Distressed Asset Update – Here They Come

We have all been surprised by the relative lack of distressed assets in the marketplace thus far in this cycle. Two years ago, we were anticipating a significant amount of distressed assets coming to market. This was described in many ways, most notably as a potential tsunami or an avalanche of properties and notes that could be scooped up for pennies on the dollar. However, this condition has yet to occur.

The reasons for this are numerous. Essentially, everything that has happened from a regulatory perspective is allowing lenders and special servicers to not have to deal with their problem assets. Whether it is mark-to-market accounting rule changes, modifications to the REMIC guidelines or bank regulators leniency, distressed assets have not been coming to market in the numbers that we all know exist.

Bank regulators, for instance have essentially said to banks that if they have bad loans on their books at par and they know the collateral is only worth 60 percent of par, they can leave asset values as they are without incurring any write-downs.

The Fed’s highly accommodative monetary policy is allowing banks to borrow at close to zero and, if they are lending, they are making whopping spreads of 500 to 700 basis points depending upon the loan type. To the extent they don’t even lend, they can simply buy Treasuries and make nearly 400 basis points today. Just a couple of short years ago, spreads were as narrow as 30 or 40 basis points on some loans as the competition to put debt on the street was fierce.

Today’s massive spreads are allowing the banking industry to recapitalize itself, which was, after all, the Fed’s intention. Tremendous profits are being generated which can be used to write down bad loans incrementally. From the bank’s perspective, they are able to wait, make large quarterly profits, write-down bad loans and wait until the write-downs reduce book value close to market value. Once this occurs, distressed assets can be disposed of without incurring losses. For this reason the distressed asset flow has not been nearly what was anticipated.

Notwithstanding this fact, we have seen a significant increase in the amount of distressed assets that have been coming to market recently. During this cycle, Massey Knakal’s Special Assets Group has completed over 1,100 valuations for lenders and special servicers, giving them valuations for the underlying collateral of their loans. From September of 2008 through September of 2009, these efforts resulted in only12 exclusive listings. From October 1 of 2009 through the present, we have received 66 exclusive listings from banks and special servicers and we anticipate this flow of distressed assets to continue.

Although the flow has increased, it remains a drop in the, proverbial, bucket compared to what actually exists in the market. But the flow has tangibly increased which is a welcome occurrence for the brokerage community. A major reason for this is the cumbersome foreclosure process that exists in New York. Foreclosure can take two, or three, or even four years to complete in this state. Many holders of distressed notes do not want to go through that protracted process. This is particularly true given the relatively high recovery rates on note sales relative to collateral value. Therefore,  selling distressed paper has become a much more viable option.

As interest rates start to increase, as evidenced by the recent rise in the 10-year T-Bill based up on the Fed’s halting their asset buying program, these increases will put additional stress on distressed assets and could be a motivating factor for potential sellers to act quickly. If interest rates continue to rise, it will create more pressure on holders of distressed assets to sell as the opportunity cost of not doing so becomes greater and greater.

Adding to the increase flow of distressed assets is the fact that advantageous mortgage terms are beginning to expire. On an increasing basis, we have seen interest-only periods provided on 2006 and 2007 vintage loans start to evaporate. Interest reserves, which have carried many properties which have been fundamentally under water for quite a while, begin to burn off and floating rate loans originated in 2005 and 2006 are either at or nearing maturity. If these loans were floating over LIBOR, debt service rates may only be 2 or 3 percent today and, clearly, there are no lenders that will renew or extend a loan at these extraordinarily low interest rates.

We, therefore, expect the flow of distressed assets to continue to increase as we move farther into 2010 and into 2011 and, perhaps, 2012. Time will tell, but this recent trend is a very encouraging sign for those of us in the transaction business.

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty in New York City and has brokered the sale of over 1,050 properties in his career having an aggregate market value in excess of $6.2 billion.

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22 Responses to “Distressed Asset Update – Here They Come”


  1. 1 lighthouseas April 19, 2010 at 9:05 am

    Robert,

    As usual great information. The way the accounting rules are set up, loan loss reserves are more based on a process oriented analysis than a true mark-to-market valaution. We’ve been working with several financial institutions on their ALLL Analysis and noted that the current rules allow to much flexibility in avoiding a drastic write-down.

    Are you seeing most of the assets coming to market are from CMBS special servicers or from local and regional banks? From information that we gathered the special servicers should be ramping up the their offerings in the near term. LNR has a couple offering in the market as well as CWCapital.

  2. 2 tom hicks April 19, 2010 at 3:16 pm

    We are seeking to raise $50 MM for each of our two funds, western US multi-family housing and US non investment grade capital equipment leasing. Our track record is superb. Can you assist us with this capital raise?

  3. 3 Bobby April 19, 2010 at 10:07 pm

    Bob,

    I’m looking at a deal in Queens, 55k a door, 5x rent. What do you think market for a deal like that is? In a solid B area of Queens, with a B quality product.

  4. 4 David April 20, 2010 at 2:34 pm

    Bob,

    For those of us focused on the Manhattan office market, please comment on the impact that the sales of 340 Madison, 600 Lexington and 125 Park will have on deal flow if they trade at the low cap rates being reported?

    David

  5. 5 rknakal April 22, 2010 at 6:38 am

    Hi Everyone, I have been out on vacation and will be responding to all posts tonight. Best regards, Bob

  6. 6 Adam Luysterborghs April 22, 2010 at 7:29 am

    Your point about the New York foreclosure cycle is well taken. In states that consider property rights seriously, like Texas and Georgia, non-paying tenants can be removed in a week and properties foreclosed upon in a matter of 30-90 days.

    This is one more example of how the political economy impacts our business and can skew the investment decision making process.

  7. 7 Jon April 22, 2010 at 1:18 pm

    Hey Bob,

    My name is Jon and I am entering the world of NYC commercial real estate as a commercial loan originator up graduation at the end of May. My boss has given me a list of blogs to follow and yours is at the top, great stuff. I have heard many different opinions on if now is a good time to get into the commercial mortgage business. The two main arguments (bulls vs. bears if you will) are that since financing is very hard to come by there is a strong demand for mortgage brokers or on the contrary since there is relatively little deal flow, there is not a lot of people who need these services. My team typically works in the 1 to 40 million range. Do you have an opinion on this?

    I appreciate the time,
    Jonathan

  8. 8 UrbanDigs April 23, 2010 at 10:16 am

    Bob great post as usual and enjoy your vacation!

    A few things.

    1) Fed engineered Carry Trade Environment / Bank Recap – YES YES YES! Been writing on this in detail since early/mid 2009. make no mistake about it, this is a huge dollar carry trade environment engineered by our fed to recapatilize the banks. The assets are held at 70, current bid is 30…carry trade it up to 40, mark it down to 60, carry trade it up to 45, market it down to 55, all of a sudden it doesnt matter anymore. This is a methodical solution to a big problem and acct changes are allowing this take place.

    If you are wondering WHY the recent dollar rise is not unwinding this trade, here is the answer: The vast majority of HY and equities are in USD anyhow so the FX component is not too relevant. It would really only matter to investors overseas investing here and vice versa.

    The carry trade that’s on now has nothing to do with the FX carry of old. It’s that a US bank can have illiquid assets on it’s books at 40 when they are worth 10. They just make $10 a year for 3 or 4 years and write down the investment a little bit more each time around while still able to show a profit. So long as nothing drastic happens eventually they’ll have it written down to market. That’s why even if you bid 15 for it you can’t get them to sell it. Yes the carry trade is on, but if banks can earn their way out then who cares?

    2) Whole Loans – on the books of banks, whole loans do not have to be marked to market, and are held in ‘hold/accrual’ books. This is largely considered to be the elephant in the room and will cast a cloud over banks AFTER they deal with securitized assets help on and off balance sheet. For now, nobody talks about whole loans originated in 2005-2008 that are being held at par on banks books but whose actual value is far less.

    3) Transfer of shit – clearly the fed’s 1.25trln MBS debt monetization experiment transferred a ton of shit from banks BS to fed’s BS..but no one really cares right now on how bad the feds BS might have been compromised. Print more money I guess, hey its electronic and easy.

    All of this has delayed the reckoning with hopes the problem can be methodically carry traded away with time. We are yet to see consequences of such actions.

  9. 9 rknakal April 25, 2010 at 8:39 am

    Hi Lighthouseas, Thanks for your post. We are seeing most activity in new distressed assets coming to market from portfolio lenders. While we have done hundreds of valuations for special servicers, assets from them have been much slower to come to market. However, we expect the flow to pick up considerably based upon recent conversations we have had with the servicers during the past few weeks.

  10. 10 rknakal April 25, 2010 at 8:41 am

    Hi Tom, thanks for the post. We can help with the capital raising. Please send me an email at rknakal@masseyknakal.com with your contact information or feel free to call me at 212-696-2500 x 7777.

  11. 11 rknakal April 25, 2010 at 8:42 am

    Hi Bobby, thanks for your post. For Queens, that sounds like a great opportunity. If you would like to discuss it further, please feel free to give me a call at 212-696-2500 x 7777 or you can email me at rknakal@masseyknakal.com.

  12. 12 rknakal April 25, 2010 at 8:56 am

    Hi David, thanks for your post. One of the interesting things about the office market is that to fully understand it, it must be segmented. The average price per square foot of office buildings in manhattan dropped 55% from the peak in 2007, however, reductions ranged from 70% to only 25% depending on market exposure. Those will little or no vacancy and low lease rollover in the short term were only down by 25%. Those with large vacancy and large short-term lease roll were at the high end in terms of value dimmunition. Given these dynamics, it is not at all surprising to see 340, 600 and 125 trading at the expected levels.

    I believe the most important aspects of these sales is that the results may create incentive for additional discretionary sellers to get off the sidelines and put additional properties on the market.

  13. 13 rknakal April 25, 2010 at 9:16 am

    Hi Adam, thanks for your post. Certainly, the convoluted nature of the foreclosure process in New York is a drawback to the local market, however, it has not had a tangible negative impact on lenders as ours is still one of the preferred locations to deploy debt capital.

  14. 14 rknakal April 25, 2010 at 9:26 am

    Hi Jonathan, thanks for your post. I believe now is a great time to get into the business and I tend to think professionals become more heavily relied upon as conditions remain more challenging. Transaction flow has already begun to pick up and will continue to, creating more opportunities for all of us on the transaction side. If there is anything I can do to help you, please feel free to contact me. I wish you the best of luck in yoru new career.

  15. 15 rknakal April 25, 2010 at 9:48 am

    Hi Noah, thanks for the post. I always appreciate your insights. Clearly, the highly accomodative monetary policy of the Fed is allowing for the carry trade and the recapitalization of the banking system. This has been going on for quite a while and will likely continue for as long as inflation stays below 2%.

    I also agree with your perspective on whole loans. There are many of these that are severely unwater, particularly the loans made in 2006 and 2007 which will be maturing in 2011 and 2012. At some point, the extend and pretend mechanism will not work and losses will have to be realized.

    As for the TOS you mentioned, the fed has already ceased their asset buying program. They have also recently announced the intention to sell about $1 trillion of assets on their balance sheet. When the buying program ceased, we saw the 10-year go from the mid-3s to above 4%. This could be just the beginning.

    Interest rate policy and direction are an underestimated factor in the future of our market.

  16. 16 UrbanDigs April 27, 2010 at 4:11 pm

    Bob,

    Yea its a crazy world out there..one part of me wants to think rates will rise due to reversal of QE policy, and another part of me thinks rates will rise as a market reaction to the consequences of behaviors both before and after this crisis around the globe. Sov default cant be priced in right now. Maybe today a bit more than yesterday.

    So, hear me out. If Greece, port, spain, others, are the beginning of another deeper problem, and many believe they are, could this not CONSTRAIN treasury yields as a flight to safety; The Howard Lutnick way. Today was a clear example of it with gold, dollar and treasury prices up. How will this affect rates on loans? Or, will we see bond yields fall due to flight to safety and loan rates stay flat or rise due to other factors? disconnect there? that would be the worst case scenario. fed loses all control in loan world but gets what they want in treasury world with so much issuance still in pipeline.

  17. 17 rknakal April 28, 2010 at 8:40 pm

    Hi Noah, thanks for the post. With regard to soverign defaults and interest rates, its anybody’s guess. Sure a flight to safety could keep rates low but with yield up all over the globe, rates might have to follow. I understand Greece floated some bonds today bearing 25% to 30%!! Wow!!

  18. 18 UrbanDigs April 30, 2010 at 7:44 am

    yep! Any country with Greece’s types of issues whose debt is not in their own currency will be subject to this. For US, we can just print our way out of the mess with debt in our own currency. For Greece, if they are removed from the EU, and forced to create their own currency, it likely will have no faith and confidence from outside investors and cause a hyperinflation issue. Doubtful the same scenario will hit home here, although I get into hyperinflation arguments all the time with people due to fed printing. So far, deflation is only real threat.


  1. 1 Distressed Asset Update – Here They Come « HOW will you EMERGE? Trackback on April 19, 2010 at 2:36 am
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