Distressed Debt & Asset Update: Then and Now
- Dec 15, 2011
By Steven Bandolik and Seth Weatherly
As we approach the end of the year, we enter a very different investor climate than even four months ago. The first and second quarters of 2011 brought the potential promise of an economic recovery, a more liquid debt market and possibly a more robust transaction market. Unfortunately, however, it seems that “A Tale of Two Cities” may be a better analogy for the investor climate of 2011, and these are not exactly the best of times.
Political turmoil in Europe and the United States, a notable decrease in transactions in the debt and asset market, and a “re-tightening” of underwriting standards have left us once again in uncertain circumstances, both for the overall economy and the real estate market as a whole. The investment prospects of the next six to 12 months remain murky.
So how is a real estate investor supposed to interpret the changes that have occurred this year, and how do we move forward into the next year? In a word: carefully.
As the “green shoots” of recovery emerged early in the year, transaction and debt markets began to see the outline of a fully functioning real estate market. At times, cities such as New York, Washington, D.C., Boston, Chicago, San Francisco and Los Angeles attracted increased interest in trophy assets, according to a recent Deloitte report, as some investors’ “flight to quality” led them to what could be seen as safer options. However, as we approached the summer, the political environment in the United States changed considerably, eventually leading Standard & Poor’s to downgrade the country’s sovereign credit rating for the first time ever. That coupled with the sovereign debt issues in the Eurozone may lead some in our industry to believe that we are potentially approaching an investment climate similar to that of 2009.
Second, the first two quarters of 2011 saw liquidity returning to the real estate investment market, as both debt and equity transactions increased, underwriting loosened and many investors began to reenter the market. As a result, year-over-year transaction activity increased 100 percent, according to Real Capital Analytics Inc., largely because liquidity returned to the CMBS market as total issuance boomed to between $40 billion and $60 billion during that period.
But almost as quickly as an apparent recovery had begun, these macroeconomic stressors have abruptly changed the climate. Real Capital Analytics also notes that, although third-quarter transaction volume was up over last year, it slowed drastically from the first two quarters of this year. Across property types, year-over-year transaction activity was up only 13 percent. Furthermore, according to Citi Investment Research and Analysis, volatility in the CMBS market led to credit spreads widening 75 percent for triple-A-rated debt in the third quarter alone. Investor expectations appear more pessimistic than just six months ago, reiterating the point that investment prospects may be limited until clarity returns to the market.
Finally, the beginning of 2011 brought renewed confidence that the looming glut of distressed CMBS debt, scheduled to mature over the next five years, could effectively be dealt with through refinancing or other workout scenarios. Unfortunately, due to volatility in the markets, some lenders appear to have become skittish once again, and of the large portion of distressed debt coming due over the next five years, a smaller portion appears eligible for refinancing due to stricter underwriting standards, renewing fears there will be a glut of foreclosed real estate. Extensions may be a viable solution, but if many lenders decide that liquidation is a more financially viable option, the impacts on asset valuation and the transaction market as a whole are uncertain.
And so we return to the watchword of “caution.” Many investors are already moving to safer investment options, according to CoStar Group, as sales of single-tenant properties have averaged 10,000 transactions per quarter since the first quarter of 2010, the highest totals on record. The multi-family space has also showed strong signs of growth, but may be riskier when it comes to new development.
No matter what the investment option under consideration, conservative underwriting will be required. As an investor, you should consider relying on the preceding 12 months’ in-place net income of an asset or portfolio of assets. Include extra allowances for vacancy and credit loss, as economic shocks may affect not only the assets but also the tenants that occupy those assets, and be extremely careful when underwriting growth of any kind.
Hopefully, the new year will bring renewed optimism and a revitalized real estate market. But until that point, a return to valuation fundamentals may serve the real estate investor well.
Steven Bandolik is a director and Seth Weatherly is an associate with Deloitte Financial Advisory Services 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. is not, by means of this article, rendering professional advice or services.