Experts Agree: Commercial Real Estate Endures through Tough Times and is Poised to Grow

At a recent USC-sponsored conference featuring many of the top minds in the commercial real estate sector, the "end-of the-world" scenario predicted for the commercial sector was given last rites. Almost all were in agreement that all indicators reflecting the downward spiral in the sector are bottoming out and recovery is around the corner. This new recovery will be more measured, unlike the artificially-stimulated growth of the last bubble. Most feel that a new real estate “Peak” will be the norm around 2015.

As an improving economy led by job growth, affordable home prices and growing commercial opportunities opening in tertiary markets, the general consensus of the conference affirms the trends we’ve identified in the market – that new lending sources are opening up daily, the flow of credit is increasing and significant improvement is being made in making more loan products available to meet both residential and commercial demands.

2012 should also see a release of properties being held by both regional and large banks in the $10 billion and $50 billion in assets range. As the FDIC turns its scrutiny from the larger banks to smaller institutions, these banks recognize that to meet the minimum capital ratios required to pass stress tests they will either need to shed assets or set aside large reserves to cover potential losses on questionable assets. Asset disposition will be the preferred method over large loss reserves, and as a result of improving balance sheets, financial institutions are in better financial shape to sell assets at a discount. This means more properties will be coming to market but not to be dumped at fire-sale values. Larger private equity firms are fully-funded and are aggressively scouring the market for discount notes and assets.

Conference attendees also affirmed the potential for more activity in the acquisition and disposition of distressed notes. Over $350 billion in vintage 2007 commercial loan originations are expected to mature this year, and it’s projected that half of these notes will not be able to meet refinancing criteria and will be classified as distressed or non-performing assets. While this may constrain full market expansion, it presents some real opportunities to acquire commercial notes.

Commercial real estate investors are now finally experiencing an uptick in acquisition opportunities after several years of limited options. Investors generally expect the note market to remain active for another two to four years. In the next five years, close to $1 trillion of commercial loans will mature, putting additional pressure on US banks to step up efforts to shed more than $100 billion of non-performing loans currently on their books. They also cited the high number of construction, acquisition and development loans made by regional and local banks nationwide, now labeled as distressed. Two-thirds of potential loan purchasers last year completed their transactions. In the previous year, less than 50 percent were successful.

The Conference also highlighted some emerging trends that have the potential to hinder a robust recovery:

• The financial strength of municipalities and pension funds. Retirement obligations that are coming due will bankrupt many institutions that are already in trouble. Taxes, taxes and more taxes will be necessary thereby creating a recessionary impact.

• The loss of manufacturing jobs. This is a huge problem as is the outflow from California of these valuable jobs. Manufacturing jobs present one of few opportunities for disenfranchised groups to move out of a lower-income status into the middle class. As these jobs disappear, so will middle class productivity and wealth. A sobering statistic: 65% of U-Haul’s business in 2010 and 2011 was moves out of Southern California.

All in all, the tenor of the Conference was the over-whelming feeling that commercial real estate is working its way back; good news for all.

Foreclosure Settlement Falls Short

As published in the Los Angeles Business Journal, March 5, 2012:
 

The recent landmark foreclosure settlement between the nation’s five largest lenders and 49 states has certainly captured the headlines. After over a year of intense brinksmanship between the involved parties to mitigate bank liability while setting a realistic level of restitution to compensate victims of the robo-signing debacle, an agreement emerged.  The resulting accord may have minimal impact on the final wave of projected foreclosures still on the horizon, and won’t provide a meaningful boost to help real estate. At best, it’s a punitive solution for past abuses that will not be adequate to actually help the industry recover.

To be fair, any part of the settlement that provides relief for struggling borrowers can provide a stimulus to the market.  An estimated $18 billion of the $25 billion total settlement amount will go to California, with $3.92 billion of that earmarked for Los Angeles County.  Over 59,000 foreclosure filings occurred in Los Angeles County in 2011.  While awards up to $2,000 for borrowers wrongfully foreclosed on won’t bring back their homes, it at least provides some compensation to begin a fresh start. 

Recent estimates suggest that approximately a million borrowers in California alone who are currently underwater could be eligible for up to $20,000 in principal reductions thus making payments much more affordable.  An ancillary benefit to lower payments or any principal reduction on the senior deed could occur in situations where a 2^nd trust deed exists on properties and borrowers would be encouraged to stay current on payments giving life to lenders on the verge of being wiped out by foreclosure.  At first glance, this could appear as welcome news.

Deeper analysis reveals that the agreement falls short of addressing the 180,000+ REO inventory in Fannie and Freddie’s possession or the borrowers separated from these homes through the foreclosure process. Nor does it address the thousands of underwater mortgages held by the GSEs to which the GSEs are resistant to enact refinancing solutions.   Moreover, mortgage lenders now face a new wave refinancing applications generated by homeowners seeking to qualify under the new agreement. 

Borrower Backlog

One lender has already been quoted as citing processing times as long as 90 days for refinancing applications. Borrowers not qualified for refinancing under the new proposal could create such a backlog that eligible borrowers would be forced to wait. Or worse still, the market could see the return of higher interest rates to slow and manage the flow of mortgage applications.

Private capital has long been courted as the white knight to lead the recovery.  While prevailing sentiment would hardly characterize the private investor segment as a “victim,” the principal reductions proposed in the current agreement which would significantly affect investor returns, could result in the mass exodus of private capital from the market. Remember, too, that private capital is comprised not only of private equity firms and high-net-worth individuals, but also of insurance, pension and other institutional investors seeking maximum return for their beneficiaries.  Private investors provide a necessary back stop that if removed, may require more taxpayer and / or government intervention to fill the void.

While this $25 billion mortgage settlement plan gives genuine hope to many Angelenos to receive compensation or even lower monthly payments, it truly serves to provide regulators, lenders and government with a concrete example they can point to confirming that they took definitive action to restore economic equilibrium. There are some substantial cracks in the pavement, however, that will limit the true intent of the settlement in providing real help to the real estate market.

Consumers: The Missing Fundamental

"Market fundamentals" are often cited when evaluating the real estate industry. Indices measuring home values, cap rates valuing commercial properties, office vacancy "absorption rates," REO inventory, are great examples of accepted standards used by the industry to measure success. What's missing from this list is the influence consumers and small business have on core fundamentals, and they could arguably be the most critical component in driving the real estate recovery.

Let’s start by looking at the distressed homeowner segment as one example of how consumers are contributing to the recovery. Armed with more information and options than ever before, borrowers are confronting and no longer running from delinquencies. Their proactive efforts to modify loans, refinance underwater mortgages to lower rates, and accept a short sale as a foreclosure alternative are having a positive effect on containing non-performing assets held by lenders. At the other end of the spectrum, consumers with less debt and on more stable financial footing are feeling more confident in their ability to handle the obligations of a mortgage. Realtors, builders, and loan originators alike should soon see their numbers improve as more buyers are enticed into the market by low rates, more affordable homes and evidence of an improving economy.

Fundamentals in multi-family real estate are also improving thanks to the rise of the latest “renter nation,” a new generation of younger and more transient households not interested in the overhead of a mortgage. As a result of this new demand, developers and investors with positions in multi-family projects are seeing a much needed jump-start in apartment construction.

And finally, as more consumers get back to work, small business expands in pace with current economic growth, and construction of new office product is at a standstill, office vacancy rates will continue to contract and generate more healthy returns for owners / investors in the office and retail sectors.

The real question at this point is, as consumers and small business are in the drivers’ seat of the recovery, what can the industry and government policies do to ensure the recovery moves forward?

• Let’s start with government policy. Efforts should continue for crafting workouts for borrowers who could afford to keep their homes under loan-modified circumstances, and toward removing barriers for short sale or other foreclosure alternatives for homeowners who cannot afford to keep their homes.
• Realtors should better adapt to service a market heavily-influenced by distressed properties. Short sales and REO sales are projected to dominate the market through 2012. Major stumbling blocks in 2011 were protracted short sale negotiations and pervasive litigation. As expertise is required, realtors should partner with specialists familiar with the unique lender-buyer-seller process to facilitate more efficient, litigation-free sales.
• Investors and developers have an opportunity to step up to meet the growing demand for affordable rentals through new multi-family projects, and by participating with GSEs in bulk REO purchases and converting them to rentals to meet the demand for affordable housing and limiting the “for sale” inventory.
• Lenders need to step up the most. Without the flow of credit, the system simply stops working. Lenders must not only be a reliable source of capital for the investor class, they need to loosen restrictions for consumers as well. Easing restrictions and making loans more accessible and financially-viable to today’s new class of buyers and business owners who understand the responsibilities required of long-term credit commitments, is the glue that will make this recovery stick and move forward.

So goes the consumer and small business, so goes a recovery in real estate. This “fundamental” concept cannot be ignored.

Real Estate Recovery: The Race is On

Real Estate’s journey in 2011 has been a wild ride based on the criteria many use to measure success. Optimistic expectations at the beginning of the year have not produced sustainable returns at year’s end. Or have they? The saga of the real estate recovery in 2011 seems to enact the familiar fable of the tortoise and the hare. Which approach would be the most accurate in characterizing the sector’s performance --- an aggressive approach seeking tangible, quick returns or a more measured approach whose success is measured by long-term results? While the inclination may be for instant gratification, perhaps a “slow and steady” perspective provides the best evaluation of how well real estate has performed this year and where it’s headed in 2012.

2011 started, and the race was on, driven by hopes of a much better year than 2010. In some instances, optimism had merit. There was a general, shared sentiment that the economy, overall, would rebound, creating jobs and a stronger environment for small business to begin to grow again. High-profile commercial property acquisitions and note purchases driving up the values of assets in key urban markets captured the real estate headlines. Businesses felt confident enough to expand into new square footage, while both existing households and newly-forming “echo boomer” households valued renting over ownership which drove down vacancy rates in both office and multifamily sectors resulting in steady revenues for commercial investors.

The average consumer had reason to be optimistic as well, as seemingly negative economic influencers created new opportunities. The deluge of foreclosed homes on the market (which drove sale prices down), combined with political and financial volatility abroad drove fixed mortgage rates tied to Treasury yields to record low levels affording consumers with new buying power not seen in years. Even distressed borrowers had reason for optimism as the government promoted a dizzying number of “Home Affordable” programs; and lenders, under the scrutiny of regulators, slow-tracked foreclosure filings due to processing improprieties like robo-signing.

But along the way in 2011, the hope for a brisk recovery took a cat nap, as evidenced by the following:
• Threat of a “double-dip” recession reflected by anemic GDP growth and stubborn unemployment
• Scarcity of commercial deals in top markets accompanied by a stall in the ascent of commercial asset values
• Homeowners unable to qualify for historically-low mortgage rates to purchase bargain-priced homes
• Decline in equity in non-distressed home values as a result of a market flooded with distressed properties
• Less Americans seeing the long-term value of owning a home versus renting
• Lenders, now confident about their back-office procedures, filing foreclosures at a stepped-up pace starting in the 3rd quarter 2011
• Extremely tight guidelines for loan qualification

Those seeking signs of a speedy housing recovery could point to the above as proof that 2011 was a year the industry should forget. However, the following represents just a few of the areas quietly developing this year to support the notion that real estate is showing signs of improvement:
• Commercial opportunities emerging in “out-of-market” areas (suburban or “B” class office assets)
• New construction to meet demand (unexpected demand for rentals and short supply sparked new construction in the multifamily arena)
• All-cash investors sustaining the market (all-cash investors accounted for up to 31% of all purchases in 2011, filling the vacuum created by the absence of first-time buyers)
• Surge in loan modifications, short-sales as an alternative to foreclosure (over 5 million approved as of the third quarter 2011 involving both interest and principal reductions to keep borrowers in their homes )
• Non-distressed home values appear to be stabilizing in many markets

But perhaps the most important evidence of a recovery can be seen in the segment most affected by the housing crisis: the consumer. As noted before, more borrowers are taking advantage of modifications and short sales to avoid being a foreclosure statistic. Additionally, consumer debt and delinquency levels in mortgage and in all other credit products dropped significantly in 2011. Compared to the consumers during the housing boom of the last decade, today’s consumers are significantly better-educated in managing debt and knowing the consequences. A key component is the accountability of appraisers deciding true values based on the reality on the street and not on the number needed to complete a loan.

When credit conditions make home ownership a viable option again, these consumers will be ready to jump-start a new phase of responsible home purchases from a stable credit footing. And what benefits the average borrower in the future will also benefit the smart investor who is ready to leverage opportunities in a new cycle of real estate growth.

The race isn’t over for real estate. Fundamental gains took place in 2011 that will bear substantial fruit in the years to come for investors and consumers alike. “Slow and steady” wins every time.

Private Equity and Commercial Notes Strike the Right Chord

Commercial note trading is big business these days, with motivated parties on both sides. Recently, Bank of America agreed to sell a commercial note package valued at approximately $880 million to an institutional investor / hedge fund JV partnership at a discount rumored to be as high as 25% off the original pool value. The note pool was comprised of performing as well as
non-performing assets. On a smaller scale, private equity firms nationwide have also enjoyed healthy returns of lucrative note acquisitions. This segment has great potential for sophisticated investors if partnered with the right private equity firm.

While commercial banks clearly control a substantial segment of available note inventory, smaller equity firms are quietly carving out a successful niche in the note sector with the goal being acquisition of distressed assets. As the pool of desirable commercial assets available for outright acquisition diminishes, investors have turned to distressed note purchases. Institutions holding problem mortgages are extremely motivated to sell distressed notes through discounted sales rather than foreclose and dispose of these assets on the open market at an even greater loss. Unfortunately, due to the inherent complexity of the typical commercial loan deal involving not only the borrower, but also multiple financing instruments used to complete the purchase, along with the fact that lenders don’t openly promote these offerings; it requires an experienced private equity shop with an ear to the pavement to ferret out and negotiate these opportunities. The issues relating to compliance, guarantees, bankruptcy among others are paramount for determining the success of such acquisitions.

One of the greatest strengths private equity firms bring to the table is their willingness to explore a workout solution for existing borrowers in an effort to achieve sustainable returns in the long run. In instances where the borrower is also owner / tenant of the commercial property, the borrower has a vested interest in the property and will be extremely motivated to continue to manage and maintain the property. If a workout is not feasible, private equity firms can often craft an exit strategy that works for all parties. Private equity firms have the flexibility to find ways of making the borrower a part of the overall solution in ways that institutional lenders cannot. This flexibility provides private equity firms with the option to nurture a non-performing note to “performing” and maintain the asset as a revenue source until the market price is right to sell it.

There’s an abundance of capital poised to invest in commercial real estate these days. It’s projected that 2012 and 2013 may prove to be milestone years for commercial investors as 2002 and 2007 vintage commercial notes reach maturity, and short term loan extensions negotiated for some commercial borrowers during the mortgage meltdown come due. It’s our belief that as the availability of profitable commercial assets in top markets become increasingly rare to find, the availability of distressed notes will rise to meet the demand. Investors partnering with the smaller private equity firms not only avail themselves of access to available deals but also to the opportunity of long term gains through restructuring the lending terms with existing borrowers. As a result, these firms create a healthy environment in the commercial market that benefits its investor base as well as provides much needed relief to distressed borrowers in need of alternative financing solutions their lenders can’t offer.

Cautious Optimism for Market Recovery

The country has gone from one extreme — lax oversight in financing — to the other, making it nearly impossible for potential homeowners to qualify for loans and purchase property resulting in a large inventory of homes and unstable markets. It’s now up to the banks. The only way for the residential real estate market in the U.S. to recover is for the banks to return to more flexible lending processes. At the commercial level, however, deals are taking place as pent-up cash rushes to well-priced real estate.

At Peak, we are more optimistic in the real estate market’s recovery and see buyers ready to commit to developments in both residential and commercial property, creating both opportunities and new jobs. We lend our own capital and are committing to new townhouse developments and shopping centers nationwide.

Three trends to watch in 2012:
1. Banks will increasingly embrace both short sales and modifications to loan principals. Over the past few years as new bills were introduced to protect homeowners, it’s become harder for banks to foreclose on properties, though in California alone over 800,000 properties were lost to foreclosure in the past five years, according to property information service DataQuick.

In reality, legislation has only delayed the inevitable foreclosure, exposed banks to legal issues and provided no real motivation for lenders to make the system move again. Banks have several options available to them to maximize cash flow in 2012 including short sales, which allow a third party to buy the property and the bank to recoup more of its investment than with foreclosures and loan principal modifications which incentivize homeowners to not abandon property and keep paying mortgages while recalibrating the system to current fair market values. With California’s Bill SB 458 signed into law in July, we’ve seen an uptick in short sales as homeowners feel protected against any future lien holder payments on the property. In 2011, the number of federally-sponsored and proprietary loan modification programs increased substantially despite the wave of new foreclosures.

2. Demand will return and necessitate new construction. While the building industry has suffered along with every other sector of real estate and construction of new homes – a key indicator of economic health – recently posted its largest decline in 27 years. Smart investors see potential in the building and construction industry.

Analysts at Fannie Mae and other organizations predict that the available rental units many consumers are turning to – away from single family homes – will not meet the growing demand for affordable housing. Also, on the retail and office front, as businesses expand, there will be shortages in commercial square footage. With new capital from private equity and large banks, selecting the right location to build in good markets is key to achieving a fair return on investing in new construction.

3. Revolutionary ideas will help kick-start the industry. From sanctioning Freddie Mac and Fannie Mae to act as landlords, effectively managing and renting distressed properties, to razing large numbers of homes to reduce the sprawling inventory and stabilize home prices, there are a number of expert recommendations on how to save the real estate industry. Enticing home occupancy to improve a community’s overall property value may be the best option. Without it, properties will depreciate.

As the natural cycle of short sales, loan modifications, and foreclosures runs its course, coupled with new construction driven by demand and implementation of strategies to liquidate the governments’ inventory of distressed properties, we feel a market recovery benefitting homeowners as well as investors is within reach.

REO to Rentals: What's in it for Investors?

The government, in its bid to seek solutions to extricate itself from the mortgage business, is asking investors for help.  In August, the FHFA (who oversees the government’s conservatorship of Fannie Mae and Freddie Mac) along with the Departments of Treasury and HUD, openly solicited ideas on how to divest itself of over 250,000 homes. Stealing a profitable page from the investor communities’ playbook, these three agencies are extremely interested in whether or not investors would step up to buy blocks of government-held REOs for transition to rentals (R to R).  And with good reason: over the past few years, savvy investors seized the opportunity to snap up bank-owned bargains.  Through this anemic housing market they have implemented a “buy and hold” strategy and are renting out these properties.  This not only meets the growing demand for single family rentals, investors are enjoying a healthy revenue stream on their investments.  In this context, a governmental R to R strategy appears to be a slam-dunk.   At least, that’s how the government would like to position it. 

It’s easy to see how this R to R strategy benefits the government.  If you add the 800,000+ delinquent mortgages on the foreclosure fast track to the 250,000 the government has had to take back, you can feel the lump in the administration’s throat starting to rise if it doesn’t get the private sector to back this strategy. 

This strategy benefits the community as well.  Occupied homes increase the value of the community. Vacant homes lead to disrepair, crime, and depreciation of value.  And clearly, this strategy benefits the average consumer and distressed borrowers in that it should provide more affordable housing options including the possibility of leasing lost properties back to their distressed borrowers to keep them in their homes with continuity for families.  

The real question is, will investors jump in knowing that an investor/landlord status in this scenario will potentially saddle them with questionable returns.  The private sector needs to be convinced that this R to R strategy does have merit for them.  While such a plan could clear the backlog of foreclosed homes off the government’s books, if there’s no real benefit to investors, the strategy will be seen as merely shifting the albatross to the private sector without curing the problem.  Success, therefore, is predicated on three conditions favoring investors and the government’s willingness to implement them:

1. Below-market pricing on foreclosed properties.  Government entities will need to make serious price concessions on already discounted pools of distressed properties to mitigate the risk and expense of investors inheriting potentially non-paying tenants. As an example of how steep discounting of assets created a win-win for the government and investors, the FDIC disposed of a large pool of distressed properties to fellow investors at a significant discount. With below-market rates and aggressive LTVs, the government also gave loss-sharing security to further motivate the pool purchases.
2. Favorable financing conditions.  As part of the program, the government would need to facilitate financing that provides investors with a rate that needs to be very favorable to insure an income stream. The length required to hold any property as rental cannot exceed five years and must include a recovery measure that may allow the disposition by the investor in as little as three years.
3. No government involvement.  The government needs to allow the private sector to manage its newly-acquired assets without interference. The bureaucracy and micromanagement typically associated with Federal “participation” after the deal is done would only stymie efficiency and ultimately erode long-term investor profitability.  The idea is not to create a new “Government Landlord Agency.” An efficient system of compliance can be monitored with clear penalties for non-compliance by investors. The paramount concern will be to assure that these rentals do not in actuality bring down a neighborhood. Investors must agree that property maintenance cannot be neglected.  Such neglect will only perpetuate declining values for years to come.

In a recent town-hall speech, President Obama conceded that the government needed the help of not only the public and bankers, but also the help of investors to tackle the current housing crisis head on. The investor community will be more than willing to help if the government can make it worth their while and not over-regulate.

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