Investment Analysis Distressed assets

Money Magnets

Today’s distressed assets attract well-capitalized investors.

Capital that is now on the sidelines is likely to return to the market as a floor on asset pricing emerges and values become attractive once again. However, while lending conditions are expected to remain tight during the next 12 to 24 months, industry experts are forecasting increased opportunities for commercial real estate investors to recapitalize distressed borrowers. Now may be the time to invest in maturity defaults, construction loans and bridge loans, mezzanine positions, and preferred equity stakes in properties.

Record Pace of Loan Maturities
During the next few years, distressed borrowers are expected to create persistent demand for refinancing capital. More than $814 billion of commercial real estate loans are set to mature this year through 2011. More than half of these mortgages were originated from 2004 to 2008 when real estate markets were particularly active.

Through 2011, refinancing of existing mortgages is expected to constitute 80 percent of loan originations. In 2009 alone, nearly $250 billion in combined commercial and multifamily mortgages will mature, representing an all-time high for the market thus far. However, as the commercial real estate asset class responds to pressure to deleverage, it must compete for increasingly expensive capital with the broader global financial system, which also is deleveraging.

Preferred Equity vs. Debt
Recapitalization opportunities can enable investors with cash — or ready access to it — to acquire large investment portfolios with preferred priority returns. Opportunity-style investors may take preferred equity stakes in high-quality properties that are performing well but need a capital infusion.

Unlike debt investments, preferred equity investments may benefit from capital appreciation as property values recover. Preferred equity investment opportunities are expected to be more plentiful than in the recent past, even in high-quality major-market assets, as long as property values remain soft and the loan-to-value ratios senior lenders offer remain low.

Whole Mortgages vs. Securitized Mortgages
Investors also should consider the significant risk differential between investing in whole mortgages and commercial mortgage-backed securities. Whole mortgage investors obtain full ownership and control of the mortgages, which gives them full decision-making authority.

In contrast, CMBS investors are buying only a securitized fraction of a bundle of loans, and portions of some may be securities within other CMBS arrangements. It may be difficult for investors to assess the quality and performance of the underlying real estate assets for all loans in the CMBS package.

Decision-making control over the mortgages also can be diffused among many investors. Unless there has been skillful and thorough analysis of the underlying loans and arrangements, real estate investment programs with limited CMBS exposure have a distinct advantage in today’s market.

Price Discounts and High Yields
In the current environment, investors also may identify unique opportunities to purchase first-lien mortgages at large discounts. These investments have the potential to represent a twist on tradition by providing opportunity-level total return that consists primarily of high current yield. Investing in these loans at currently available discounts also can provide the opportunity for capital gain in addition to current interest yield.

Senior debt investment opportunities aren’t new, but their attraction is compelling in today’s market. Senior debt acquisitions in distressed assets could enable skilled investors to acquire properties at significant discounts, perhaps as much as 50 percent to 60 percent of the original capital stack’s value. Because banks generally don’t want to become real estate operators, they can be motivated sellers. These properties often aren’t marketed for sale through traditional channels, which can lead to fewer competitive buyers and discounted property pricing.

Capital gains are possible if the market recovers and the loan can be sold later at a profit. A quality real estate operator also has the opportunity to wring value out of the mortgaged asset if the loan purchaser ultimately forecloses on the property.

But such endeavors aren’t for inexperienced or faint-of-heart investors. After purchasing a first mortgage from a senior lender, the buyer also may be required to negotiate with the seller as well as other mezzanine lenders and equity providers to complete a foreclosure. For this reason, senior debt investors with capital restructuring expertise, a commitment to in-depth due diligence, and superior relationship-management skills are more likely to succeed.

Investors Delay Pulling the Trigger
Potential investors must understand that the timing of their market re-entry is critical to their ultimate success. For now, low transaction volume continues to complicate the process for discovering property prices, and the market still lacks capital liquidity.

As for the fair-market price of real estate assets, a wide variance exists between potential buyers or lenders with capital to invest and sellers or those in need of capital infusion. The pricing mismatch is amplified by the market’s uncertainty. Many still are reluctant to invest directly in real estate while property prices appear to be falling.

Fund operators have been slow to push ahead with distressed debt purchases due to fears that the market hasn’t hit bottom and uncertainty about what the federal government may do to spur property sales, according to Real Estate Alert. If that forecast proves to be accurate, heightened transaction velocity should return when clarity is achieved on these and related issues.


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