The Shadow Effect
A backlog of unforeclosed properties haunts today’s marketOne of the mysteries of today’s commercial real estate market is the current dearth of foreclosed properties on the market. After the credit meltdown of 2007–2008, industry professionals expected foreclosed properties to flood the market, but few ever did. Today, brokers and investors alike question why more foreclosures are not occurring. The economic climate is not that much better: Unemployment is almost in double digits, discretionary spending is almost zero, and banks are failing across the country. Many more institutions are conspicuously on life support.
Even solvent companies have downsized, giving space back to the market. Rising vacancies in most market segments across the nation are putting downward pressure on rents, squeezing property owners who are unable to cover their debt service. Owners should be in default and banks should be foreclosing.
At least that was the traditional process. Obviously other factors are at play in this “new normal” commercial real estate market. Determining what is happening with defaulted properties and how it is affecting the real estate market in general may give some insight into the opportunities that will be available in the next 18 to 24 months. This article attempts to define the shadow inventory that exists through broad analysis as applied to commercial mortgage-backed securities statistics.
Defining the Shadow InventoryTo find the answer to the lack of foreclosures, we must rewind time to Oct. 30, 2009. The bank regulators have just issued “Guidance to Prudent Loan Workouts,” allowing lenders to classify commercial real estate loans in technical default as performing and thus avoid foreclosure. This came to be known as “kicking the can down the road” or “extend and pretend.” The purpose was to allow banks to return to solvency and strengthen their balance sheets before being required to “dump” these assets and absorb large losses, thus shifting the wealth to the private-sector investors.
An unintended consequence of the loan workout guidance was the creation of a shadow inventory in the commercial real estate market: property that should be on the market but is withheld due to loan workouts and is thus perpetuating a large bid-ask spread.
Figure 1 shows the workout strategies for delinquent CMBS loans. Adding up the loans that are in modified, resolved, or other categories (we assume they are not going to market) indicates approximately 66 percent of delinquent loans are not making it to market. This is our shadow inventory.
Figure 2 shows CMBS delinquencies by category. Of special note is the 90+ day delinquency, which has seen a hefty rise over the past 12 months; most notably in January 2010, when it spiked at more than a 43 percent increase month over month. This comes as no surprise: Loans entering 30-day delinquencies, which would have otherwise been foreclosed, now make their way to the 90+ delinquency category because of the new guidance.
As the government’s policy took effect, increases in the 90+ category normalized and has hovered around a 2 percent monthly increase since January 2010. While foreclosures have been increasing, real estate-owned inventory has remained relatively flat, suggesting many loans are worked out during the foreclosure process. The large delinquent categories (30/60/90+) also indicate the shadow inventory, and Figure 2 shows it is growing faster than the actual inventory is allowed to clear the market through conventional sales methods.
The Effect on Market PricingThe unpaid balance of the commercial real estate mortgage market is estimated at approximately $3.5 trillion. Currently, the total unpaid balance of the CMBS market is approximately $773 billion, or about 22 percent of the total commercial real estate mortgage market. (Assume that the market value is the unpaid balance.) Of this, the delinquency rate is about 8 percent, translating to an unpaid CMBS delinquent balance of $61.8 billion. Apply the extended modification number of 66 percent and we are left with $40.8 billion in loans as CMBS shadow inventory (roughly 5.3 percent of the CMBS universe). If we assume this data is consistent with the market at large, when applied, we arrive at a shadow inventory of $184.8 billion.
This has a profound effect on market pricing. The CMBS market has experienced liquidated loan loss severities of about 51 percent, according to the Realpoint Delinquency Report. When applied to the entire commercial real estate mortgage market, the new unpaid balance is approximately $1.7 trillion and, as a result of the denominator effect, the shadow inventory is now 10.8 percent. Figure 3 shows the effects of the loss severities on the commercial market value in the aggregate. If we assume all borrowers borrowed at a 75 percent loan to value, the total market value for commercial property would be $4.6 trillion. When loss severities of 51 percent are applied, we see a 63.3 percent decrease in the total commercial market value. The shadow inventory has been priced into this process, within the loss severity number.
If we remove the 10.8 percent from this pricing equation, thereby eliminating the shadow inventory, the loss severity drops to just above 40 percent. At a 75 percent LTV, the percentage change decreases to 55.3 percent.
What this analysis has not taken into account is the principal paid down by owners, which is less prevalent for the 2005–2007 loan vintages but more of a factor for the 2000–2004 vintages. Therefore, the percentage changes in commercial real estate value with or without the shadow inventory will be overstated. It is impossible to gather accurate data as to how much principal has been paid down on loans while most equity positions are being severely eroded.
With or without the shadow inventory in the calculation, the decrease in commercial real estate values indicates a bid-ask spread in excess of 40 percent, consistent with what we are seeing in the market. The spread is perpetuated in both property value declines and, further, the shadow inventory. The shadow inventory will continue to increase, as another $1.2 trillion in loans are set to mature in the next few years. This will drag down bid prices until financial institutions are solvent enough to absorb the requisite losses.
If history is to repeat itself, as it has in all previous cycles, the market eventually will find a price at which actual inventory will clear. We are seeing an increase in foreclosure activity — though a less-marked increase in REO properties. This suggests lenders are posting property for foreclosure as an intimidation tactic and are still choosing a workout rather than foreclosure. In addition, many states’ required foreclosure procedures would dissuade lenders from foreclosing.
What Are the Opportunities?When the proverbial floodgates finally open, opportunities for well-capitalized investors and investment firms, with strong banking relationships, will permeate the market. Thus, the favorable redistribution of wealth may occur, at least initially to the institution’s favored depositors and directors. A saner, truer value-oriented, reality-priced market can be addressed by the well-educated brokerage community.
However, where will the product be? A large percentage will be held by special servicers with little incentive to liquidate. Individual investors and small funds will see very few, if any, well-priced, sound investment opportunities. Where will they go?
To find out, we looked at the special servicers and their parent capital. The majority of the special servicers are in poor financial condition, as they have been in first-loss positions on many CMBS deals that are now toxic, making them prime targets for takeover by large investment funds and investment banks. We already have seen a round of special servicer mergers and acquisitions: Island Capital Group purchased Centerline Holding Co.’s servicing, and Berkshire Hathaway and Luecadia National Corp. acquired Capmark Financial Group servicing, creating Berkadia Commercial Mortgage. LNR Property Corp., owned by Cerebrus Capital Management, is in the process of recapitalizing some $1.7 trillion in debt from Goldman Sachs and Bank of America. Orix Capital Markets has a real estate investing wing as well, providing sound financial backing to its special servicing arm.
This creates opportunity when assets are released by the servicers. The best will be given as priority to the investment banks and capital funds who own the servicers and their clients.
Furthermore, they will be sold in portfolio volume. This is great for the market as the property will clear faster and reasonable pricing will allow transactions to resume. Unfortunately, for smaller funds and individual investors, the best deals will be gone and they will continue to find the poorly priced, low-quality deals they are seeing today.
However, not all REO properties will lend themselves to bulk sales. This presents multiple opportunities for the smaller players. To be well positioned to take advantage of the coming 18 months, smaller players should establish and maintain relationships with as many lenders as possible. This is where the bulk of business will originate. To restore lending ratios, lenders will need to shed their portfolios of commercial mortgage notes and REO property, or seek substantial new capital, which, considering their current anemic condition, will be all but impossible.
These challenging deals will require hard work and creative analysis by the CCIM community. But, as we are learning, they will be salable and offer opportunity when the market is allowed to clear and some semblance of sane, non-artificial pricing returns. Institutional owners will possess a large number of non-core assets priced either below their minimum guidelines or of a non-performing use within those same guidelines. While such owners are adept with many valuable skills, marketing and selling such assets demands the skill of well-qualified brokers who most frequently can provide results far in excess of the seller’s ability and his cost to the process.
For brokers to succeed over the next few years, they must possess exceptional local demographic and product knowledge, complete competency in the capital markets, contracting and closing structures, and the ability to demonstrate their talents to the asset owners.
Figure 1: CMBS Loans by Workout StrategyBankruptcy 2%
Deed in Lieu 2%
Note Sale 1%
Source: Investcap Advisors
Figure 3: LTV Assumptions$ trillions
|Market LTV||CRE unpaid balance||CRE value||Loss severity||Adjusted debt value||% change in CRE value|
Figure 4: Loan to Value Assumptions Without Shadow Inventory$ trillions
|Market LTV||CRE unpaid balance||CRE value||Loss severity||Adjusted debt value||% change in CRE value|
published by CCIM
by Rowan Sbaiti and Robert Grunnah, CCIM