It’s Springtime for Some Investors in CRE Debt, but Others Head into Hibernation

By Chris Seyfarth, Partner, Transactions Real Estate, Ernst & Young L.L.P.

After more than a year of dormancy, some investors in distressed debt are waking up to the opportunities afforded by a commercial real estate debt market that appears to have sprung into life.

By Chris Seyfarth,
Partner, Transactions Real Estate, Ernst & Young L.L.P.

After more than a year of dormancy, some investors in distressed debt are waking up to the opportunities afforded by a commercial real estate debt market that appears to have sprung into life, according to a recent survey conducted by Ernst & Young LLP. But this year’s survey also reveals a growing number of investors who appear to have given up on being able to buy distressed debt.

Our survey showed a bifurcated market for distress where a growing number of investors appeared to have given up on getting the right deals and have exited the market. But, ironically, those investors staying the course seem to have access to a much more robust market and seem quite optimistic.

Ernst & Young estimates that sales of distressed commercial real estate loans totaled approximately $18 billion in 2010 and it is looking like 2011 will be similarly active. However, whereas FDIC sales are still likely to dominate transaction activity in 2011 (as they did in 2010), our survey anticipates bank loan sales to account for a much higher percentage of activity going forward. Banks are warming up to the idea of selling problem loans and, although they may still have to sell for a loss, pricing is now much more attractive and is inducing more banks to bring loans to market.

The prospect of more opportunities to purchase problem loans from regional banks is exciting some investors, according to the survey. In the last three years, the FDIC was by far the biggest seller of distressed debt with structured sales totaling $23 billion. Yet that appears ready to change although, further complicating the data is the fact that banks in 2010 set aside almost 50 percent lower loan-loss reserves, suggesting that many banks feel they have their real estate loan losses under control. There is perhaps a shakeup coming in the market, and something has to give. Either banks will fully clean up their balance sheets and release their problem loans or a lot of investors will go home empty handed.

From an investor’s point of view, this year’s survey revealed a significant change in sentiment. Nearly a third of those responding characterized the market for distress in 2010 as “active” compared with just 8 percent in 2009. Further indication that this is widely perceived to be the right time to buy distressed debt is apparent in the fact that 43 percent respondents believe that market conditions are favorable enough today for them to entertain distressed debt purchases. That’s double the number of respondents who felt similarly last year. What’s more, almost 40 percent of respondents see market opportunity stretching into the future, while only 5 percent believe the time to invest in distressed debt has passed.

At the same time, investors return expectations seem to have solidified in the high teens. The percentage of respondents who targeted returns in the low teens dropped 12 percent between this year’s survey and the one conducted by Ernst & Young in 2009. Investors shooting for 20 percent or greater returns also saw a drop of 8 percent but the percentage of investors expecting returns in the high teens increased from 43 percent in 2009 to 62 percent this year. This may point to the emergence of more opportunity funds in the market for distressed debt in 2010 since these funds typically have higher return requirements. It may also be indicative of a belief that the return of the financing market may offer investors the opportunity to benefit from positive leverage.

For a detailed analysis of this year’s Ernst & Young survey of distressed debt, visit www.ey.com/realestate.