Distressed Asset Update

Two years ago, almost everyone was discussing, and looking forward to, a tsunami of distressed assets which would be coming to market based upon the sub-prime mortgage crisis and the stresses it would exert on the credit markets in general. In September of 2008, when Lehman failed and Wall Street as we knew it was structurally transformed from an investment banking platform to one of bank holding companies, the “almost everyone” mentioned above was changed to “everyone”. But the tsunami has not arrived, not even close.

The fact that only a few distressed assets have been put in play is not because they aren’t out there. The pipeline is chock full of them.

Let’s use the New York City marketplace as an example. In the 2005-2007 period, there were $109 billion of investment sales in New York City. Based upon reductions in revenue (rent levels) across all product types including residential, office, retail and industrial and cap rate expansion, values have declined by 32%, on average, year to date. If we eliminate multifamily properties from this analysis, values have fallen from peak levels approximately 48%. Based upon these reductions, we estimate that, of the $109 billion spent on investment properties, $80 billion of that was spent on properties which now are in a negative equity position. This relates to about 6,000 properties.

If we include properties which were refinanced during the 2005-2007 period, the number of properties having negative equity jumps to 15,000. We estimate that there is about $165 billion in debt on these properties and, based upon today’s underwriting standards, there should only be about $65 billion in debt on them. This means that in order to have a conservatively leveraged marketplace, we would need to extract $100 billion in debt.

Clearly, this will not happen. Many investors have the ability to feed their properties and, based upon a desire to own them on a long-term basis, will do so. Other transactions will be worked out utilizing any of our favorite terms which have become commonplace in today’s vernacular including, “extend and pretend”, “delay and pray”, “a rolling loan gathers no loss” or “kicking the can down the road”. We do believe, however, that $30 to $40 billion will ultimately be extracted from the market in the form of losses.

So where are those distressed assets now? Some have not come to the market because they aren’t even in default yet due to mortgages which are still in interest only periods or are operating on an interest reserve set up by the lender when the loan was originated. Others have loans floating over 30-day LIBOR which closed on friday at 23 basis points (3-month LIBOR is only at 26 basis points). At 150 over LIBOR, the rate being paid on those loans would only be 1.73% and they can cash flow at those levels of debt service. While some properties are fundamentally under water, they are not yet in default, but likely will be when these advantageous terms expire.

Other distressed assets haven’t come to market because everything that has happened legislatively has allowed lenders to hide bad assets on their balance sheets. The FASB mark-to-market accounting rules have been modified to allow loss avoidance. Similarly, bank regulators will now allow lenders to hold a loan on their balance sheet at 100 even if they know that the underlying collateral for that loan is only worth 60. Additionally, modifications to the REMIC regulations have made it easier for CMBS loans to be kicked down the street.

Any of these delaying tactics will only be beneficial if appreciation is anticipated in the short-run. Given the massive deleveraging the market must experience and unemployment rates which are anticipated to remain elevated for at least another year to 18 months, we do not see support for the short-run appreciation argument.

We really don’t understand the reluctance of lenders to deal with these problem properties. Many of those that are in default are currently in the foreclosure process. This is a frustrating process, especially in New York, as it can take years to get through the process and obtain the title to the collateral. Many borrowers further complicate things by going into bankruptcy, which, based upon backlogs in the bankruptcy courts, adds additional time to the process.

It is very difficult to say this without sounding completely self-serving ( After all, I do sell buildings and notes for a living) but, if a lender wants out of a bad deal, selling a note today is likely to lead to a better recovery than waiting a year or two.

We believe this because the lack of product on the market toady has created a dynamic in which many investors are fighting over relatively few opportunities. Because of this, particularly on our income producing properties for sale, we are generally receiving 25 to 35 offers for each. Furthermore, on each note we have sold this year, we have received over 50 offers. This is due to the fact that buyers today would rather purchase from a lender than a private seller, believing they will get a better deal. “Believing” is the key word in the last sentence.

Due to the excessive demand for distressed assets, buyers are currently paying aggressive prices for anything banks are selling.  In many cases this year, we have obtained prices for notes that, we believe, are at or very near the value of the underlying collateral.

Some lenders are taking advantage of these dynamics to rid their balance sheets of underwater loans and are using the proceeds to make good loans today. Consider that two years ago, bank spreads, based upon all of the competition to put money out, were as low as 30 or 40 basis points. Those spreads can be 300-400 over corresponding treasuries today. Additionally, today’s loans have less risk associated with them as, rather than a loan to value ratio of 75%-85%, LTVs today are generally in the 60%-65% range. These loans are also significantly less on a price per square foot basis than they were two years ago.

If your business was 10 times as profitable as it used to be and there was much less risk involved, wouldn’t you be trying to do as much business as you could?

“Out with the bad, in with the good”, should be the mantra of lenders today. Until now, this has been slow to develop. To illustrate this, consider the following very telling statistics: Massey Knakal is asked by potential sellers to provide opinion of value reports and provide an explanation of our marketing program and we exclusively list about 31% of the properties that we are asked to analyze. It is just like a batting average in baseball, if we are hitting .300, we feel pretty good. With lenders and special servicers we are working with, we have completed just over 1,000 valuations and have exclusively listed just 12 properties/notes. That is a batting average of just .012. Many of these opportunities have simply not come to the market in any form. Perhaps the lender/servicer is waiting to see what the future will bring; perhaps they are simply making deals with the borrowers.

We have, however, seen this freeze thawing slightly as 2009 comes to a close. We expect to be coming to market with several distressed notes from lenders and special servicers right after the holidays and remain optimistic that we will be able to continue to achieve pricing at levels where the recovery versus collateral value is significant. There are also some foreclosures which should be concluding shortly which will lead to some REO which should be placed on the market shortly thereafter.

Let’s hope that 2010 sees a significant rise in these opportunities coming to market. It appears that the year will, at least, start out that way.

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,000 properties in his career.

20 Responses to “Distressed Asset Update”

  1. 1 Mr. Bippy December 6, 2009 at 11:22 am

    One Day Sale Only…Buy One Get One Free….Act Now…..Supplies Are Limited…Distressed Assets….

    See what I’m getting at? I think you’ve nailed it on the head. The perception of purchasing a distressed asset in today’s market is perceived as a bargain by commercial investors. Investors are lining up like it’s Black Friday outside a Walmart to get these assets. When they come home with that new flat screen they just got they will probably realize they paid fair market for it. The only thing they may have got was the publicity from the local news looking for someone to get trampled.

    There are two other reasons why I think we have not been seeing a tremendous amount of distressed assets flooding the market.

    1. Banks don’t want to go out and publicize to the entire world that they have bad loans on their books. It’s just not good for business. They would rather handle things quietly and sneak under the radar. This makes them more likely to do a workout with the current borrower if possible.

    2. They are using this climate as relationship opportunity with their best customers. Keeping in line with keeping things quiet to the general public, lenders are brokering the opportunities to extremely solvent customers they are working with already. This is a win win win. Win because a bank will get to re-write down the loan and get those great spreads you mentioned. Win because it is kept quiet. And Win, because they may have strengthened a relationship that will lead to further business down the road.

  2. 2 rknakal December 6, 2009 at 2:39 pm

    Mr. Bippy, Thanks for your post. You make some good points here. I would, however, argue that your point # 2 stating that it is a win, win, win for the bank to make a quiet deal with an existing customer of the bank is nothing but a win for everyone. What about the shareholders of the banks? If you owned stock in a bank, would you want the bank to sell an asset for less than what it is worth? You could argue that the negative publicity of putting something on the open hurts shareholder value, but I do not think so. Does anyone really believe that ANY lender is immune from trobuled loans today? If any claim to, it is not believable. I believe shareholders would prefer that the lender maximize its recovery rather than making an inside deal with a favored customer.

    Something that has interested me in this cycle is the amount of due diligence that equity research analysts who cover banks have been doing. I have made presentations on the marketplace to many groups of analysts and the detail of the questions they ask has been surprising. How is XYZ Bank dealing with their distressed assets? Are they openly marketing positions to maximize recovery? Are they just doing a workout with the borrower? Are they making inside deals? In every meeting with these folks, these same questions get asked over and over. It could be that how lenders are dealing with their problem loans may affect a research analysts’ buy, sell or hold recommendation.

  3. 3 Elliot Horowitz December 6, 2009 at 6:09 pm

    Bob, you hit it right on the head again.
    As long as the govt allows banks to basically manipulate the value of their collateral and hence their loans, we are in for another slow year unfortunately.
    I have some trades I wish I could mark-to-fantasy like the banks are allowed to do.

  4. 4 Carl Todd December 6, 2009 at 7:57 pm

    Having worked with a bank in my past career and saw the beating they took on foreclosed commercial buildings I think over the time they have learned that running a building is no piece of cake and requires an expertise that is not inherent in banking and if the mortgagor has a track record of being a successful manager they are better of working with him than foreclosing and immediately lowering their asset values and still have hopes of stabilizing any future decline of the property. Even if the decline continues they feel the work-out and write down value will be higher than the current foreclose sales price and unless they either have an immediate cash need they are not foreclosing and prefer to play out the situation longer and see what the future brings

    All that plus practically no new construction in the pipeline leaves a prittey bear sales cupboard.

  5. 5 rknakal December 6, 2009 at 10:43 pm

    Hi Elliot, thanks for the post. I wish I could do the same. It’s nice to be able to call them how you want to, not how you see them nor how they really are.

  6. 6 rknakal December 6, 2009 at 10:47 pm

    Hi Carl, thanks for your post. Every lender looks at things differently. Something I did not mention in the article was that often, the borrower who is in default will let the asset deteriorate over time which will result in a wasting of asset value.

  7. 7 sjkurtz December 7, 2009 at 12:40 pm

    Carl makes an excellent point. During the last downturn in the late 80’s and early 90’s the banks learned some harsh lessons. Cram-downs were widespread and any commercial real estate that had little value was passed back to the banks or ultimately to the Resolution Trust Company (RTC).

    This was a time when banks were driven out of business, and some property owners and developers as well. But this was also a time when fortunes were made and/or the groundwork for future fortunes were made.

    This time is definitely different. The FDIC is supporting the bank’s stand that they should not foreclose on property that will simply diminish in value the minute they take ownership. The banks have decided that the best strategy is to try to do as many commercial loan modifications and forbearances as they can for as long as the government will let them.

    This will give them the time that they hope will provide them with a reconstituted commercial real estate market.

  8. 8 Andrew December 7, 2009 at 2:36 pm

    Thanks once again for your insight.

    The thing that is constantly amazing is the governments inability to see past one degree of separation. In other words, they hit a problem with massive amounts of cash at the most superficial level. For example, when the financial markets melted down (more appropriately, froze-up), the governments response was to through massive amounts of cash, the Fed now has over $2 Trillion on its books, at the problem to back up bank balance sheets. Interestingly enough, the far less cash out of pocket, though no doubt potentially equally or more dangerous, was the simple and up front far less costly guarantee of commercial paper (GE to the tune of $300BN) and of new bonds issued by finacial institions. In other words, without taking on a penny of debt, the government rescued the non-depository financial system. On the depository side, the government also gave a full guarantee to money market funds. While Lehman Bros. debt to take it’s toll here, the final chapter is yet to be written. so why is all of this non-cash rescue important? Because the government could have done the same thing by simply guaranteeing all interest payments on deposits and debt that was investment grade at the time it was issued or at the time the holder purchased it on the secondary market. Certainly there would have been losses. But to use an example, if the government were to gurantee interest payments on real estate bank debt coming due in the next several years, I think the current total is somewhere around $1.5 Trillion, at say an average interest rate of 6%, if ALL the debt stopped paying, the government exposure would amount to $90 Billion annually. Certainly all the debt would not default in debt payment, and certainly not all of it would fall to zero value. So now compare the cost of restoring the commercial paper market versus the cost of saving the banks from the first wave of the real estate crisis (RMBS sub-prime defaults)?

    One comment in defence of the FASB change in treatment of mark to market, and I am a strong proponent of the free market: In the cass of a systemic risk, and there was one to be sure, the disconnect between the bond price and the value of, not the underlying mortgages, but the underlying real estate, did not drop to 25 cents on the dollar. Hats off to Lonestar who bough Merrill Lynch’s $25BN+/- portfolio for about 20 cents on the dollar with Merrill financing about 80% of the purchase price! But what do you think those bonds are worth today? The folks at Lonestar will be drinling champagne for the rest of their lives on the trade alone. Do I know for a fact the bonds rebounded? No, but I’d bet on it. Several months back you spoke with Jeff Deboer and Shecky Scheckner at a REBNY function. One of the slides shown showed how CMBS investment grade pricing had bounced back from a low of about 70 cents on the dollar back to above 90 cents on the dollar based upon the as yet un-finished TARP legislation. Apply the same logic to RMBS and you can see where the governments knee jerk response was amatuerish at ill conceived. Apply the guarantee of interest logic to credit default swaps (CDS) on investment grade and sub-prime RMBS at AIG would not be the beneficiary of almost $200 Billion of tax payer money!

    So why all this long diatribe? The answer is that, sometimes changing regulations during a crisis is the right thing to do. The government has been doing this already. But they are missing one more step. Extend and pretend will save the banks some money, but they will still take huge losses at taxpayer expense. There are two problems with bank and REMIC foreclosure regualtions: The first you correctly point out is their lack of expertise, and staffing, in asset management and maximizing value. The second is that both are forced to sell the assets within a relatively short stipulated time frame. In other words, they a forced to sell into the same down market and realize permanent losses. The missing regulatory change is that banks and special servicers should not be forced to make open market sales of foreclosed properties. Let them higher asset managers who want to “buy” the contracts by agreeing to invest in the cost of maintaining the portfolio. Perhaps creating REITs of foreclosed assets and holding them as investment assets on the banks balance sheet. The point is that sold assets are permanent losses at the expense of tax payers. Held assets will, over the long term appreciate in value. We are at the bottom of a cycle. It will take time but asset value will recover. Perhaps not to some of the highest prices and there will be losses, but not as bad. And the profits that will be made, will be used to pay back governement loans, reduce the debt and re-pay tax payers.

    No doubt the foregoing has flaws, not the least of which is playing with the free market. Investors who sat out the insantity and were waiting for the game of musical chairs to stop have been robbed of their just reward to buy low. But, extending real estate debt in perpetuity means that we still have a highl leveraged real estate market place. And no matter how you slice it, high debt to equity is a precarious place to be that can only go in one direction. To use a real estate metaphor, a building built on an unsound foundation, will fall and kill people.

    A closing note to my fellow free marketers: As a taxpayer, if the government guarantees it then the government has an obligation to regulate it. Would you lend money to someone and not watch what they were doing?

    One final unrelated comment: The institutions that are the recipients of the hundreds of billios of taxpayer money have, by virtue of the losses necessitating a gevernment bailout, have taken massive losses. These tax loss carry forwards will mean that they will not be paying taxes for sometime to come. But we will.

    As Niall Furgeson wrote in a recent issue of newsweek, the debacle we are in now is nothing compared to what is ahead. The government has floated $2 Trillion of short term debt at historically low interest rates at little expense to taxpayers. Go out a few years when interest rates normalize and the goverment has to refinance this debt with long term debt. $2 trillion at an average cost of 1% per annum (probably less, is about $20 billion a year. $2 trillion at, say 5%, is $100 billion a year. If we get significant inflation, the ‘natural’ successor to massive increase in government debt/money supply, then we should shudder to think what annual interest expense could become. And, will the Chinese be their to buy ever increasing pile of debt?

  9. 9 dayat December 7, 2009 at 9:51 pm

    Bob, Great post. I find the information very useful and your insight is right on the money….thanks!

  10. 10 asunderam December 8, 2009 at 11:15 am

    All very good points. I think that the lack of distressed product, particularly on the commercial side out of the community banks simply has to do with self-preservation. I do not think that many of these banks would be solvent if they unloaded their assets – the write-downs would be too great. The only way that I see the issue being forced is either the bank has a liquidity crisis or their respective regulator forces the issue. It is also clear that the FDIC (and other regulatory agencies) are being slow in pushing the issue – they do not have either the funds (FDIC insurance) or manpower to aggressively deal with the issues. I also suspect that the political climate is not there for government agencies to “come down on” small community banks when the “too big to fail” banks have been bailed out so significantly.

  11. 11 MB December 8, 2009 at 4:06 pm

    Great post. It’s surprising(and not surprising all at the same time) to hear that buyers are purchasing notes at close to the value of the underlying collateral. Is this a function of investment funds flocking towards the next “good story”?

    I remember when rent stabilized properties were being priced at ridiculous prices per square foot with the claim that there was “tons of upside” in the rents. Buyers would pay these prices despite the fact that the upside was already baked into the deal price.

    It amazes me that despite all that we’ve been through, there are buyers out there who still buy the story over the fundamentals.

  12. 12 Carl Todd December 9, 2009 at 10:03 am

    In my former bank arrangement periodically (every yearor two no longer) I had to make a field inspection of the commercial properties that I appraised for the bank’s mortgage. If there was a condition of neglect I reported that to the mortgage officer and he enforced the correction of the condition. He had that enforcement right because the mortgages had a clause requiring that the property be maintained in good physical condition. I don’t recall any owner refusing to correct the deferred maintenance to satisfactory standards.

    Funny when there is a continued interest in a loan how bankers were concerned with their security therein. The original loan maker should never be free of his due diligence obligation on the loan until its paid off or the buyer of the loan gives the originator a performance bond that covers the bank’s due diligence obligation if the loan purchaser defaults on their responsibility to see the property is maintained in good condition to end of the mortgage period and paid off.

  13. 13 Steve M December 9, 2009 at 10:35 am

    The following was cut and pasted from an article forwarded to me from a friend and I thought it gave a good viewpoint on why banks are extending and pretending and aren’t recognizing and dealing with their problems now.

    The article:

    Prices paid during the most recent bout of speculation in commercial real estate left our industry with many loans worth significantly less than the amount owed. Any experienced investor will tell you that in this situation success lies in letting your winners ride, and most importantly, cutting your losses. Yet up to this point the prevailing attitudes and resulting actions within our industry have been the opposite. Why is this? And what are the implications for our industry and the country?

    The phenomenon of selling “in the money” investments too early and holding losing investments too long is not unique to our industry. As a result it has been studied extensively. Due to the $770 billion of underwater commercial real estate loans estimated by Foresight Analytics I am going to focus solely on the tendency to hold losing investment positions longer than is rational.

    Nobel Laureate and Princeton professor Daniel Kahneman along with former Stanford professor Amos Tversky documented a strong aversion to realizing financial losses. In multiple experiments, subjects were given two choices: Choice A would result in a certain but smaller financial loss. Choice B would result in either no loss or a materially larger loss than choice A. Subjects consistently chose B, the riskier option.

    The impact of this aversion on investor behavior was documented in a 1985 paper by Santa Clara University Department of Finance professors Hersh Shefrin and Meir Statman. Their paper showed that the aversion to realizing losses resulted in investors consistently holding their losing positions longer than a rational person would.

    What both papers suggest is investors are painfully aware that as soon as they take the loss there is no way to continue to deny that they made a mistake. Rather, they are left only with proof of their mistake and regret.

    This tendency to choose the riskier option is exacerbated when the results of realizing losses are so dire for the decision maker, like losing a job, that he will take any gamble no matter how bad the odds. This is understandable but not justifiable. While the result of the gamble is no worse for the person already likely to lose their job, for the rest of us, the taxpayers, it exposes us to the likelihood of far greater losses. How long do we have to wait for the “gambler”?

    The fallacy of waiting

    Armed with the awareness of our strong aversion to realizing losses and an irrational tendency to hold losing positions too long, we can now objectively review the following: “Extend and pretend” and government liquidity programs that target commercial real estate.

    “Extend and pretend” is based on the belief that if we just wait long enough property fundamentals will improve, restoring loan values. This is circular logic. If banks aren’t lending because of the “extend and pretend” loans for which they need to hoard cash, then waiting to sell those loans will only ensure continued lending inactivity. This continued lending inactivity will perpetuate our weak economy and result in further deterioration of property fundamentals.

    Additionally, the assumptions used to underwrite “extend and pretend” loans were so aggressive that even an improving economy wouldn’t put these loans “in the money.” Double-digit rent growth does not last over a 10-year period, and prices don’t go up forever. Hence, over time values won’t return to where they were underwritten because they weren’t really based on sustainable fundamentals, but rather on assumptions necessary to justify the speculation that was occurring.

    In the meantime, credit remains anemic, the economy weakens further and property fundamentals deteriorate further. This all results in a greater divergence between the underwriting assumptions of yesterday and today’s reality leading to greater losses every day we “delay and pray”.

    The real driver behind competent lenders engaging in circular logic and overlooking the growing divergence between their underwriting assumptions and today’s values is simply the following: They now know they made loans based on values that were unsustainable.

    According Real Estate Research Corp., even without the current deterioration in net operating income (NOI) levels, the underwritten values of the properties purchased during the peak of the last mania were approximately 30% to 35% greater than the underwritten values prior to the mania.

    And they know the resulting losses are large: According to the Moody/REAL Commercial Price Index, the current peak to trough decline in valuations is 42.9%. Our industry might not have overbuilt this time but it sure lent too much on the properties that it did build.

    The fallacy of priming the pump

    Let me first note that in my work with both the staffs of the Federal Reserve and U.S. Treasury they have proven to be very sharp and have a strong desire to make the best decisions. Unfortunately, their initial information regarding the commercial real estate industry came mostly from a small, vocal group of market participants.

    Part of this “information” was the idea that the current problems in commercial real estate were the result of the credit crisis, not investors having paid too much for properties the last few years. Due to the Federal Reserve and Treasury’s unavoidable reliance on market participants for information, this led them to believe the problem was liquidity. As a result they pursued the programs we have today such as TALF.

    Now armed with information regarding the run up prices paid the last few years, however, the appetite for this form of government intervention is waning. And when it becomes clear that delaying only results in the further lowering of property values government intervention will likely take a different form: Helping banks ensure they are cutting their losses.

    In the meantime, many market participants believe that if we just “prime the pump” with government-subsidized liquidity, valuations will go back up. Again the focus is on liquidity as the problem, not the prices previously paid. Priming-the-pump proponents believe that if we just generate some sales it will establish “market” pricing and we will have the comps we need for more investors to feel comfortable pricing.

    First, acquisitions made with government-subsidized debt is not “market” pricing. Second, those sales will not be considered comparables for future investors because future investors won’t have access to the same subsidized debt. Rather, the likely result of these limited sales will be to train the remaining sellers to expect the same artificially high prices that government-subsidized debt results in, further hardening the bid-ask spread.

    While both the desire to put off realizing losses and the regret involved is understandable, let us look at what the resulting “delay and pray” has led to. Who hasn’t heard of the following situation: A buyer offers a price today, the seller says “no” and then six months later, the seller tells the same buyer he will accept the price. Because values have dropped further, due to declining rental and occupancy rates, the buyer won’t pay the price originally offered. Thus continues the bid-ask spread at lower valuations further increasing our future losses.

    This is what “delay and pray” and “extend and pretend” have led to. And we haven’t even taken into account what happens when today’s abnormally low interest rates normalize. The 20-year median rate of the 30-day London Interbank Offered Rate (LIBOR) is 4.94%. Today 30-day LIBOR is .24%. Today’s thinking and decisions are exposing banks and the taxpayer (the likely source of future bank bailouts), to this inevitable rise in interest rates. The resulting increase in foreclosures will again lead to greater losses for the taxpayer.

    Anything that increases the ability of banks and sellers to delay their losses— whether it be relaxing mark-to-market, reclassifying underwater loans as performing etc. — will only increase eventual losses. The increased losses may be in the form of further declining real estate valuations, or as in the case of Japan, the lost economic activity of an entire nation over a decade. Beware advice coming from those bearing underwater loans

  14. 14 Barry Smith December 9, 2009 at 11:25 pm

    As a loan sale advisor(LoanSaleCorp.com)we are dealing with community and regional banks on a daily basis.
    We see the entire gamut of what is going on in the market.
    Some of our customers are beginning to position themselves to sell ( or at least explore the option ).
    With this comes the harsh reality of current market value, and it is proving to be shocking to many.
    The trend is to try and hold out for an uptick in value, or simply ignore current market conditions and put the problem loans into a bucket which ignores reality and delays disposing of asset.
    The latest “guidance” by the regulators is nothing but a Band-Aid. No permanent solution.
    We need the market to clear. Mark to market is the only way to start things rolling and move into the next phase; recovery.
    Job preservation, ignoring the mistakes, and extending the pain is not going to make our recovery take place; it will simply delay the inevitable.
    Lets hope that the banks will make some profit in the short term and be able to accept the reality of current values.
    We are advising our customer that selling “today” will prove to be a much more profitable execution.

    Great article, great feedback from your audience.

    Barry Smith

  15. 15 Michael Moorin December 10, 2009 at 12:09 pm

    Excellent article and insightful comments. I have an observation that is more general in nature. It seems to me that the system is set up to create these boom and bust cycles. That is, as economic activity increases, lending policies do the exact opposite of what is required and only exacerbate the trend. In real estate, this means that as asset values go up, lending requirements go down. We know from experience that risk is going up. But lenders require less equity and compete provide the lowest interest rates. This just increases speculation, i.e. stress, and produces the kind of supercharged markets that we see time and again crash and burn. Conversely, when economic activity is down, we know from experience that asset values will eventually rise so that these loans are actually less risky. But lenders require more equity and charge higher loan rates, which puts economic activity further into decline. It should be the reverse and there should be a mechanism for ratcheting up loan requirements as the market advances. So, if an asset index was established and it grew beyond a certain percentage per year, lenders would be required to get more equity and charge higher rates. These requirements could be incremental and increase as guided by the index. This would be a constraint on speculation. When economic activity is down, lenders could then extend better terms, lower equity requirements and this would lead to more investment.
    This mechanism would not stop activity on the upside, but it would create a helpful restraint. People would still be able to buy, but with higher requirements. If your view of future value was strong, you would still buy. On the downside, the mechanism is a positive catalyst.

    Imagine you are in a jet and there was no known speed limit for the jet but you did know that certain signs indicated problems. Those signs included stress pressure in the form of vibrations and shudders. Upon sensing these stress signals, would you as a pilot increase the accelerator? It’s the same in the lending market. No one knows the limits of the economy but we do know the signs of stress. Loosening lending standards in a market with rapidly increasing price levels is analogous to pushing the accelerator in a jet just as the vibrations are blurring your vision.

    I am putting on my flak jacket, awaiting the onslaught of “socialist condemnation!”

  16. 16 David Barrand December 11, 2009 at 10:06 am

    This is all great reading and a lot more insightful than what is typically gleaned from other sources.

    My first comment regarding the banks holding these assets considers basic supply and demand. Putting distressed assets on the market would do nothing but drive asset values down further, exacerbating an already troubled market.

    My second comment, however, wonders on how the additional exposure is caclulated (you noted “We estimate that there is about $165 billion in debt on these properties and, based upon today’s underwriting standards, there should only be about $65 billion in debt on them”). If banks lent at 75% LTV, the $165 billion in debt would reflect total asset value of $220 billion. A 48% drop in values would reflect current asset valuation of $114 billion. Of course, all equity is gone, but the banks exposure (before cost of sale of foreclosure is considered) is $51 billion, not $100 billion. This does alter the fact that, at the new 70% LTV requirements (not unreasonable since a further drop of 30% in the CRE market is not likely and would portend far greater troubles) leveraged debt should be about $80 billion.

    Third, part of the decline in value is based on cap rate expansion. Cap rates are based on a) the ability to repay debt and b) return on equity. The change in cap rates is all attributable to (b), as interest rates are actually lower for commercial properties than they were two years ago (so it seems to this appraiser). Therefore, all the decline is based on increased demands for equity return. Now, if the debt repayment portion of the cap rate is lower, then less cash flow is required to meet the mortgage, and the asset, while underwater, still performs. If the cash flow drops further, it may still be sufficient to meet the banks cost of capital, meaning that the bank is still wise to hold the debt, rather than force a sale which will, as previously noted, tend to depreciate the asset even further (supply v demand). Add in the cost (and time) of foreclosure, and the prudent investor may hold an asset that does not meet the cost of capital but that, with a forced sale, will generate the realized negative value that so many other responders noted, and I can see why a portfolio manager, waiting optimistically for the recovery on the horizon, may put off the sale of a well-maintained asset indefinitely.

    Of course, selling the note short solves three problems. The headache is off the banks books; the borrower may now have a lender with whom to negotiate; and the note purchaser (hopefully) generates an adequate return. If this scenario at all mirrors reality, we breathe a sigh an move forward into recovery. If not, buy gold!

  17. 17 JM December 11, 2009 at 2:58 pm

    “Kick the can down the road” (Let our children deal with it)

    “I don’t need to out-run the Jaguar; I need to out-run you”
    Exporting inflation will keep the dollar from falling.

  18. 18 rknakal December 11, 2009 at 4:53 pm

    Hello All, Thanks for all of your posts. Sorry for the delay in responding but this week was a very busy one for me. We are getting some of the distressed assets, which were mentioned in the article, teed up and ready to go to market. I will respond to all posts this weekend. Thanks again for your support. Bob

  19. 19 A Catalano December 15, 2009 at 3:02 pm

    First time here, stumbled upon the blog and distressed asset article while updating some research. Well written and really encapsulates the current trends – thank you.

    A month ago, I contributed something a lot less eloquent (but with a similar message) in the New England Real Estate Journal. Journal’s audience tends to be less sophisticated on average.

    You take this message a step or two further and hit all the right points.

    Regarding the “speed of the jet” analogy in a follow up post: I could not agree any more. It seems as though lending practices are reverting right back to pre-9/08 standards. Lenders are really pressing firmly on the gas-peddle anticipating an 18-24-month recovery. Both macro and micro data suggests otherwise. Demand generators are broken. Bad loans produced by bad actors continue to mutiply. This market is not fighting a cold or flu, it’s battling cancer. Long term anemia with susceptablity to infection around every turn.

    The US cap-markets are among the most “engineered” in the world, led by industry veterans a lot smarter than myself. I’m confused….why is the industry ignoring these fundementals?

  20. 20 Kyle Johnson September 7, 2010 at 4:24 pm

    All of the above comments are very helpful considering the very low visibility in the distressed space over the last two years. I took the time to read all of them and appreciate the perspectives. My company has been working with two private equity groups to find product for 15 months now and it’s been very challenging with the spread gaps, banks concerns of required capital ratio’s potentially increasing, determining the valuation of assets, which is absolutely a moving target, and wondering what the government will do next to help them. Why sell if there is another lifeline coming down the pipe, this seems to be the mentality. They also are just trying to get their arms around the enormity of this problem, understandably!

    However, since we moved into the third quarter, we have seen much more activity and we think it will continue as we move forward. We’re seeing some of our banks come back to us ready to consider “bulk/wholesale” strategies in concert with their current retail, “one off” strategy. The tax credit expiring caused most banks retail strategy to implode! This along with mounting shadow inventory is getting them closer to trying another approach.. Many banks are also in the process of doing capital raises in preparation to do a large sale that will need heavy loan loss reserves in order to take the write down. Banks aren’t interested in new loans at the moment as much of the liquidity that’s being held is being seen as capital needed to shore up additional write downs..

    At this point, like many investors, we haven’t deployed as much capital as we wanted, but deals we have closed on, we bought at prices that protect us from the additional downward pressure in pricing that we knew was on the way and is being seen currently. You make your money on the front end! We also have pulled away from the open bidding process on large pools from banks because we fell like if we bid against 25 to 50 investors on a pool and win the bid, then more than likely we paid to much for it. This will impact our exit and success. Building a solid relationship with three or four large banks will go a long way when the mentality changes from hold and retail, to a sell in bulk/wholesale strategy.

    I think we’re in for an interesting ride over the next several years and I am an optimist about it. There is tremendous opportunity to generate wealth and get our country moving in the right direction again with a consumer lead recovery and not a government lead one.. I have a lot of faith in us as a people to get past this challenging economy.

    I look very much forward to following these discussions further with all of you and wish you all much success… I’m glad I stumbled onto this blog while trying to glean insight from others on the space!

    Kyle Johnson
    Asset Procurement Group, LLC

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