Now that the credit crunch seems to be settling in for a longer stay, many real estate professionals are trying to figure out how to profit from this market and credit dislocation.
Capital formation is now occurring – with a particular focus on distressed and illiquid situations. There is a feeling that a wave of distress is coming, and many people are trying to position themselves for what may be further opportunity. This article will explore how capital, sponsors and brokers can profit from the impending storm.
First, some facts: In order to participate in what may be a distressed real estate market, one must separate commercial – or income-producing – assets from for-sale assets such as homes, lands and condos. The dynamics in front of us are very different between these two types.
There has yet to be seen any real property-level distress in such income-producing asset classes as multifamily, retail, industrial, office and hotel. Most of these assets are performing well at ground level. However, there are still a few concerns:
- Poor exit underwriting on recent value-added floating-rate transactions. There is a concern that many with these currently performing loans will not be able to repay their floating-rate bridge loans because they were underwritten with low exit cap rates and optimism regarding net operating income (NOI).
Thus, the view is that while the property is performing now, it will not be able to be refinanced or sold at a level that will pay off the existing debt.
Most likely, there will be scattered distress situations, but unless there is a recession or other macroeconomic event, there does not appear to be a meltdown coming among commercial assets. The distress in most cases will be financial (at the note level) and not at the asset level.
We anticipate the projected NOIs will not be achieved, exit cap rates will be higher than underwritten, and the floating-rate debt will not be able to be repaid. Yet, this will not be a large-scale default event, but rather individual opportunities.
- B-Notes on existing paper. The securitization market has frozen up, and the thaw is taking longer than most people thought it would. The reason is that the investors who bought the riskier tranches of commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS) have been burned. They don't want to go back to the well right now.
There is, therefore, a lack of liquidity in the securitized market – a trend that is leading to the sale of paper below its face amount. These sales, in turn, will enhance yield, but they do not speak to the credit quality of the asset.
The problem is a Wall Street-centric one, as these players are holding paper that is now worth less than what they paid for it. There will be losses, but this will be a short window of opportunity to ‘pick off the Street,’ for this type of arbitrage opportunity does not generally last long.
- Forced asset/note sales. There will be some banks, collateralized debt obligations (CDOs) and credit companies that – due to regulators, accounting and risk-based capital issues – will be forced to sell loans and bonds that have taken a paper write-down due to pricing. This development will create some opportunity, but again, it will be on a spot basis.
In summary, for participants to take advantage of commercial market dislocations, capital will have to be in a position to move fast. The commercial assets are not yet distressed, and it is only the paper that has been below what is now considered to be acceptable pricing.
For-sale residential, including homes, lots, land and condos, continues to be in a freefall, and this distressed market is growing, not shrinking. There are numerous distressed points that need to be considered:
- Value declines. Land and home values have declined – dramatically in some places.
- Large inventory. Builders and developers were caught with a large pipeline of to-be-completed condos and resort communities, land to be developed, and finished lots and homes.
- Lack of buyers. Less available financing due to credit underwriting tightening, plus a psychological element of market fear combined with the possibility of a recession, leads to fewer buyers.
- Less capital in the market. When the credit markets were hot, all asset classes were able to be securitized. Consequently, many for-sale projects ended up in CDOs and other structured investment vehicles. That party is over, and the availability of financing for for-sale assets has dramatically decreased.
For-sale assets, unlike commercial assets, are distressed on two levels: First, the value of the paper on the lenders' books has fallen in value.
Additionally, asset-level distress means that many of these assets are no longer performing, and the owners – hit with liquidity problems – cannot repay the loans as they are coming due. This combination will lead to a distressed buying/financing opportunity.
In some ways, it is simpler to analyze for-sale assets than income assets, as the former features fewer moving parts. The analysis starts with the acquisition basis: What will the loan/acquisition price be per foot/door/key/acre? All distressed deals start with the basis, and obviously, the new basis needs to be lower than the old basis.
The next step of the analysis is to move to the built-out basis. You need to develop a budget that can project the costs required to take the asset to a finished-product stage, which will enable a more sellable asset. Examples of this asset movement include approved lots to finished lots, finished lots to homes and un-renovated condos to fully renovated condos.
Another consideration is carrying costs, as the lender/investor working with distressed for-sale assets is taking a basis bet and a market bet. Obviously, because the market is not good now, the investor/lender must build in carrying costs until the market recovers. Carrying costs to consider include interest, taxes, insurance, legal fees, homeowners association fees and cost of sale.
In most cases, the exit strategy for the distressed buyer will be selling to a local sponsor or operator sometime in the future. Therefore, the distressed investor must build in a profit component – typically 15% to 25% of the finished-product sales.
The final step is the residual analysis. The key to pricing a distressed asset (on an acquisition basis) is being comfortable with your price – knowing that you have factored in built-out costs, carrying costs and entrepreneurial profit.
As a general rule of thumb, the finished lot retail price should be 20% to 25% of the ultimate home sales price.
Finally, where can the deals be found? The answer is that today, these opportunities for distressed and illiquid opportunities are everywhere. Popular opportunities include sponsors who need liquidity to keep the deal alive; bank loans that are upside-down on value; bank loans that are running out of interest reserve; properties in – or going to – foreclosure; stalled projects looking for more time and more cash; properties in bankruptcy; and loans coming due with complex structures, such as first-trust loans, mezzanine loans and preferred equity.
There are multiple entry points into this space, and much capital today is forming around it. For those with capital, a two-to-three-year view, and an appetite for returns, the tide has turned, and your day is coming.
Jay Rollins is president and co-founder of JCR Capital LLC (Johnson Capital/Rollins). JCR Capital is a specialty real estate finance company, specializing in providing structured debt and equity capital for opportunistic and value-added commercial real estate transactions. Rollins can be contacted at firstname.lastname@example.org.