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Action Matters

Challenges Ahead for the Commercial Real Estate Sector

With billions of dollars in commercial real estate loans set to come due in the next three to five years, the industry is poised to face even more challenging times. Action Matters sat down with A&M Real Estate Advisory Services Managing Directors, Scott Morey (U.K.), Jerry Pietroforte (U.S.) and Klaus Kretschmann (U.S.), who are working with lenders, investors, owners and operators of commercial real estate to navigate these difficult times both in the U.S. and abroad.

Action Matters: Everyday we hear warnings about what the next few years will bring in terms of maturing commercial real estate loans. What's the state of the market?

Mr. Kretschmann: While the commercial loan market is still below the peak levels we saw prior to 2008, there's some slow improvement. In March 2009, only 14% of securitized loans were repaid at maturity. Over the past 12 months the average has been 32%. That said, we're not out of the woods yet.

Mr. Pietroforte: The market is still relatively quiet. Transactions are still down, primarily as a result of very limited liquidity in the market.

AM: What about beyond the U.S.? What is the state of commercial real estate in Europe?

Mr. Morey: In the UK, we're seeing stakeholders just trying to hold on for another few years, which is producing a shortage of properties to chase. This is disappointing for the large number of investors looking for distressed assets in Europe.

AM: Are there any bright spots?

K.K.: There are a few bright spots in the investment sales market. Namely, foreign investors continue to view the U.S. as a relatively stable economic environment and commercial real estate as an appealing investment, with the potential for good returns on a risk-adjusted basis. Because of this, we have seen an increase in the amount of foreign capital entering the commercial real estate market. Also, there's an interesting dynamic developing between buyers and sellers that is resulting in a uniquely favorable window of opportunity for both parties. Acquisitive groups are being more aggressive and sellers are receiving a significant amount of attention due to pent-up demand.

J.P.: There are also very specific types of transactions that are seeing activity. For example, we have seen a lot of interest in multi-family transactions as well as "trophy properties" - office properties in well-known buildings in major markets. These properties are bought and sold and refinanced more regularly.

S.M.: The bright spot in Europe has been the German banks. If you look over the past year, in the 15 of the top 20 big non-German deals, the senior debt was provided by German banks. There's a decent amount of money - whether it's coming in as equity or debt on the private equity hedge fund side - and the German banks seem to be the most aggressive in offering senior debt.

AM: Are you seeing a significant increase in loan modifications? What types are becoming most common?

K.K.: There has been a significant increase in loan modifications. From January 2009 to March 2010, over $12 billion has been modified compared to 2000-2008 when just over $1 billion of CMBS loans were modified. To date, pure loan extensions without any other change, have accounted for one in three modifications. A combination of rate reductions, amortization changes and loan extensions have accounted for an additional 16%. Modified loans that do not neatly fit into one of these categories (extension, amortization change, rate reduction or combination) represent nearly 40% of all modified loans.

AM: What types of capital are available and what types of transactions are investors looking for?

S.M.: What I'm seeing in Europe is either new or repackaged money on the private equity / hedge fund side looking for distressed assets. It comes down to finding someone who doesn't just have the money, but also has the technical capacity and know how to make a difference with that asset and realize its value.

J.P: In my view there are two issues. The first is a need for technical expertise and asset-specific technical expertise, and secondly, a capital need. And those two capabilities don't always reside under the same roof. For example, an owner may have billions of dollars, but they don't necessarily have the technical expertise to restructure and turnaround a regional mall asset or an office tower. It's just not what they do everyday. The result has been a lot of joint venture arrangements, which can be a good marriage if everyone does what they say they're going to do – and terrible if they don't.

AM: What are lenders doing to preserve asset value if a borrower is unable to keep up with payments during the lengthy foreclosure process?

K.K: Receiverships certainly are a major way you can help to preserve asset value particularly during a contested foreclosure process. I think we have it pretty adequately covered.

AM: There is so much capital on the sidelines, where are some of the more opportune places to deploy that capital?

K.K.: Investment capital has been waiting on the sidelines since mid-2008. Many investors are frustrated that they cannot deploy investment dollars at velocities originally projected, or achieve the higher returns originally forecast. However, banks and special servicers are unwilling to write-down and sell loans, resulting in a huge bid / ask differential where the capital wants a higher rate of return (lower purchase price) than what current distressed owners and their lenders are willing to accept. Lenders and most investors remain conservative and cautious, pursuing primarily quality properties. As such, the market has seen an increasing bifurcation, as quality assets continue to see prices bid-up and while distressed and value-added prospects have seen little movement. As markets stabilize, access to capital will expand from the "A" list properties in high quality, well located areas, to B and C properties, or properties in secondary and tertiary areas.