The buzzword in commercial real estate for the last two years has been "distressed," which is often placed before the word "assets" and best describes the state of the industry that many analysts predicted would be the next shoe to fall in the Great Recession.
While losses on commercial loans took down a number of smaller banks, such as Silver State Bank and Community Bank of Nevada, doomsday predictions have largely failed to materialize.
Several reports suggest that the worst of the commercial real estate debt crisis may have passed. The rate of loans in delinquency or foreclosure has declined nationwide. Banks are negotiating more loan workouts, a healthy sign for distressed real estate.
Delinquency rates on commercial real estate loans fell to 8.6 percent in the first quarter from a 17-year high of 8.7 percent in fourth quarter 2009, the Federal Reserve reported.
Lenders and special servicers resolved $14.6 billion in troubled commercial loans in the first half of this year, compared with $3.8 billion a year earlier, Real Capital Analytics reported.
"What is happening is extend and pretend," said Whitney Tilson, principal of New York-based investment firm T2 Partners. "The losses are still going to be huge from everyone I talk to, but because you have far fewer properties — $10 million for a commercial property versus $200,000 for residential — it’s a smaller market. You can go in and have negotiations."
Commercial loans usually have a 10-year maturity and borrowers can often negotiate with the lender to extend the maturity, Tilson said.
Starting in 2008, monthly additions to distressed real estate averaged $8.5 billion, although July was $5 billion, the lowest monthly increase since October 2008, Colliers International chief economist Ross Moore reported. With nearly $4 billion of restructured or resolved real estate in July, the net increase in distressed real estate was just more than $1 billion.
That’s largely because of the "pretend and extend" phenomenon being applied to all but the most impaired real estate, Moore said. Lenders and owners are hoping that the market will rebound and push values back up.
This business strategy has saved struggling shopping centers, office buildings and industrial parks in Las Vegas from entering foreclosure.
"I think for the last couple of years, lenders have really tried to do workouts, whether it’s refinancing, extending the loan or working with the borrower to keep control of the property," said Chris LoBello, vice president of Colliers in Las Vegas. "That sort of played out. There are properties now with notes in default and the asset is the only thing to secure that note. Lenders want to make sure it’s handled properly and at least try to maintain the value."
LoBello is serving as receiver for Colliers’ new assets resolution division. He aims to maximize the value of distressed assets through property management, marketing, leasing and ultimately sale of the property.
With a law degree and 15 years of commercial real estate experience, LoBello will work through complex issues of receivership and reach out to key players at banks and special servicers, or companies handling delinquent loans.
"What we’re experiencing here, with what’s coming down the pipeline, we realized the need for a receiver," LoBello said. "Lenders like a single point of contact. You run into difficulty when your receiver is in California and your property manager is in Nevada."
Predictions vary on how much commercial real estate is distressed and the rate of delinquency, said Abran Vigil, attorney for Ballard Spahr law firm in Las Vegas. The firm represents the lending group holding the senior loan on Town Square. Bank of Nova Scotia commenced foreclosure on the south Strip retail and entertainment center earlier this year.
"Some reports say on a national level real estate loans are OK," Vigil said. "When people see shopping centers and office buildings go into receivership in Las Vegas, it raises the question, ‘What are these reports saying?’ "
Ron Opfer, director of special asset solutions for Coldwell Banker Premier Realty, said distressed assets in Las Vegas have increased significantly from last year. He has 15 bank-owned listings ranging from commercial land to office buildings. Based on default notices filed in September, he expects the pace of commercial foreclosures to increase in the short term.
"I think there is a lot of investor demand for distressed assets," Opfer said. "However, the demand is way more focused than one year ago. In the past, investors would say they were looking for anything. There was an overwhelming excitement to get involved in distressed assets. Most people put together a three-year pro forma and had some expectation that the market would turn around or at least stop falling.
"Today, the distressed investor is keenly focused on finished commercial buildings located in outstanding areas where there is demand for commercial. Their pro formas are five years or more with a long ramp-up period to stabilization. They want the best distressed assets in the best areas and they want to purchase them at numbers that make sense. The deal has to pencil (work financially). It has to make sense under commercial investment principles."
Demand slows to a crawl on unfinished projects or properties that require substantial capital expenditure to bring in some kind of return on investment, Opfer said. The investor pool for those assets is slim because investors are reluctant to pour good money into a bad project, especially when the commercial market is expected to worsen, he said.
Loan resolutions are few and far between, said Dean Jalili, managing partner of Fortis Commercial Advisors in Las Vegas. Banks are still unwilling to write assets down to real market value and when they take back the asset, there’s a "disconnect" on value, he said.
"An investment property is only as good as the income it’s capable of generating," Jalili said. "Rental rates are poised to stay low in Las Vegas Valley because of our extremely high vacancy rates and declining economy, which will keep downward pressure on property values for the foreseeable future."
The origin of the loan can also exacerbate the problem, he said.
Commercial loans are typically either held by banks and managed by asset managers or they were originated as commercial mortgage-backed securities conduit or securitized debt, which is serviced and managed by special servicers. Because commercial mortgage-backed securities debt is serviced by a third party on behalf of investors who own that debt, the special servicer is often encouraged to keep its position and the fees generated by that servicing assignment, Jalili said.
"They usually will not, under any circumstances, work with the current borrower. They obtain fees for facilitating the foreclosure and continue to garner fees for managing the asset once the foreclosure process is complete," he said. "One can certainly raise the question (of) whether or not this is truly in the best interest of the investment group they represent and if there exists a conflict of interest. These properties are usually foreclosed on and managed by the special servicer as asset manager."
Attorney Vigil said the role of the special servicer is triggered when a loan is on the verge of default or in default. The special servicer has better knowledge of the property, the loan’s value, how much is owed and the value of the property itself. They maintain clear communication with the borrower and are better-equipped to work with the borrower, he said.
"If the value of the property is no longer enough to satisfy the loan, that’s what we call distressed property," Vigil said. "Your typical shopping center has mom and pop shops that are not doing so well. Couple that with declining value of the land. Say the shopping center owner borrows $2 million in 2004. Suddenly the security is at risk with the declining value of land and less income. We have to see if a loan resolution is viable or not."
Regardless of loan workouts or foreclosure, the value for most commercial real estate needs to be reset to reflect current market conditions, including declining lease rates, Coldwell Banker’s Opfer said.
"When rents have fallen by double-digit figures, vacancies have increased and absorption is not even measurable, you can bet that the fundamentals of commercial real estate are unbalanced in an unhealthy way," he said. "I believe banks are way more inclined to find a loan workout solution than at anytime before. In some cases, it makes good sense. In others, the projects are too far gone to salvage and foreclosure is the only way."
The key to keeping loans out of default is adequate cash flow, or at least enough to service current debt payments, Moore said. Exceptionally low interest rates and a loosening of rules by banking regulators have made this possible.
"The status quo cannot last forever and certainly there is a growing view that lenders will begin to unload problem real estate in the coming months, but banks and regulators look set to drip real estate to the market and not flood it," Moore said. "As the market stabilizes, rising distress sales will be a key feature, but will most likely resemble a wave and not a tsunami."
Jalili said favorable opportunities are available to savvy investors, but product is hard to find. He said Fortis has shifted its focus to purchasing distressed assets on behalf of investors at trustee auctions throughout the West, working with local and regional banks that have in-house asset managers and sufficient balance sheets to effectively dispose of toxic assets at true market pricing.
Tilson, author of "More Mortgage Meltdown," said in 2008 that "we’re still in the early innings" of the housing and credit bubble, and that the next wave of losses would come from the $3.5 trillion in commercial real estate loans.
Of the $1.4 trillion in commercial loans expected to mature by 2014, approximately $245 billion will mature this year and the same amount will mature next year.
"Commercial real estate is going to be in the toilet for many, many years, but the losses will come over a longer period of time," Tilson said. "It’s not systematic, but every Friday, a few more small banks close down."
Contact reporter Hubble Smith at firstname.lastname@example.org or 702-383-0491.