Betting on Bad Debt Becoming a Growing Investment Play

With the Great Recession in mid-stream and commercial real estate being a lagging component of the economy as demand for CRE space is a derived demand once potential tenants outgrow their current space needs and feel confident in the future, the declining property fundamentals, lack of liquidity in the market and rising investor yield requirements as reflected in cap rates, a large percentage of commmercial properties are not worth the face amount of the debt.

In this week's CoStar Watch List, A weekly column focusing on distressed market conditions, commercial real estate properties, mortgages and Corporations Published by CoStar News, the opportunity to buy distressed debt is highlighted. The article is below. You can sign up for the eblast from CoStar through their website www.costar.com.

The key is to recognize that buying a loan, while based on a thorough underwriting of the collateral (the foundation is always the real estate), is not buying a property and has a different cash flow characteristics and risks. I will be addressing issues in the loan valuation/pricing process in future blogs but awareness of the opportunity is the first step for many investors.

For many this is back to the future going back to the RTC days, but for others, this is the first time to pursue the acquisition of commercial mortgage debt on the secondary market. I have significant experience in this arena - from both the buy and sale side as well as a loan sale advisor and due diligence provider. Please let me know if I can be of service.



Betting on Bad Debt Becoming a Growing Investment Play
With Distressed CRE Debt Mounting, Investors Are Scouring Loan Books for Good Property Deals
By Mark Heschmeyer
With most if not all facets of commercial real estate investment mired in the dumps, one area is burgeoning -- the market for distressed debt. Indeed, investors say the distressed debt market is more active now than it has ever been, and still nowhere near where players see it going over the next couple of years. Spurring the action is new paradigm in property acquisition. Debt buyers are keen on the notion that properties can be acquired at significant discounts to their loan values - offering even bigger savings than the cost of purchasing a property outright.

Examples of this new arrangement are abundant, with AION Partners, a real estate private equity company in New York, being just one. AION is utilizing this loan-to-own strategy as a starting point for increasing its ownership portfolio. It recently purchased a portfolio of eight loan-to-own assets in opportunistic markets throughout the Sunbelt with a value in excess of $110 million. Since acquiring the loans, AION Partners has already foreclosed, or taken a deed in lieu on five of these non-performing first mortgage loans and plans to take control of the remaining properties in 2010.

The eight loans purchased in 2009 include: a 234-unit multifamily complex in North Miami, FL; a 192-unit multifamily property in West Palm Beach, FL; a 178-unit assisted living facility in Arlington, TX; a 287,000-square-foot distribution warehouse in Chester, NY; a 150-unit multifamily complex in Phoenix, AZ; a 196-unit multifamily property in Tucson, AZ; a 480-unit multifamily community in Atlanta, GA; and a 220-unit multifamily building in Charlotte, NC.

"We are committed to building a large, national portfolio of multifamily assets and are executing this strategy through the acquisition of distressed loans and properties and then employing our experience as investors, developers and managers to stabilize and build value," said Michael Betancourt, principal of AION Partners, which also owns office, retail and condominium properties in major cities including New York, Washington, DC, and Los Angeles. "If our success during 2009 is any indication of things to come, we anticipate activity in 2010 both on the investment and asset management fronts to surpass our initial projections for our partners and ourselves."

The bulk of the distressed debt sales in 2009 were in the CMBS arena and from the Federal Deposit Insurance Corp. and industry participants expect those numbers to continue growing this year.

The FDIC alone sold about 3,500 commercial real estate loans with a book value of more than $6.1 billion last year; that compares to commercial real estate loans sales in 2008 of just $153 million. Nonperforming loans went for 37 cents on the dollar last year but November and December 2009 sales prices coming in closer to 30 cents. Performing loans sold for about 57 cents on the dollar, but with the most recent sales coming in at 44 cents.

Also, the FDIC has a growing portfolio of bad loans to deal with as regulators are closing banks in record numbers.

According to analysis by Property and Portfolio Research (PPR), a CoStar Group subsidiary, as commercial real estate fundamentals continue to deteriorate through 2010, banks with large exposure to the commercial real estate sector will face increased pressure on their balance sheets. FDIC guidelines suggest that a bank whose commercial real estate holdings exceed 300% of capital is "overexposed" to the sector. Based on that metric, PPR says there is no shortage of candidates that the FDIC could seize in 2010. As of the end of the third quarter 2009, more 1,200 banks had commercial real estate exposure of greater than 300% of capital, and 500 of these banks had exposure greater than 400% of capital. The assets of those banks total approximately $650 billion.

So as far as the growth in the amount of debt the FDIC can dispose of, Steve Miller, director of debt research and risk management at PPR, says it is limited only by the FDIC's ability to deal with the growing volume of distressed financial institutions.

CMBS loan liquidations were averaging about $108 million a month in 2008 and last year the average jumped $182 million with November's totaling hitting $255 million and December's ballooning to $585 million, according to CMBS bond rating agency Realpoint. Loans were being liquidated at losses near 66%.

In addition, the rate at which liquidated or resolved CMBS credits are replenished by newly delinquent loans is growing and remains a high concern, especially regarding further growth in the foreclosure and REO categories (evidence of additional loan workouts and liquidations on the horizon for 2010).

To the selling side of the equation, industry participants also expect to see heretofore reluctant community and regional banks begin to dispose of more of their distressed commercial real estate assets.

"The secondary market for buying loans is a crowded space right now," said Barry C. Smith, president of LoanSaleCorp.com in Scottsdale, AZ. "There are many groups seeking deals, but transactions (other than the FDIC sales) actually taking place are not as great as one might think. Bid / ask spreads are still wide, but we do see things narrowing somewhat."

"January was interesting; it is apparent that both buyers and sellers are ready to get things going after a dismal 2009," Smith said. "We see good momentum in the market currently and we are happy to report that the community and regional banks we deal with seem to be more interested in actually doing something proactive. This contrasts with what we saw in 2009. Some banks are starting to come out of their Zombie like state and explore the disposition of identified problems. This is an encouraging sign for the market."

Bill Looney, president of loan sales at DebtX in San Francisco, said the market for commercial real estate debt is as active as he has seen it in 10 years.

"That's a function of weakening conditions in the commercial real estate market and a recognition among financial institutions that they need to actively manage their portfolio to reduce risk and protect the bottom line," Looney said. "Many institutions realize that a loan sale can expeditiously dispose of a loan at fair market value. By selling, rather than holding onto the loan in workout, institutions can remove the headwind from their balance sheet and get back to the business of making profitable loans again."

In addition to selling a significant volume of non-performing loans, Looney said he also expects to sell a fair amount of performing debt start coming to market.

New York-based Mission Capital Advisors conducted $9.2 billion in loan sales last year including $571 million of CMBS loan sales, a 77% increase year over year versus 2008. "We see the market as extremely active, with the most active sellers being the healthier community and regional banks who have successfully raised capital and nearly all special servicers (regardless of financial condition)," said William David Tobin, principal of Mission Capital Advisors. "Mission's commercial loan sale business was up 57% in 2009 versus 2008 in terms of balance offered. We expect a similar increase in 2010."

"The most active buyers are localized operators teamed with high net worth individuals or groups of individuals, with a strategic use for the property (and accordingly, a price advantage over strictly financial buyers)," Tobin said. "The second most active buyer profile is $50 million to $500 million private equity / high net worth investment funds."

In terms of buyers, Bill Looney said DebtX is seeing a lot of bidding and purchasing by opportunity funds, private equity funds and hedge funds.

"In addition, we're seeing a number of equity buyers who previously owned property, but have been in cash looking to get back in," Looney said. "Because many distressed properties are mired in default or are unable to service their debt, some equity players are seeking to re-enter the property market by purchasing the loans. Finally, we're seeing local players, such as community banks, selectively buying loans. Community banks often have a local market advantage because they are tied so closely to their communities."

Barry Smith at LoanSaleCorp.com said the major buying activity presently is in the sub- and nonperforming loan space. Buyers are not showing a clear preference for property types but that clearly loans in the major metropolitan markets are of the most interest.

Ken Cohen, chairman and CEO of The Mortgage Acquisition Co. in San Francisco, which has been active buyer in the capital markets since 1990, said the current market is tremendously active and is going to stay active.

"As a buyer we look at performing and nonperforming loans, although right now we're seeing many more nonperforming situations as borrowers are starting to miss payments," Cohen said. "We look at a lot of property types, but we stay away from land loans and major lease up issues - empty retail, big box office, big box anything."

In terms of pricing, Cohen said he is looks at the underlying cash flow of the property and strength of the sponsor backing the loan.

An open letter to the Appraisal Insitute: 20th Century Valuation Techniques are not appropriate for 21st Century Finance and Investment

When an economic calamity is so great it compels economists to reach for a new paradigm incorporating the value of collateral and the amount of leverage used to finance its ownership. When the understanding of commercial real estate operations and cash flow characteristics – and the ability to use computer programs to model it makes the three approaches to value – cost, sales comparison and capitalization of income – simplistic and, with one exception, anachronistic….

Δ First, the cost approach in which estimated value “is derived…by estimating the current cost to construct a reproduction of existing structure, including entrepreneurial incentive, deducting depreciation from the total cost and adding the estimated land value”* (which fluctuates based on market conditions) only works for special purpose properties as a reflection of value in use – as a factory which is designed and built to house production of a unique production process.

- Having been in a position to sell a Class B building in downtown St. Petersburg for under $15 per square foot in 1992 at the bottom of the last cycle which was empty in a time of oversupply I know that an empty building is not necessarily worth the cost of bricks and mortar and a developer adds value above replacement cost by developing and leasing the property which provides incentivized investment returns to both capital and management.

Δ Second, the sales comparison approach derives value “by comparing the property being appraised to similar properties that have been sold recently, then applying appropriate units of comparison making adjustments to the sale prices of the comparables based on the elements of comparison.”* This approach may be appropriate for owner-occupied housing where the principal of substitution is the primary basis for determining what a buyer would pay for a home; however, differences between commercial properties; including location, functionality and operational efficiency, lease structures and terms, and the capital structure, cost of capital and yield expectations of the buyer who pays “investment value” for a property; are too significant and extensive for an appraiser to be able to adequately address them in order to estimate the value of a comparable property.

- Being on the opposite side of a street or having more points of ingress can change the marketability of a property and reduce or increase market risk which should be reflected in the buyer’s yield expectation as reflected in the Internal Rate of Return and the resultant capitalization rate.

- Even if an appraiser used sales data on sales that closed as of the date of the appraisal, the information is dated since a normal commercial real estate deal takes between two and three months to negotiate and close with the purchase price generally agreed upon at the outset of the process – not the conclusion.

Δ Finally, the income capitalization approach which can be applied using two methodologies: (1) the capitalization of “one year’s income expectancy” at a “market-derived capitalization rate,” which happens to be the most commonly used method due to its simplicity; or (2) the discounting of “the annual cash flows for the holding period and reversion….at a specified yield rate.”*

- The capitalization of a one-year pro forma has the fatal flaw in that it implicitly assumes the net operating income from a property will be the same in perpetuity – and commercial real estate professionals including appraisers know that a property’s cash flow is not the same from one month to the next, much less does it remain the same for years on end. With the sole exception of a long-term absolute net leased single-tenant property, commercial real estate does not generate bond-type income streams. It has a mix quality of tenants with varying lease rollover times, vacancies and releasing costs.

- In addition, the traditional application of the income capitalization approach is to capitalize net operating income, which may be a proxy for net cash flow when there are no tenant improvements or leasing commissions to pay as is the case with apartment complexes, self-storage facilities and hotels but not with office buildings, shopping centers or industrial facilities. For commercial properties, the NOI should be reduced by an estimate of the annual expenditure for leasing costs and rollover vacancy to approximate the estimated net cash flow to be generated from the property operations. Problem is, appraisers cannot get the same information on competing properties in order to develop an appropriate cap rate.

Accordingly, the only reasonable method to establish what the accountants call “fair value” of commercial real estate is to forecast future cash flow from the operation and re-sale of the property and discount the resulting cash flows reflecting a prudent investor’s yield requirements given the cost of debt financing and the perceived market, operating and financial risk assumed through ownership in relation to other investment opportunities.

It is the 21st Century - we know better and we have the capability to estimate market value by employing the same tools investors use to establish investment value.

For the record, the generally accepted definition of market value (“The most probable price, as of a specified date, in cash, or in terms equivalent to cash, or in other precisely revealed terms, for which the specified property rights should sell after reasonable exposure in a competitive market under all conditions requisite for a fair sale, with the buyer and seller each acting prudently, knowledgeably, and for self-interest, and assuming that neither is under undue duress.”) is not at issue – the issue is that the aforementioned approaches to value are still accepted as a basis for estimating market value.

Accordingly, in my humble opinion, market value can only be based on the income characteristics of the subject property. Minimum standards would be established for the research and support used for developing the forecast assumptions used in preparing the cash flow forecast. Appraisals would be evaluated based on the assumptions used in estimating market rent, stabilized occupancy, downtime between leases, leasing costs, operating expenses, growth rates, capital improvement and replacement costs, reversionary capitalization rate and selling costs, and the yield, or discount rate, used to present value the future cash flows.

Δ The traditional cost, sales comparison and capitalization of income approaches would be used to test the reasonableness of the resulting range of values developed pursuant to the discounted cash flow approach within which “market value” is most likely to occur.

The Appraisal and Mortgage Financing Considerations

From a prudent lending perspective, the information contained in an appraisal provides many underwriting benchmarks – in addition to the traditional loan to value ratio - which provide establish loan sizing and structuring. For instance, prudent lending practice dictates that a construction loan should be capped at the cost of construction excluding land; however, in the last cycle, many non-recourse permanent loans were made based on appraised values far exceeded replacement cost which has increased the exposure to risk above which is prudent for commercial lenders: Permanent financing sizing should also be capped at replacement cost.

The objectively-created cash flow forecast used in an appraisal provides lenders with a timeline for potential default events like tenant rollover or major capital improvements or replacements enabling the loan officer to structure the loan with appropriate rollover and capital reserves. Further, the lender can determine a property’s ability to cover debt over the anticipated loan term and size the loan using a debt coverage ratio-based mortgage payment reflecting the minimum cash flow generated after unreserved leasing and capital costs including lost rent during rollover.

If an appraisal is being conducted for purposes of a loan application, the cash flow forecast should be for a minimum term of the loan plus at least two years. This timeframe allows a lender to fully evaluate the risk of default at maturity that may result from a major tenant rolling over immediately subsequent to the proposed loan maturity. Further, the lender can structure the loan with appropriate reserves and shorter amortization term to reduce the balance to reduce the default risk to an acceptable level.

It is clear from the impact escalating market value of commercial real estate based on unrestrained market liquidity and investor demand that the 20th Century valuation methods embraced by the Appraisal Institute and the financial community leads to ever escalating values in boom periods and draconian values in recessionary periods does not provide a prudent basis for loan sizing and structuring.

New loans, and loans to be restructured, need to reflect the property-specific risks of the collateral as reflected in an appraisal that appropriately reflects the cash flow characteristics of the property and the risks and returns of ownership.

- For instance, the interest rate and loan sizing parameter, loan to value ratio, would be influenced by the credit risk in the property’s tenancy and lease tenure, or rollover risk in the rent roll.

- The physical reserves would be structured to provide fro un-depreciated replacement cost in the year the expenditure is expected to occur as, ideally, the reserve and capital expenditure forecast would be obtained from a current property condition report.

The considerations in establishing the size and terms of a commercial mortgage loan extend far beyond loan to value and debt service coverage ratios – and it is time for mortgage lenders to fully utilize the information in the appraisal to minimize default risk.

Conclusion

The objective of policy-makers, regulators and bankers in the wake of the Great Recession is to provide prudently underwritten loans to qualified borrowers which will serve to eliminate, or at least moderate, market bubbles. Updating the appraisal methodology to reflect anticipated property performance is one of the first places to start. It is clear that the traditional approaches to estimate market value do not result in a value estimate appropriate for prudent loan underwriting and sizing.

My prediction is that issues involving collateral and collateral value will be at the forefront of financial and real estate industry concerns as we reach for the new economic paradigm. While traditional appraisals and broker’s price opinions will provide financial institutions a value benchmark, they will not provide the basis for the new economy.

It is time for the Appraisal Institute to effect a paradigm shift in the appraisal process of a commercial property – it is time for valuation methodology and loan underwriting to enter the 21st Century!

This is my first eblast this year but it is not my first post to my blog. I welcome your comments and opinions and look forward to continuing the dialogue.

We know real estate and we understand commercial mortgages - let me know if we can be of service.
Best regards,

Paul Jones, CPA, CRE, FRICS

* NOTE: All definitions are from The Dictionary of Real Estate Appraisal, Fourth Edition, Appraisal Institute, 2002.