Distressed Debt & Asset Update: Rough Path to Recovery
By Steven Bandolik and Mark Wojteczko
Hard on the heels of the United States’ economic recession, the nation’s commercial real estate market appears to be on a gradual but uneven path to recovery. Increased transaction flow, driven by real estate investment trusts and distressed deals—in turn aided by improved access to debt and equity capital—has helped revive the commercial real estate markets as property fundamentals continue to improve across sectors.
A bright spot in the commercial real estate recovery process is transaction activity, led by REITs, foreign investors and distressed assets. Net positive acquisitions of $34.1 billion by REITs and $6.1 billion by foreign investors have significantly impacted investment recovery post-recession (2008), according to Real Capital Analytics Inc.
Distressed property transactions continue to rise due to improved financing conditions and favorable convergence of bid-ask spreads. Real Capital Analytics data found that during the first half of 2011, distress-driven sales increased 125 percent year-over-year, to $15.7 billion, and comprised 17 percent of total U.S. commercial real estate sales.
Distressed assets may be nearing a peak, as new additions to the inventory decreased for the sixth consecutive quarter in second quarter 2011, to their lowest level since 2008. Total loan workouts also exceeded new distress additions during the first half of 2011.
However, transaction opportunities still exist for distressed assets, with nearly $182 billion in troubled assets estimated in the marketplace, according to Real Capital Analytics. Indeed, an increase in real estate owned by lenders will help feed these trades, as these entities seek to permanently resolve troubled mortgages.
However, a broad-based transaction market recovery, requiring increased demand for “non-trophy” assets, may be delayed in light of current economic uncertainty. Transaction growth appears to be moderating, as global economic uncertainty begins impacting investor appetite and real estate debt availability and pricing.
A Pause in the Recovery Momentum
The U.S. economic recovery appears to be stalling, following Standard & Poor’s Corp.’s sovereign debt rating downgrade, the Eurozone sovereign debt crisis and concerns over U.S. fiscal policy.
The continued economic uncertainty has resulted in lower consumer confidence and business expectations; consequently, unemployment may remain high, and housing demand could stay muted. In addition, the U.S. residential real estate market appears to be years away from a full recovery. The mortgage market faces significant uncertainty amid continuous change, and looming debt maturities through 2017 continue to act as a potential impediment to the recovery of commercial real estate. A constant theme of the recent downturn was the “amend and extend” strategy, in which lenders were willing to extend terms for troubled loans at below-market interest rates.
But lenders have gradually moved away from this strategy as a result of a rise in commercial real estate values due to higher transaction activity and a boost in distressed-debt resolution through loan sales, refinancing and foreclosures. This uptick in loan restructuring and improved property fundamentals has decreased commercial real estate loan delinquencies: to 7.1 percent in the second quarter of 2011, compared to 8.8 percent in the second quarter of 2010, according to the Federal Reserve.
Adding further uncertainty to the recovery of commercial real estate is the residential housing and mortgage market. The residential mortgage market was the root cause of the sub-prime crisis and a major contributor to the 2008 economic recession. While mortgage debt levels continue to drop, new non-agency securitization issuances remain at record lows. Further, delinquencies hover at historic highs despite several bank and government loan modification efforts. The residential mortgage market may continue to evolve significantly over the next few years as a result of the regulatory environment, declining home prices, foreclosure practices and troubled-loan resolution.
Despite improved financing conditions due to availability of capital from increasingly diverse sources, issuance continues to be focused primarily on high-quality, stable assets, especially in gateway cities like New York, Washington, Boston, Chicago, San Francisco and Los Angeles. Prospects for a broad commercial real estate market recovery likely will be enhanced when lenders resume loan originations for non-trophy as- sets and refinancing options increase to respond to growth in debt maturities. According to Trepp L.L.C., at least $1.8 trillion in commercial real estate debt matures prior to 2015, with nearly 60 percent of this debt estimated to be “underwater,” as the amount of existing debt exceeds the market value of the property itself.
Slower recovery of non-prime properties and continued economic un- certainty remain challenges for the commercial real estate market. The industry will need to take on these challenges in 2012.
For further information, see Deloitte’s “Commercial Real Estate Out- look: Top Ten Issues in 2012—A Potential Pause in Recovery Momentum.” A copy of the report is available from Deloitte.
Steven Bandolik is a director for Deloitte Financial Advisory Services L.L.P. and Mark Wojteczko is a senior manager for Deloitte & Touche L.L.P. This article contains general information only and is based on the experiences and research of the authors. Deloitte Financial Advisory Services L.L.P. and Deloitte & Touche L.L.P. are not, by means of this article, rendering professional advice or services.