Ever since the commercial real estate market turned south in early 2007, investors have speculated about when this cycle’s distressed real estate opportunities would materialize. That conversation has not been limited to the United States. And it turns out that investors in Europe and Asia have largely seen the same process play out there as has happened here; distressed real estate exists, but banks are working at a glacial pace in resolving problems.
A panel at the ULI Fall Meeting took up this discussion. The session, “Global Deals on Distressed Assets”, was moderated by Stephen Blank, senior resident fellow, finance, with ULI, and featured Robert Peto, president, the Royal Institution of Chartered Surveyors, and Simon Treacy, group CEO of Australian private equity real estate investment advisory firm MGPA.
New York City-based research firm Real Capital Analytics pins the current amount of total distressed commercial real estate in the U.S. at about $290 billion. Peto, for his part, pinned the level of distress at a similar level in Europe, where there is about 1.4 trillion euros in commercial real estate debt outstanding and about 150 billion euros in distress. According to Terry, the picture in Asia is a bit murkier given the lack of transparency in China’s real estate market, while in Japan there is about $170 billion in commercial real estate debt coming due in the next few years.
To date, however, banks have largely sat on that debt. Phenomenon like “extend and pretend,” where banks have opted to roll over troubled loans rather than recognize losses, has led to less opportunity than many investors imagined. In the U.S., about $90 billion in distressed debt has been dealt with. In Europe, Peto estimates that the total amount of outstanding commercial real estate has shrunk by as little as 20 billion euros since the market’s peak. “Almost nothing has been taken out,” he said. “There’s been no meaningful pay down.”
What’s enabled the situation to play out like this has been the fact that governments across the world have largely opted to save the banks. That, in turn, has enabled them to delay dealing with bad debt, according to Blank. Banks don’t have to mark their loans to market. That’s significant because a large percentage of commercial real estate that was financed at the market’s peak is now worth less than the mortgages arranged on the assets. If banks had to mark-to-market, the panel said, they wouldn’t have enough equity to cover the resultant losses.
Instead, banks are able to borrow money at near 0 percent interest rates. That money, in turn, is generating profits through trading desks or by buying government debt, such as Treasuries. This process is enabling banks to recapitalize and—the idea goes—enter into a position to resolve distressed situations as they build buffers of capital.
But Blank pointed to another factor delaying the resolution of distressed assets. He said that banks missed out on the upside after the Resolution Trust Corporation (RTC) bailout in the late 1980s. At the time, the government-created institution absorbed assets from liquidated savings and loans and other bad debt and then auctioned off assets. The buyers of those assets profited as assets recovered in the next real estate cycle. So banks are trying to hold on and wait for real estate values to recover so they don’t miss out on profits this time around.
As Peto put it, “Nobody is willing to put assets on the market. Banks can’t take hits to satisfy your need for cheap property.”
Another problem the panel identified was the fact that the market doesn’t understand what properties are truly worth. Peto talked about how even the concept of “distressed” assets is a bit of a misnomer. “A distressed sale is one where you are forced to the market and have to move the property in a short amount of time,” he said. If you have six months to prepare, market it and complete the sale, “then it’s not a distressed price, it’s the actual market price.”
Ultimately, none of the speakers saw the logjam of distressed assets getting resolved any time soon. Unless banks are forced to act, they will continue to dribble out properties and spread the pain as long as possible. In short, that “tsunami of distress” everyone talked about a few years ago is never going to materialize.