Insights and observations from the IMN 3rd Annual Distressed Real Estate Symposium May 5-6, 2004 New York, NY
I recently had the pleasure of attending the Distressed Real Estate Symposium produced by the Information Management Network. This is an annual event held in New York for the purposes of discussing the various insights of opportunistic fund managers, Wall Street firms and other private investors in distressed real estate and debt. I found this year’s event especially informative as it was my second visit to the conference and as such it allowed me the opportunity of framing this year’s tone of discussion against the prior year’s. Representatives of many of the largest and most active distressed debt funds such as Blackacre Capital, Morgan Stanley Real Estate, Goldman Sachs and Colony Capital were among the panelists facilitating discussions centered on the current opportunities and issues in the real estate debt market.
As we are now keenly aware we have entered what is potentially the leading edge of a sharply rising interest rate environment with the ever increasing specter of inflationary pressures. Recent forecasts by economists as to the level and speed of Federal Reserve Board interest rate increases are ratcheting up significantly. With nearly $40 billion in CMBS debt maturing over the next 12 months and nearly $20 billion of that amount maturing before year end one can begin to imagine the implications for the lower tier real estate assets within this group that have to date managed to perform largely thanks to historically low costs of carry. Most of the panelists seemed to agree that an increase of only 100bps to 150bps over the near term combined with the underlying weakness of many real estate classes will propel us once again into a significant cycle of distress.
So where is the distress?
Several asset classes are seen as likely suspects in the coming cycle. Amongst the retail sector, older 1970’s and 80’s constructed open air malls in many markets are viewed as a dying breed. In a common scenario, the center has lost a now out of business big box ?anchor? which in turn has precipitated the exodus of many in line tenants and possibly other large anchors that had ?trigger? clauses. The competition exerted by new regional super malls, power centers, and build to suit big box retail centers may be rendering these older facilities unviable. The general consensus is that such properties will have to be ?de-malled? and redeveloped as alternate uses such as residential, mixed use and possibly industrial/office depending on the specific market demographics.
Similarly, twenty to thirty year old, exterior corridor, limited service hotel/motel properties are viewed as presenting significant challenges. As many national brands are moving away from the exterior corridor properties, requiring significant and costly property improvement plans and in some case simply refusing to renew franchise agreements on such properties this class will continue to struggle. Further exacerbating the problem is the severe over building that has occurred in many markets such as North Carolina, South Carolina, Florida and Texas to name a few. As one speaker remarked, ?There’s a reason we use a 30 year depreciation schedule?. A few of the individual properties that are well operated and extremely efficient may indeed survive leaving the rest to either be razed completely or to be redeveloped as extended stay and efficiency units.
Although many primary office markets have begun to show positive absorption trends, there appears to have been a steady migration over the last several years of ?B? and ?C? property users to ?A? quality space. Taking advantage themselves of recent distress in this sector, tenants have been able to upgrade their space while maintaining or even decreasing their rental rates. This has increased the pressure on the less desirable properties which have in turn had to continue to cut rents in order to attract new tenants. In addition, many markets still contain significant and possibly under reported shadow leased and sub leased space as well as reported vacancy levels averaging mid double digits.
Other suspects include smaller assisted living facilities where ?mom and pop? operators face difficulties reaching efficiency levels capable of producing adequate cash flows as well as ?B? and ?C ?multifamily properties that have experienced the same flight of tenants to better quality properties in addition to a loss of renter base due to the increased affordability of home ownership given the favorable interest rate environment of the past few years.
Important metrics aside from specific asset class issues include the historically high number of bankruptcy filings (both corporate and personal), historically large high yield debt market, the more than doubling year over year of downgrades in commercial debt obligation tranches, and steadily creeping commercial loan delinquency rates.
What’s different now?
During the conference held in 2003, panelist after panelist detailed structured transactions in which an asset which was believed to be an opportunistic investment was acquired at cap rates frequently in the 5% to 6% range on existing or even projected income with the reasoning that actual spreads where higher than in the past due to historically low cost of capital. It was also often assumed that the 15% to 25% vacancy levels would allow for future up side potential. In addition, most of these transactions included mezzanine debt and/or equity participation’s resulting in highly leveraged transactions in which the original sponsor had little true equity. This year?s panelists were more often heard not only to lament investors who took this approach but claimed to not know who these investors were.
The moderator of the final panel session perhaps summed up the current situation best when he posed the question ?are these the distressed assets of the next wave??
Karl P. Coleman is President of Interwest Capital Corporation and can be reached at 858-622-4900 or through the corporate web site at www.interwestcapital.com