Hedging Their Bets

Eager investors are eyeing the next three years with anticipation, but if they reach out to grab the falling knife at the wrong time, they may get cut.

As the industry enters 2010, the question is: When will all of those distressed assets emerge from limbo? Better yet, when will the peak of opportunity (or the pit of despair, depending on your point of view) reach its zenith?

“You can’t time an absolute bottom, and people who try are going to miss the opportunities,” says Dan Fasulo, managing director of New York-based Real Capital Analytics. “We’re still in the early innings of the distress cycle—a lot of opportunity-focused investors will be disappointed.”

For the past year, several factors have kept the floodgates of distress closed—from the availability of capital from government institutions to the “extend-and-pretend” dynamic that has dominated lender activity. “The issue right now is one of valuation. There are a lot of properties that continue to cash flow, but if you value it today, there would be a substantial discount,” says Craig Butchenhart, president of Minneapolis-based Northmarq Capital. “As long as a property continues to cash flow, the lenders will extend a year or two and hope that things get better.”

But that practice is ending. Several investors believe that the peak of opportunity is right around the corner. It’s just a question of simple math, they say. Five-year, aggressively underwritten CMBS loans done at the height of the market—from 2005 to 2007—should come due starting in 2010. “The next three years are going to be great,” says Eric Silverman, managing director of Boston-based equity investor Eastham Capital, which is raising a $50 million opportunity fund. “The loans coming due in 2010 and 2011 will have difficulty refinancing and will have to re-trade.”

A Different Floodgate

Where will all of these maturing CMBS deals find refinancing capital? Fannie Mae and Freddie Mac obviously continue to be active lenders in the space, but they’re generally only doing 70 percent LTV loans on higher-quality deals. And regional banks aren’t big on nonrecourse long-term loans. “Ultimately, there isn’t enough regional bank capacity to bail those guys out,” says Mike Kelly, president and co-founder of Greenwood Village, Colo.-based Caldera Asset Management. “If you look at the maturity schedules, there’s only so much time that people can delay the inevitable.”

Indeed, these are boom times for special servicers. Like many of its brethren, CWCapital Asset Management has been inundated with business—its portfolio of assets grew from $3 billion a year ago to $11 billion now. The division hired more than 40 people in the first half of 2009, a nearly 50 percent increase in staff, mostly in the distressed debt and REO groups. “I haven’t seen any kind of financing source enter the market on a broad basis,” says Brian Hanson, managing director of Washington D.C.-based CWCapital.

But just as lenders are extending loans based on sunny projections, many special servicers are now opting to asset-manage their way through the downturn, trying to stabilize or increase the NOI of an REO and wait a couple of years before selling. “I don’t think the wave is coming. I don’t believe that the maturity defaults are nearly as scary as we thought six months ago,” says David Rifkind, principal and managing director of Los Angeles-based George Smith Partners. “If the fundamentals and underwriting are there, extensions are granted fairly easily. The headlines we saw six months ago about the maturity tsunami—that’s all bullshit.”

Rifkind’s firm offers a lender services group, which advises lenders on maximizing the value of their distressed assets. And based on what he’s seen, the majority of lender sales are going to be driven by measured strategic decisions, not the panic dumping that opportunity funds assumed would occur. The quality assets will generate serious bids at a pretty high level, he says.

Sandy Pockets

Not all markets are created equal, though. Caldera’s Kelly points to the large number of units that recently came online in some markets as further proof that a wave of distress is coming. Consider Phoenix, where builders delivered about 5,000 units in 2009, adding 2 percent to the existing stock. That doesn’t bode well for a market that ended 2009 with a vacancy rate above 12 percent, according to Encino, Calif.-based Marcus & Milli-chap. “From a global view, the supply-and-demand balance of the apartment market looks good,” Kelly says. “But it’s all about submarkets: You start going down from 30,000 feet, and it’s a different story.”

In hard-hit states such as Florida, there’s no denying that more distress deals will take place in 2010. More than half of the deals that NAI Tampa Bay has processed since the beginning of 2009 have been distressed, a trend they see increasing this year. “The servicing industry is so overwhelmed right now that we’re seeing a dramatic slowdown in the pace of transactions,” says T. Sean Lance, president of the Troubled Asset Optimization group of NAI Tampa Bay. “But the banks are starting to get comfortable with where some of the values lie, and they’ll start disposing. The drip might turn into a faster drip, but it’s not going to be the tidal wave everyone is talking about.”

Big Fish in a Small Pool

The size of deals currently at play has also changed. The vast majority of the distressed acquisitions closed in 2009 were smaller (less than $20 million), but larger deals emerged in the fourth quarter. For instance, Apartment Realty Advisors (ARA) marketed an ING portfolio of 10 assets located mostly in Texas and received more than 200 offers on it. The assets were mostly Class B- and C-quality. “We are seeing people coming off the sidelines who were quiet six months ago; there’s been a real change in the number of offers we get on transactions now,” says Debbie Corson, who heads ARA’s Distressed Asset Solution Group. “These larger guys with equity are really coming out of the woodwork.”

Opportunity funds that hoarded cash for much of 2009 are starting to realize that the discounts won’t be as jaw dropping as they once believed and are starting to engage the market. Addison, Texas-based Behringer Harvard has been the most active buyer, closing deals in the $80 million to $90 million range. Chicago-based Equity Residential has also been active, recently paying $100 million for a 326-unit property in Arlington, Va. These acquisitions signal that it’s not just older assets that are hitting the distress auction block—larger deals constructed in the past 10 years are also at play, many of which have solid occupancy rates.

NAI Tampa Bay marketed a Class A REO asset of less than 100 units recently and received several full-price offers. “Six months ago, it wouldn’t have been the case, but now, people are starting to realize they’re missing the boat,” Lance says. “They’re willing to pay a little premium now as opposed to having to compete for deals when prices go up.”

The 12-property Bethany portfolio deal in Phoenix attracted 50-plus offers, though deals of that size were few and far between at the end of 2009. “There are only a handful of deals out there that the entire buying community looked at, so it’s sort of an artificial feeding frenzy,” Kelly says. “There’s not a giant, deep bench of qualified buyers. You’ve got a couple of REITs and a handful of high-net worth guys who can close deals.” [For more on the competition today, see “Playing the Field” on page 46.]

The distressed assets Caldera sees generally fit into two categories. The majority are Class C assets, but on the flip side is a growing number of construction loans going south. “We know the quality assets are there; it just takes time for them to come through the snake,” Kelly says. “It’s like what happened in ’07 and ’08 when it took so long for single-family homes to roll through the foreclosure process.”

RTC Redux?

When the Great Recession began, many expected a second coming of the Resolution Trust Corp., the government program of the 1990s that sold off troubled properties after the Savings & Loan scandal. Back then, the pace of dispositions was swift and orderly. But this cycle won’t behave like the last one. Why? For one, the assets of 20 years ago were facing severely overbuilt markets. Throughout the 1980s, developers delivered about 4 percent of the existing apartment stock annually. But from 2000 to 2009, only 1 percent of existing stock came online annually, according to Marcus & Millichap.

Today’s culprit is unemployment. “This is not caused by overbuilding; it’s not a problem with the industry. As the economy strengthens, then the problems will go away rather quickly,” says Linwood Thompson, managing director of Marcus & Millichap.

Another major difference is the owners themselves: In the late ’80s, the industry was fragmented, with more smaller owners. Today, a larger percentage of units are owned by well-capitalized firms.

And the type of loans backing these properties is different today as well: 20 years ago, unwinding a balance-sheet loan was easy. CMBS-backed loans pose a more difficult knot to untangle. “It’s like taking a building down floor by floor,” Thompson says. “You’ve got a mezz lender, a CMBS loan with four stacks in it, some [of which] has been syndicated across 15 different investors. It’s more time consuming because nobody wants to get out of the way.”

Kicking the Can to 2012

By 2012, the multifamily sector should be in full recovery mode, but getting there is the hard part.

Most economists don’t see a return to significant job growth until the end of 2010. The 10-year Treasury rate is expected to rise in 2010, pushing up prices on fixed-rate debt. And rising concessions and vacancies will produce more negative NOI growth in most of 2010. “It’s going to be a slow, tough climb out of the recession,” Thompson says. “We’re still going to be bouncing around the bottom for another 12 to 18 months. But attitudes have already started to shift; people are less concerned about it getting substantially worse.”

Several factors complicate this forecast. Congress plans to debate the future of Fannie Mae and Freddie Mac in the spring, and any disruption in the flow of GSE funds could have serious ripple effects on the level of distress. “It’s a false sense of security that there’s an efficient market for multifamily,” Rifkind says. “How the GSEs operate going forward could upset the fragile efficiency of multifamily finance, which is holding the market together.”

One thing is certain: People are anxious on both sides of the coin—hungry investors on offense and struggling owners playing defense—to find a resolution. But when is anybody’s guess. — Jerry Ascierto

Stop the Bleeding

FDIC, IRS rules help industry ride out the storm.

The government has been busy. Last fall, the IRS announced a new rule allowing CMBS loans to be modified without massive tax implications. Around the same time, the FDIC clarified a rule that would allow banks to extend loans without requiring higher capital reserves. On the surface, the changes provide cover for assaulted owners, but finance experts say the impact of these rules is still unknown.

Both policies apply to performing loans that are hurt by either a weak local market or the lack of liquidity in the market. The FDIC’s policy clarification is also a signal that the government believes sunnier days are ahead and that waiting for the capital markets to pick up is a better bet than forcing foreclosures now.

“It was definitely a sigh of relief for the lending community,” says Dan Fasulo, managing director of New York-based Real Capital Analytics. “Just about every asset purchased over the last few years has broken loan-to-value (LTV) covenants, but it’s just a function of valuations falling.”

To some, the policy may prevent banks from originating more new loans. Like all lenders, banks recycle their cash: When loans get paid off, new loans are made with that capital. This FDIC policy, however, allows banks to tie up more of their capital into existing loans. “Their cash is just sitting there. The previous deals aren’t coming through the system, so banks don’t have the money to re-lend back into the system,” says Mike Kelly, president and co-founder of Greenwood Village, Colo.-based Caldera Asset Management.

The IRS’ new rule, meanwhile, allows servicers to modify and restructure securitized loans before they slip into default, all without incurring tax penalties. In the past, borrowers could only negotiate modifications once loans were transferred to a special servicer. But that was a catch-22: By waiting until default, it was already too late for a workout.

The rule doesn’t change how master servicers determine which loans can be modified, however. That information exists in contracts. “The servicing documents still rule,” says Brian Hanson, managing director of Washington, D.C.-based special servicer CWCapital Asset Management. “So it’s not an automatic wave into special servicing when [there are] issues.’” — Jerry Ascierto