45 percent of all retail loans in tertiary markets were of the conduit variety. 

As secondary and tertiary markets stabilize and re-establish some transaction activity, institutional equity looking to increase returns that are no longer available in the major metro markets likely will increase capital allocations to these markets. This also should drive down the cost of equity to sponsors from the current exorbitant returns required of private investors and opportunity funds in these markets.

In a recent PwC real estate investor survey, respondents were asked if current market conditions favor buyers or sellers. The results indicated that some secondary markets present good buying opportunities, and many of the major metros are sellers markets.

Commercial mortgage brokers working with borrowers that own distressed properties in these markets can draw helpful conclusions from these results. Most significant, there will be capital available at more competitive prices to assist in extricating property owners from imminent default as a result of loan-maturity issues. This capital also can provide resources necessary to negotiate economic workouts with lenders.

Interest rates

This past year, the Federal Reserve announced that interest rates would be tied closely to unemployment levels. This should make for a bumpy ride on the pricing of commercial real estate mortgages. Employment data is notoriously volatile and the conduit-mortgage market specifically is sensitive to the fluctuations of the money markets. 

Volatility almost always means additional risk that investors surely will price into mortgage financing. Whether or not this additional risk results in higher rates irrespective of actual rate action by the Federal Reserve could be an important determinant in conduit financing becoming a more competitive product with other sources of commercial lending.

• • •

Commercial mortgage brokers who keep these various trends and factors in mind can anticipate what will impact their business in the distressed market and can provide the right guidance to their clients. In addition, with this knowledge, brokers will make sure they’re working in the right markets and making educated decisions for their business and on behalf of  their clients.


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