Distress Market Thaws
The volume of distressed-asset sales nationally in 2010 has nearly tripled from the first half of last year, driven primarily by an increase in sales by bank lenders. For distressed-asset investors who have been stymied in their efforts to deploy capital in the acquisition of troubled properties, this is welcome news. To the general consternation of these investors, policy flexibility in support of banks and special servicers has largely stanched the flow of distress into the marketplace during this cycle.
At midyear, however, there are indications that the pace of workouts—and asset sales, in particular—is slowly developing momentum.
Resolutions of distress through sales rather than loan modification have increased to 48 percent of all workouts by dollar volume in the first half of 2010, up from 43 percent in 1H09. More importantly, the dollar volume of resolutions has jumped in recent months, rising from a paltry $3.8 billion in the first half of last year to $14 billion in 1H10. The improving health of the core marketplace, described in last week’s Lead Indicator, has been a key factor in facilitating the increase in distressed sales activity.
Of course, the volume of sales resolving distress is still only a fraction of investors’ demand for deeply discounted assets. Manna is not falling from heaven.
Nonetheless, the current trend augurs further gains in this segment of the market. As transaction volumes rise and commercial real estate pricing becomes less opaque, first in the most liquid markets, lenders holding assets can better quantify losses on sales and can thus make informed judgments about where and when to restructure or dispose.
Default Rates Rising but New Distress Slows
Real Capital reported last week that the value of loans on properties falling into distress totaled $6.3 billion in June, the smallest one-month increase since late 2008. While the timing of special-servicing transfers and developments related to large portfolios drives significant month-to-month volatility in addition to distress, the slower growth in trouble bears out over the year to date as well. In the first half of 2010, broadly defined additions to distress have totaled $56.4 billion, down 24 percent from the same period last year.
Just as the pace of additions to distress slow, restructuring and resolution via sales activity is accelerating. Total workout activity in 1H10 reached $29.2 billion in June. This includes first-half restructuring activity of $15.2 billion, more than three times higher than for the same period a year earlier. Resolutions have posted even larger gains, increasing by 272 percent, from $3.8 billion in 1H09 to $14 billion in 1H10.
With slower growth in distress and the coincident increase in workout activity, the balance of trouble outstanding has increased by 15 percent in 1H10, down sharply from the increase in 1H09. Similarly, lenders’ real estate owned (REO) has increased by 30 percent in 2010 through June, down from an increase of 95 percent in the same period last year. As a result of these diverging trends, resolutions through sales during the first half of 2010 have climbed to 8 percent of total trouble and REO outstanding as of June, doubling from the first half of 2009.
Banks Capture Higher Recovery Rates
The frequency and success of workout activity varies significantly across lender types. And not all lenders have contributed to the increase in resolution activity. While CMBS led all other lender types in additions to distress in the first half of 2010, accounting for just under two-thirds of new distress, CMBS resolution activity remains muted. Of the resolution through sales in June, for example, CMBS comprised a modest 15 percent of the total.
In contrast with the dominance of restructuring activity for securitized loans, workouts of bank debt have been increasingly likely to involve resolutions through sales. Approximately $8 billion in bank-held commercial mortgages were resolved through sales in the first half, compared to less than half that in restructuring activity. Restructuring of bank debt edged out resolution volume in June, but the lion’s share in restructured debt was tied to two specific portfolios.
With the exception of local and regional banks, recovery rates on sales have improved from 2009 to 2010 year to date, rising from 63 percent to 67 percent across the major lender groups. This improvement has been a key facilitator of sales out of distress. In the specific case of local and regional banks, more than a third of resolutions in 2010 relate to development sites, reflecting the importance of construction loans on their balance sheets and weighing on the overall recoveries for these lenders.
In the case of CMBS, however, the lower recovery rate is not related to problematic construction and development loans; at least in part, it reflects the more recent vintages of the loans, underwritten at the peak of the market in 2006 and 2007.
Do not expect the floodgates of distress to open. Policy makers have provided lenders with considerable flexibility in managing the timing of sales out of distress. So far, the data suggest that banks have been able to leverage that flexibility. The increase in distressed sales has been measured, coinciding with a general improvement in investments sales activity.
Going forward, investors can reasonably anticipate that opportunities for distressed investment will avail themselves alongside broader measures of transaction activity. Distressed sales will occur because of the healthier investment market, not because of its absence.
-With Andrew Florio and Ben Thypin. Messrs. Florio and Thypin are analysts in the debt and troubled assets groups at Real Capital Analytics.
Sam Chandan, Ph.D., is global chief economist and executive vice president of Real Capital Analytics and an adjunct professor of real estate at Wharton.