There are few motivated sellers in commercial real estate markets today, and difficult underwriting formulas and cautious lenders are giving buyers fits. As they wait for signs of life in the market for commercial property, investors are circling around debt tied to commercial properties. Industry wags have predicted that commercial real estate is hurtling toward calamity, and investors are anxious to take troubled or potentially troubled loans off lenders’ books – if the price is right.
The volume of commercial debt deals remains low, however. That’s because a yawning chasm lies between the price investors are willing to pay for distressed debt and the price lenders are demanding.
Fred Pittaro, an attorney at Mintz Levin, relayed the experience of one investor who recently made the rounds of commercial lenders.
“He would knock on doors and ask about their bad loans, and the banks ask, ‘What bad loans?’” Pittaro said.
“You can call a bank up and ask about their distressed debt and they’ll say, ‘What distressed debt?’” added Jeffrey Libert, chairman of Forest Realty Funding. “They want to keep it very close to their chest.”
“I find that all the time, ‘We have no bad loans.’ Nobody seems to have any bad loans,” said John Keough, president of the New England Phoenix Co. “Maybe it’s true. But it’s hard to believe.”
Dare We Say ‘A Perfect Storm’?
Four separate storms have converged to wallop commercial real estate values. Falling rents, rising vacancies, a shell-shocked financing system and a near-total absence of liquidity have combined to erode real estate values, threatening to throw properties into distress and put loans underwater.
“Commercial real estate is in the early innings of its decline,” Keough added, predicting that “a fairly significant decline in values” is approaching quickly. As a result, he said, “people build that [decline] into their pricing model.”
The secondary market for commercial debt hasn’t yet reflected those developments, though. When prospective buyers and sellers price debt, they’re finding themselves anywhere between 20 percent and 30 percent off.
“It’s a big gap,” said Stephanie Lynch, a vice president in Jones Lang LaSalle’s investment banking practice. “It’s not a few cents. It’s 15-20 cents.”
Investors looking to buy debt are underwriting their purchases at the granular level, scrutinizing properties’ rents, tenant rolls and capital needs.
“Everything starts with the value of the underlying real estate,” Keough said. “Is it going up or down? Is it going to be a headache to foreclose on?”
Keough’s firm buys non-performing loans. He sticks to New England, he said, because the geographical restriction “gives us a better feel for, and access to, the underlying real estate. We can jump in the car and go look at the property.”
‘How Do You Get Out?’
Commercial refinancing woes are also driving down prices on the buy side.
“People are looking at their exit strategy when a loan matures,” Pittaro said. “How do you get out? They didn’t look at that before.”
Pittaro said investors are changing cap rates on deals based on the risk rollover poses to an existing loan.
“They’ll apply different cap rates. Maybe it’s an 8, not a 7. The values come down.”
Falling values, lease rollover risk, loan maturity and pessimism about the economy’s short-term prospects are all causing investors to demand steep risk premiums, Lynch said.
“Buyers are looking for significant yields,” she said. “Yields will play the primary factor, taking into account real estate values. If you buy a $100 million note for $80 million, and you get repaid in two years, what’s the return? It’s a very different conversation if the building is worth $120 million or $90 million. If you’re paying $80 million for a note on a building worth $90 million today, you’re asking, ‘Am I going to have to fight to get paid back $100 million note principle?’ Buyers want to be sure there’s very little risk.”
“There has got to be a good profit potential because of the risks, the time, the work, the potential costs and delays of litigation or bankruptcy,” Keough said. “These workouts are labor-intensive. It’s not a passive investment. We’re rolling up our sleeves, getting involved, and we’ve got to have a reasonably good cushion for profit to make it all worthwhile.”
All of this means that investors are coming at banks and insurance companies with bids the lenders consider to be ridiculously low. Lynch has seen several deals come to market over the last few months. Very few have closed, she said, because sellers “don’t like the pricing.”
Many lenders appear to be hung up on the face value of loans on their books, Libert said.
“I don’t care what the face on your loan is,” he said. “They don’t want to face a big loss. They don’t want to write them down yet.”
Don’t Attract Attention!
Part of the fear in taking a markdown on one loan sale, Pittaro said, is that regulators will come through and make the lenders mark all of their loans down to that level – even the ones that aren’t for sale. In banks where auditors have already come through and marked down loans’ values, he said, that price is essentially the floor price for any sale, regardless of any one asset’s true value.
“They don’t want to sell substantially below the markdown because they might have to go and reevaluate the rest,” he said.
That’s also why many banks and insurance companies are marketing and selling their debt quietly: they don’t want to attract attention to the loans that remain on their books.
Denis Walsh, president of Weld Management, is buying debt tied to industrial, commercial and multifamily real estate in New England. He’s seeing a lot of action around soured condominium projects.
“Today, all the deals are underwater,” he said. “If they have to mark it to market, it’s all underwater by 30-40 percent. That’s the next shoe to drop.”
Walsh compared the market for commercial debt to the market for credit.
“It’s basically frozen,” he said. “Sellers are still not prepared to take the markdown because they haven’t been leaned on by the regulators. They don’t want to take losses until they have to take them.”
As investors and lenders eye each other across the pricing gap, they’ve also got an eye on Washington. Dr. Jeffrey Fuhrer, director of research at the Federal Reserve Bank of Boston, recently pitched a pair of oncoming federal programs as cures for markets he termed “distressed” and “not performing in normal ways.”
Fuhrer told a recent NAIOP forum that the U.S. Treasury’s Public-Private Investment Program (PPIP) and the Federal Reserve’s Term Asset-Backed Securities Loan Facility (TALF) are intended to get debt deals transacted with a minimum of pain.
“We don’t know how it will play out,” he said. “The most difficult part is how to price [mortgages]. There are serious differences of opinion. If you do hold them, you believe they have long-term value. If you don’t hold them, they’re not worth much, so you don’t think you should pay much. Getting the two to agree – that’s what the two programs are supposed to be doing.”
