As CRE Loan Stress
Peaks, Debt Investment and Modification Strategies Change
CRE Loan Delinquencies Leveling While
Severity Remains High Changing the Nature of Workouts and Deals
June 15, 2011
The level of commercial real estate loan distress appears to be at or
nearing its peak – a welcome sign that the worst of the Great Recession may have
passed. And with this new phase, the market for distressed commercial real
estate borrowers and investors is also undergoing major changes.
Statistically, at any given point in time at least, the Great Recession
has wreaked havoc on less than 10% of outstanding CRE debt to date. Overall
though, the percentage of damaged CRE debt has been higher when factoring in
outstanding loans that have been modified and reverted back from delinquent into
The overall distribution of the troubled loans has by no
means been even. For example, the overall CMBS delinquency rate remained
relatively flat in May at 9.2%, after reaching all-time highs in 20 of the
previous 25 months, according to CoStar Group.
Delinquency rates for
other groups peaked at levels lower than seen in the last major real estate
downturn during the early 1990s – some by large margins, according to the
Mortgage Bankers Association’s (MBA).
Between the fourth quarter of 2010
and first quarter of 2011, the 90+-day delinquency rate on loans held by
FDIC-insured banks and thrifts remained the same at 4.18%. The 60+-day
delinquency rate on loans held in life company portfolios decreased to 0.14%.
The 60+-day delinquency rate on multifamily loans held or insured by Fannie Mae
decreased to 0.64%. The 60+-day delinquency rate on multifamily loans held or
insured by Freddie Mac increased to 0.36%.
Together these groups hold
more than 86% of commercial/multifamily mortgage debt outstanding.
Still, the amount of CRE loan delinquencies represents hundreds of
billions of dollars in damage – hence value-add opportunities.
the delinquency numbers don’t take into account the level of severity among the
Tiandan Wu, a debt analyst with CoStar Group, and John
O’Callahan, a capital markets strategist for CoStar, recently looked at the
severity and timing of delinquencies. CoStar created a Delinquency Severity
Index (DSITM) to capture the spectrum of severity within overall delinquencies
and to provide a more meaningful indication of periodic change, such as whether
conditions are improving.
Although the rise in the delinquency rate
began to taper off in early 2010, the Delinquency Severity Index has not begun
to taper off until much more recently.
If the pace of resolutions and
liquidations increases in 2011, the Delinquency Severity Index could begin to
turn down later this year as the more highly weighted, longer-term delinquent
loans leaving the pool outweigh the newly delinquent additions, according to Wu
Year-to-date in 2011, new delinquencies totaled $12
billion with CoStar predicting total new delinquencies in 2011 of approximately
In another analysis CoStar debt strategist, Mark Fitzgerald
and Steve Miller, CoStar’s director of U.S. debt and risk research, examined the
“extend and pretend” strategies of troubled CMBS loan modifications.
Early in the recession cycle, special servicers relied almost
exclusively on maturity and interest-only (IO) term extensions for their loan
modifications. From first quarter of 2009 to the first quarter of 2010, more
than 93% of modifications utilized one (or both) of these techniques.
However, beginning in the second quarter of 2010, while the rapid ascent
in the overall number of modifications continued, principal and contract rate
reductions began to take up an increased share of modification activity, the two
“For the CRE industry, the increase in the number of ‘true
modifications,’ as opposed to simply extending the maturity or IO term of the
loan, is likely a welcome sign as it helps to speed along the deleveraging
process and assist distressed borrowers,” the two reported. “While loans
generally received term/IO extensions in 2009 and 2010, the treatment of those
same loans in today’s environment would likely be more varied – with many loans
finding a more receptive environment today than existed in the eye of the
“The ‘extend and pretend’ moniker, while true, did not really
measure the degree of ‘pretending,’ as the overwhelming majority of loans got
similar treatment. Now we see differential approaches,” the two reported.
“Despite the obvious opposition from many servicers and CMBS investors to
reductions in principal and/or rate, the realization that impairment is
permanent for many of these loans has led to increased ‘true modifications.’
Principal/rate reductions have increased despite the fact that the costs are
onerous and have actually increased slightly since 2009.”
Miller concluded that initial modifications were short-term solutions and
logical given the economic uncertainty and the relative confusion regarding
special servicers’ culpability and latitude in seeking solutions in the best
interests of all constituents.
“The market is now morphing into the next
phase, better distinguishing the winners, also-rans and outright losers. Loosely
translated: Winners, if needed, will likely get more time; also-rans will likely
get rate or principal reductions that should allow them to become creditworthy
loans again; and outright losers will be foreclosed and sold, or result in hefty
discounted payoffs,” Fitzgerald and Miller noted.
Just as the market is
morphing for borrowers, it is also morphing for debt investors, according to
accounting firm Ernst & Young.
In a report summarizing the results
of its 2011 Distressed Debt Investor Survey, Ernst & Young says the CRE debt
market has sprung to life but with a changing set of investors.
into the market for distressed real estate loans today and you’ll find two
categories of investors: those who have slowed or stopped their search for
investment opportunities and those who continue to actively pursue them,”
E&Y reported. “If they stay active in the game, investors are finding more
The slowdown in activity may result to some extent from a
pullback by some individual investors or groups of smaller investors that
typically pursue smaller deals in their local markets, E&Y noted. And some
investors may have decided there is too much competition for a relatively
limited supply of distressed loans coming on the market. Miller and Fitzgerald
of CoStar also note that some investors express concern over “deal fatigue” –
pursuing large pool of auctioned assets require substantial commitment of
resources that can be fruitless if they do not win the bid.
other investors including large real estate companies and institutional
investors continue to pursue buying opportunities, E&Y noted. More than
two-thirds of respondents to the latest survey reported that they have bought or
tried to buy loans.
The respondents to E&Y latest survey included
real estate investment and opportunity funds, private equity firms,
institutional investors, investment banks and real estate developers and other
“While some of these investors are less active in seeking to
buy distressed real estate loans, other investors are forging ahead. They have
stepped up their efforts to try to acquire distressed real estate loans from the
pool of loans that banks offer for sale,” E&Y said. “Investors expect
regional U.S. banks to be most active in selling loans this year, followed by
the U.S. government and money center banks.”
NAI Global in a corporate
blog published this week, also noted the increasing trend.
“As we round
[into] the third quarter of 2011, we are seeing that lenders are increasingly
willing to sell notes/assets to clear up their books. With the real estate
recovery under way, more sideline capital are chasing the few opportunities on
the market and the increased demand is prompting distressed debt owners to place
more of their inventory on the market,” the company said.
noted that LNR Partners and CIII Capital Partners are selling a tremendous
amount of product through a large auction now and the FDIC has another $700
million portfolio to be sold in the third quarter of 2011.
we are at the tipping point towards a more normalized market where new
originations will commence in early in 2012 reflecting normal CMBS output and
lending patterns similar to 2005 and 2006,” the company said. “Though 2012 will
see more distressed debt opportunities we see an overall slow down as the
economy and its recovery finally impacts real estate positively.”
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