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

The Potential Impact arising from Perception of Value Disparities in Under performing Commercial Real Estate Secured Loans and Properties.

The following article discusses the position that the retention of ?performing-npl?s? (defined as distressed loans that are simply making timely payments of scheduled P&I) coupled with the hesitance of creditors to sell their assets at prevailing market prices has the potential to drastically diminish the ability of the borrower as well as the current lender from achieving a successful resolution or repositioning of the subject in a rising interest rate environment.
Q: How long does it take for a troubled borrower to screw in a light bulb?
A: It depends on how long the lender wants to be left in the dark.

By now even the most casual reader of banking industry publications and business journals will have perused many an article detailing the results of the current administration?s monetary policy which has led to a 45 year low in interest rates as well as relatively low delinquency levels among commercial real estate secured loans. In addition, it is not surprising to find that the last few years have also been witness to rapidly growing profits in the banking sector. On the surface this information seems to belie nothing but good news for institutions that originate, invest in and hold commercial real estate backed loans and securities. However, this unique convergence of circumstances presents not only exceptional opportunities for lenders but also easily over-looked hazards and potential pitfalls.

While year end 2003 reports showed over all delinquency rates for commercial mortgage backed securities (CMBS) hovering around 1.5%, that number had been steadily increasing over the entire second half of the year and had reached a record dollar amount in excess of $5B as early as the third quarter. It is important to note that while the percentage of delinquent loans appears low as an absolute number, that number has not only been growing compared to historical averages but also relative to the total outstanding balance of commercial mortgage backed securities in the marketplace. Similar reports have shown that current paying (?performing?) loans which none the less have been sent to special servicing are passing the $10B mark (1 ). A recent report by Wachovia Securities detailed in a February 2004 issue of Commercial Mortgage Insight further illustrated interesting commercial mortgage loan nuances related to the disproportionately high default risk of loans in their third to fifth year from origination. This has potentially strong implications for loans originated at the peak of the real estate market in 2000 and early 2001. According to this research, loans originated in 2000 are already defaulting at a rate exceeding two and half times the typical CMBS historical default rates (2 ).

What all this data fails to capture is the emergence of a somewhat new and certainly dangerous inhabitant of the commercial mortgage portfolio. This is what we have begun to refer to as the ?performing-npl?. In a typical case, the lender in question is saddled with a loan, likely originated sometime between late 1999 and early 2001 in which the borrower bought at the peak of the market (perhaps on the up leg of a then profitable exchange) or built speculatively into the dot-com and telecom boom. Today that unfortunate borrower is likely overwhelmed by a property that is anywhere from 40% vacant and just meeting debt service to more drastic scenarios where buildings are nearly empty and the borrower has been drawing on alternate resources to meet debt service obligations. In most circumstances the borrower and the lender are both playing into the same gambit ? namely that with real debt service almost unimaginably low given the proliferation of floating rate, LIBOR based loans (sub-4% fully indexed I/O rates on limited service hotels!), both parties are willing to precariously cling to the status quo in hopes that they will both safely rise with an improving economic tide. On one side of the equation is a borrower that is not yet willing to abandon real dollars injected into the project at acquisition and since, while the lender on the other side is not ready to mark the asset to market.

This situation has many disturbing ramifications. The longer that a borrower is required to subsidize the property?s impaired cash flow to continue making debt service payments, fewer and fewer dollars are available for routine maintenance, tenant improvements, leasing commissions and marketing efforts. A protracted period of such a nature increasingly erodes the asset?s ability to compete in its market for both current and future tenants. In many circumstances borrowers begin dropping lease rates, shortening lease terms, and offering concessions in order to simply ?get warm bodies in the door? and a few more (yet insufficient) dollars on the table. The situation may be further compounded with the tenant side of the equation where there are in most markets significant amounts of existing subleased space as well as ?shadow-leased? space waiting in the wings. The negative implications again are quickly seen in that even if the subject property?s occupancy level stabilizes, the net cash flow at the prevailing lease rates is likely to have deteriorated drastically from underwritten cash flows at origination leaving the lender with an asset that would not have passed the original underwriting review, but now is highly unlikely to pass review for a viable refinance. As real interest rates begin rising, debt coverage ratios will drop even further leading to an even more rapid decline in property fundamentals. Just as it is certain that there will be assets that will turn the corner and ?rise with the tide?, it is just as certain that many of these assets will fall even further behind due to the decrease in competitive position described above.

In the view of Mr. Dennis Frank, Chairman of Silvergate Bank, ?What we have witnessed over the last several years is that the borrower?s cost to carry has dropped more rapidly than the revenue from the properties in question. There are extremely few submarkets in the country for any commercial property type where you can point to rents and occupancies that are higher today than they were last year or even the year before. Today it would seem that many investors are making what amounts to equity risks for fixed income returns.? Mr. Frank offers a unique perspective on the current real estate cycle having been Managing Director of Houston?s Coastal Banc in 1988 where he completed the first successful bailout of insolvent institutions under what came to be known as The Southwest Plan. ?We saw assets at that time that could have been recovered at eighty cents on the dollar if people had acted swiftly, instead we saw situations draw out for such a protracted period that actual recovery in most cases came closer to twenty or thirty cents on the dollar.?

There is however, positive news for lenders. The same economic environment that has given rise to the performing-npl has brought with it a more sophisticated, better capitalized and extremely efficient secondary market of principal investors for these types of assets. In the past, due largely to the mentality bred from the ?fire sale? tactics employed by the RTC, lenders had few options other than the first-mover opportunists with little real financial capacity or cumbersome loan sale advisors that were typically slow moving and costly with no guarantee of execution. With the advent of more sophisticated trading platforms and a multi-billion dollar contingent of distressed debt funds and private investors, lenders have a much higher likelihood of achieving a satisfactory and timely resolution of a troubled loan or property while avoiding further declines in asset value. This window of opportunity however is likely to be fairly brief. This pool of potential buyers is not only in control of a large pool of un-deployed capital but is also enjoying the same benefits of historically low cost of funds. There will however, be a sharp and rapid divergence between the ?bid? and the ?ask? as those investors experience increased costs and distressed assets fail to keep pace with an otherwise improving market. The general consensus of economists recently seems to be in favor of real GDP growth rates for 2004 will range between 4.5% to 5.0% range with Fed tightening beginning to set in mid to late summer. Year end 2004 Fed Fund?s rate projections are widely nearing 1.75% – 2% with 10 year treasuries breaking to 5% (3) . Any significant near term momentum gain in the job market could revise these estimates swiftly upwards. All of these factors when considered together may signal an advantageous environment over the near term for lenders who take advantage of the existence of secondary market players to improve their portfolio while maximizing value and limiting future down side risk.

(1) Real Point Research September 2003 Frank Innaurato
(2) Commercial Mortgage Insight February 2004 Davis J. Cable of Wachovia Securities
(3) UBS 2004 Market Outlook: Who’s Afraid of the Big Bad Fed?