Betting On Troubled Assets
CCIMs share creative strategies for playing in this high-risk market.
Today’s $108 billion of distressed commercial real estate reported by Real Capital Analytics has created an opening for risk-takers of all sizes. Weak properties are prime targets for small to midsize investor-owners who have enough cash and market savvy to know when to roll the dice. Meanwhile, larger vulture capital funds circle the action, waiting patiently to pick up troubled assets at deep discounts. For these and other players, the jackpot is growing: Commercial loan delinquencies reached 4.5 percent and construction loans topped out at 17.1 percent in 2Q09, according to Foresight Analytics, an Oakland, Calif.-based commercial real estate research group.
Before playing the odds, investors must think strategically about the risks and rewards associated with this high-stakes market. Therein lies the challenge: “Each [distressed] transaction has its own strategy that needs to be unveiled,” says Beau Beery, CCIM, director of commercial brokerage and asset management for AMJ of Gainesville, Fla. “It is up to us as investors to discover what that strategy is.”
Though setting your sights on distressed properties may seem like betting against the house, CCIMs are uncovering successful strategies for working with troubled assets. From understanding the distressed property buyer pool to examining regional disposition trends to tailoring creative financing sources for these deals, CCIMs have identified proven methods for winning a share of the troubled asset market.
Who’s at the Table?
Understanding the buyer pool for today’s distressed assets is the first step to working in this complex market. CCIMs primarily see two types of purchasers seeking troubled properties. “On the one hand, you have opportunistic buyers that have put together funds just for this purpose and are looking at properties on a short-term basis. Their goal is to fix up and resell for a profit,” says Matthew K. Harding, CCIM, president of Levin Management Corp. in Plainfield, N.J. “On the other hand, longer-term owners are looking to increase the size of their portfolios. They know the market well, can see beyond the current level of distress, and envision the future value in property for a longer-term hold.”
A new breed of distressed-asset investors, frequently referred to as vulture capitalists, has emerged in the past 12 months. These cash-rich buyers are pooling funds to pick up troubled commercial real estate assets at bargain prices. “They are about the only ones with enough cash and no immediate expectation of financing being available soon,” says Ron L. Opfer, CCIM, director of commercial assets for CBPR Asset Solutions Services, a division of Coldwell Banker Commercial in Las Vegas that assists banks with distressed assets. “That is why they underwrite with a high internal rate of return. They are stepping up and taking a huge risk. They are entitled to a return that reflects that risk.”
Fledgling vulture funds such as San Diego-based Cypress Realty Advisors LLC are positioning themselves to pounce on assets when the market hits bottom. “Look at anybody who purchased commercial real estate in the last three years. They’re upside down,” said Mark Wayne, fund co-founder and former Cushman & Wakefield broker in a San Diego Union-Tribune interview. “Their equity has evaporated, their occupancy has evaporated, and their debt is maturing.”
While Cypress reportedly has commitments from well-capitalized investors to snap up distressed Southern California office properties in the $5 million to $20 million range, the ideal timing for these vulture funds to swoop in is still anyone’s guess. Federal government initiatives to free up credit and fortify banks may blunt opportunities for these investors. These and other economic factors will affect the bounty vulture funds may find in the months ahead.
Owner-users are the other primary buyers in the distressed market right now. “Owner-users have been doing either all-cash deals and/or Small Business Administration deals, which are still available at attractive rates,” says Michael W. Strode, CCIM, with Lee & Associates in Murrieta, Calif. “Pricing these has been a function of using the market rents as the debt service payment and working backward to arrive at a price. Because market rents have been so depressed, evaluating these income-producing assets has become a function of how long the asset will be held and what stabilized rental rates will be over that period. Capitalization rates are all over the board depending upon location, asset type, and property condition.”
Educating owner-users on how and what to buy in the distressed market is critical. Owner-users “look at the value of a property
differently than an investor, but they still want the same screaming deal,” Opfer says. He’s arming them with resources they can rely on to buy defaulted notes from banks. “If they can purchase a note in default before it is foreclosed, they can arrive at a fantastic real estate opportunity,” he says. “They can still get owner financing and they represent a larger audience of potential buyers in some asset classifications and price ranges,” he says.
Retail users are buying some of the distressed assets in markets such as Fort Myers, Fla. Frank A. Szelest Jr., CCIM, general manager of Re/Max Realty Group in Fort Myers has seen the most activity with properties priced below $1 million. Since financing is so hard to obtain, these small deals “have a better chance of being purchased for cash,” Szelest says.
Understanding Sellers’ Perceptions
The discrepancy between distressed sellers’ perceptions of their properties’ value and potential purchasers’ offers remains a major stumbling block to completing deals. “Many lenders are using appraisals that are obsolete the day they are submitted,” Strode says, underscoring the rapidity of market fluctuations. But lenders also are struggling to accept the value declines. “Many banks are unwilling or unable to write down to pricing that will get the asset sold in a reasonable amount of time. Huge discounts are being requested by income property buyers to account for all of the uncertainty in the market,” he adds.
However, in some markets such as Florida, “the difference between prices and values is starting to get closer and by year-end will become more parallel,” Beery says. “We are still seeing assets priced on a cap rate of what the income could be, instead of what it actually is. We hate to see this [at all], but it isn’t happening as much as it used to.”
But in Nevada, the price/value disconnect is still sizable. Buyers who have cash in their pockets continue to believe cash is king, says Garry Cuff, CCIM, senior director of multifamily investments for Commerce CRG/Cushman & Wakefield Alliance in Las Vegas. “They want to make sure they are getting the best bargain possible in exchange for parting with their liquidity.”
The root of the problem is that distressed property owners remain focused on past performance, while buyers concentrate on future values, Opfer contends. “Distressed property owners believe the cap rates have barely increased, when in reality, investors are applying double-digit cap rates.” For example, if a distressed retail property’s vacancy is 12 percent and the market rents are $21 per square foot per year, “the investor is going to underwrite with a 15 percent to 18 percent vacancy and market rents between $15 and $18 psf per year,” he says.
The 6 percent to 7 percent cap rates of the past didn’t truly reflect the risk associated with the real estate, Opfer says. “Cap rates of the past looked like a guaranteed annuity, when in fact real estate ownership has a lot of risks and few guarantees.”
Over time lenders will have to acknowledge the property value losses experienced in market, says Robert E. Lee, CCIM, managing director of SIG Equity Partners LLC in Manhattan Beach, Calif. “Most lenders have not yet accepted the reality of the ever-increasing drop in asset values due to the continued weakening of the economy. There will be deals to be had down the road as loans mature and there are no avenues for refinancing without a write down in value.”
Seeking Out Deals
Though distressed assets are plaguing all commercial real estate sectors, CCIMs are seeing the most direct-investment activity in retail, with multifamily and residential condominium projects moving as well.
New retail construction with high loan-to-value ratios is vulnerable, Harding says. “Big-box stores in the 30,000- to 40,000-sf range are often delivered to the tenant on a turnkey basis, and while that may command a higher rent, it also reflects a larger investment by the landlord.” Highly leveraged properties provide a smaller margin for error if one or more tenants file for bankruptcy and reject a lease. “And those stores are particularly difficult to fill these days,” he adds.
The service commercial sector, including retail showroom users, has been “decimated” in Southern California, Strode says. The economy’s grip on consumers who purchase items sold in these stores is very tight, virtually drying up this retail segment. Strode believes retail overall will see the largest share of distressed activity, “especially unanchored centers and restaurants.”
Distressed-retail investors would be wise to assume the market will get worse before it gets better. “Underwrite in a way that accounts for a further slide in values and a long discounted ramp-up period,” Opfer says. “Most pro formas have stabilization built in within three or four years.”
Multifamily assets are experiencing a fair amount of distress because they were the most aggressively underwritten and often acquired at the market’s peak by small buyers, says Andrew A. Heldman, CCIM, of Heldman Real Estate Brokerage in Cincinnati. In his estimation, the Midwest and Florida have led the way in distressed sales. “For the past year, I have been putting 90 percent of my time into distressed properties,” Heldman says.
The struggling condo and apartment sectors are yielding some attractive deals right now in markets such as Nevada, California, and Arizona, Lee says. In some instances, apartment properties that were trading at $80,000 to $120,000 per unit one to two years ago are going to the block at $30,000 to $50,000 per unit. “We are working on a deal right now for a small 30-unit building in the Los Angeles market that would have sold at $110,000 per door a year ago. Now we are getting it at around $42,000 per door for our investor group,” he says.
Financing and Creative Structures
Sources of financing for distressed assets are a mixed bag in today’s market. Opportunities to fund deals vary greatly depending on the region, property type, and parties in a deal. “Each transaction is likely to be an experiment, depending on who the various players are and how motivated they are to extract themselves from the property,” Cuff says.
While cash is the catalyst for many distressed transactions taking place right now, buyers and sellers who need leverage are investigating creative alternatives. For example, in August, TCM Development, a California-based SBA loan servicer, closed a $10.5 million financing deal for a borrower who met the SBA’s Energy Efficiency Public Policy Goals criteria. To secure the funds for a 132,000-sf building, the borrower, Service West, an East Bay, Calif.-based furniture installation, warehouse, and moving company, must reduce energy consumption by at least 10 percent or generate renewable energy or fuels. This specific program offers financing of up to $4 million on the SBA portion of 504 loans, as opposed to the $2 million standard maximum.
Seller financing is another avenue for buyers and sellers who wish to strike deals. Terrence P. Coyne, CCIM, senior vice president with Grubb & Ellis in Cleveland, says that seller financing is prevalent in most of the deals he is working on right now, “but the sellers are worried about having to foreclose,” he says. To counter these client concerns, Coyne is structuring land contracts in which the seller avoids giving a tenant the property’s deed and thereby protects its interest in the event of foreclosure. “I have also sold land contracts to buyers who are purchasing seller-financed notes,” Coyne says. In these transactions, “the seller takes a discount to the loan amount, but gets liquidity and gets out of the deal.”
Nat Santoro, CCIM, director of Kinlin Grover GMAC Real Estate in Orleans, Mass., has found a strategy that works so well in his market that he’s writing a book to explain the different ways to structure “lease purchase option” transactions. In these deals, a seller turns a property over to a buyer as if he had sold it to the buyer. The buyer takes on all responsibilities of ownership and puts down a nonrefundable deposit to fix the price for when deal closes later. “This is a pure net lease with payments that are the equivalent of an interest-only loan, giving the seller many options to structure the transaction in a way that satisfies both parties,” he says.
Though large, traditional financing sources maintain a tight grip on their funds, CCIMs are using their networks and solid reputations to complete deals in many regions. “We are using local banks that can make local, logical decisions,” Beery says. “Local banks know our company’s history and our potential to pay them back. Lenders just want to know how and when they will get paid back and whether the deal makes sense.”
Skill Sets for Stressed Assets
Though a one-size-fits-all approach can’t be applied to distressed real estate transactions, many CCIMs feel they are armed with skill sets that give them an advantage. “There are more opportunities for CCIMs in this market than exist in better markets,” Santoro says. “The CCIM training allows us to create transactions that get many sellers out of their distressed properties with minimum losses and in most cases with profits, making it easy for the buyers to succeed in their new investments.”
Harding agrees. “It’s really about getting back to the fundamentals on these properties. A distressed property needs a lot of focus from both the property management and leasing perspectives.” With advanced training in financial and lease analysis, “CCIMs can help lenders and institutions stabilize assets they are taking back through leasing and property management techniques that improve value for an ultimate sale.”
Commercial Loan Delinquencies
Includes 30+ days past due and nonaccruals
1Q07, 1.2 %
Source: Federal Deposit Insurance Corp., Foresight Analytics
Sector, $ in billions
Development sites, $8.3
Source: Real Capital Analytics, August 2009
Distressed Asset Regional Snapshot
Through Aug. 1, 2009
Region, $ volume in billions, Number of properties
West, $32.9, 1,502
Southeast, $24.5, 1,498
Northeast, $17.1, 595
Southwest, $16.7, 1,087
Midwest, $14.3, 963
Mid-Atlantic, $8.3, 341
Source: Real Capital Analytics, August 2009