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Reassessing Distress

Reassessing Distress

<em>Three years after the peak in retail real estate values, the market for distressed real estate remains murky.</em>

To date in 2010, Phillips Edison's and PECO Capital's $70 million Strategic Investment Fund I, which targets distressed retail developments and loans, has only been able to pull the trigger on a few acquisitions. The fund, launched in 2007, was formed to buy distressed lifestyle and power centers larger than 150,000 square feet. At the time, many firms were lining up to take advantage of an anticipated wave of distressed buying opportunities. But few deals — especially on the kinds of properties the fund has targeted — have come on the market, says David Birdsall, chief development officer with Phillips Edison & Co., a Cincinnati, Ohio-based real estate firm with a 25-million-square-foot retail portfolio.

The most notable transaction the fund has closed occurred in October 2009, when it purchased Bridgewater Falls, a 600,000-square-foot foreclosed regional mall in Cincinnati for $43 million. The property, built in 2004 for $100 million, offered a solid value-add opportunity, according to Birdsall. But in the months since, the fund's managers have not seen any other attractive deals materialize.

The fund is not alone. Although the amount of real estate counted as distressed has ticked up steadily each month, there has been no buying sprees. Instead, expectations have been adjusted when it comes to distressed real estate opportunities. The thinking now is that lenders will be more proactive about dealing with distressed properties going forward, but only at a snail's pace.

Firms have had to fight to build businesses in the distressed sector. For example, Jones Lang LaSalle Value Recovery Services currently has 48 assets under receivership, including a mix of office buildings, retail centers and multifamily properties. That's up from 10 properties at the end of 2008.

Meanwhile, by the fourth quarter 2009, real estate services firm CB Richard Ellis (CBRE) had 20 million square feet of properties under receivership nationally and was marketing $5 billion in distressed assets for sale, up from $3 billion in the third quarter. CBRE assumes receivership services for between 300,000 square feet and 500,000 square feet of retail properties on a monthly basis, according to Samuel C. Delisi, senior managing director of asset services.

The numbers represent just a fraction of the total level of distress in the market — in February, Real Capital Analytics, a New York City-based research firm, identified $43 billion in retail assets in delinquency, default, foreclosure or bankruptcy, across all lender types. But to date, only $1.1 billion of those situations have been resolved.

Government's recommendation to banks to amend troubled loans and banks' unwillingness to absorb potential losses from the write-downs explain part of the problem. Rather than tapping experts to help rehabilitate assets or selling, banks have opted to extend expiration dates and have kept troubled loans on their balance sheets longer than experts had anticipated.

Another reason for the lag within the retail sector might stem from the fact that multi-family and hospitality properties were the first to experience distress, and therefore, the first that lenders dealt with, says T. Sean Lance, managing director and president of the troubled asset optimization team with NAI Tampa Bay, a Tampa Bay, Fla.-based commercial brokerage. Lance estimates retail accounts for less than 15 percent of the 20 or so properties his firm has under receivership.

The delay might also be explained by the amount of time and effort involved in stabilizing a distressed retail asset compared to a multi-family or hotel property, adds Bernard J. Haddigan, managing director of the national retail group with Marcus & Millichap Real Estate Investment Services, an Encino, Calif.-based brokerage firm. “With hospitality, you cut the rates and fill the units probably much more readily than with a larger retail center,” he says. Most retail tenants are still not expanding. Haddigan notes he's come across at least one unfinished retail development where the owner filed for bankruptcy a year ago and the lender still hadn't initiated foreclosure proceedings.

Another factor is that there is still some expectation in the market that the government may do more to aid commercial real estate. Some are hoping for something like the Resolution Trust Corp. (RTC) to emerge. During the real estate crisis of the 1990s, the government formed the RTC to help take distressed assets off thrifts' balance sheets. RTC took over failed thrifts, then contracted out the management and disposition of the assets to private players through equity partnerships to unwind the assets.

“I have a feeling everybody is waiting for RTC 2.0. I just don't see that happening,” Birdsall says.

But lenders will likely begin putting more retail centers into foreclosure and receivership in the run up to the ICSC RECon conference in Las Vegas in May, according to Greg Maloney, CEO and president with Jones Lang LaSalle Retail and head of the Value Recovery Services team. Lenders are “starting to divide [traditional loans] into different categories — these are the ones where we want to work with the borrower, here are the ones we want to foreclose on, here are the ones we want to put into receivership,” Maloney says. “I don't think you are going to see a tsunami by any means, but I think it will continue to pick up.”

The challenge for those involved will be figuring out what these properties are worth and how much work they might need to deliver the double-digit yields most opportunistic investors are looking for. Most of the centers that lenders are taking back today have severe distress on the property level. Since retail properties are constantly in the public eye, visible signs of distress can turn away both potential tenants and shoppers, says Ross B. Glickman, chairman and CEO with Urban Retail Properties LLC, a Chicago-based retail developer and manager. In February, the firm formed Urban Receivership Services to get a piece of the business.

In making a determination about whether to go after a center, Phillips Edison, for instance, wants to know if it will eventually be able to lease up the vacant spaces and how many years the effort might take. On the flip side, lenders need to figure out how much money they should put into stabilizing the property before capital improvements stop contributing to the value of the asset.

“The formula is simple, the actual process is incredibly difficult, because it's a lot of unknowns, a lot of probabilities involved,” says Suzanne Mulvee, senior real estate economist with Boston-based Property & Portfolio Research, a CoStar company.

Green shoots

Though lenders are beginning to look at resolving distressed situations in the retail sector, the amount of progress varies, according to industry sources. So far, the lenders most likely to act have been the larger, national banks that can afford the losses associated with write-downs, as well as banks that have been taken over by the Federal Deposit Insurance Corp. (FDIC), according to Rich Walter, president of Faris Lee Investments, an Irvine, Calif.-based retail brokerage firm.

If a failed bank is acquired by a larger rival, FDIC assumes 80 percent of the losses the latter incurs as a result of the merger, including taxes, insurance costs, sales and foreclosure expenses on troubled commercial assets. That makes it easier for the bank to address loan defaults. As more community and regional banks come under pressure this year, the FDIC could become more active in putting assets on the market, Walter says. In February, the FDIC identified more than 700 banks as “troubled.”

The banks, however, are still not taking back larger, institutional quality assets. In part, that's a function of institutional owners such as REITs having capital at their disposal to properly manage a center even if they can't pay down the mortgage, Lance says. In those instances, the lenders would rather work out or restructure the loan.

A good example is what happened with bankrupt regional mall REIT General Growth Properties, according to Maloney. Because of its stellar reputation as a retail property manager and high quality portfolio, the REIT has been able to renegotiate close to $12 billion in secured loans. Under General Growth's proposed reorganization plan, the few assets it has been unable to refinance will be spun into a new company, that will also include its master-planned community business and land.

Another factor contributing to the dearth of large power centers and regional malls in receivership has to do with how these properties were financed, says Delisi. These were often complex transactions involving both senior lenders and several mezzanine lenders, with some or all of the debt ending up packaged into commercial mortgage-backed securities (CMBS). In those cases, after the borrower defaults, the large number of creditors and complex string of claims mean it can take a long time before the asset in question can be placed into receivership. That is prolonging the period between the onset of distress and resolution.

Plus, the special servicers that are put in charge of defaulted CMBS loans are more reluctant to initiate foreclosure than traditional lenders because they may not be certain they have the power to do so without the approval of the note holders, says Jonathan Littrell, an attorney with Raines Law Group LLP, a Beverly Hills, Calif.-based law firm. Larger assets will enter receivership in much greater volume later this year and through 2011 as there are too many coming to maturity, Delisi predicts.

By contrast, most of the retail properties that are going into receivership today include development parcels, single-tenant assets and smaller strip centers that were financed with traditional loans. In many cases, they have been mismanaged by inexperienced investors who bought them at the peak of the market and profited from the resulting NOI without setting aside money to properly manage and lease the assets, says Glickman. When the economy imploded and tenants started closing stores, those centers were the first to feel the effect and these situations quickly escalated into full-blown crisis, with departing retailers triggering co-tenancy clauses in their neighbors' leases.

“What we've been seeing lately is really troubled properties, where NOI has fallen 30 or 40 percent,” Maloney notes. For example, the 1.4-million-square-foot Macon Mall in Macon, Ga., for which Jones Lang LaSalle has been appointed receiver in 2009 and which has recently been put up for sale, has an occupancy level of 69 percent.

Meanwhile, Haddigan brings up a 700,000-square-foot regional mall Marcus & Millichap recently sold

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in South Carolina, which had an occupancy level of 48 percent. The investor bought the property for $55 million in 2004. Marcus & Millichap sold it out of REO for $4.5 million.

Tough job

The fact that many of these properties are in severe distress makes the receivers' job much more difficult, Glickman says. In those cases where many of the tenants have left and the owner has stopped managing the property, the center is likely saddled with a bad reputation. That means the receiver has to do damage control among local government officials, potential tenants and the public through marketing and advertising, in addition to investing in capital improvements.

Meanwhile, in trying to stabilize a center's cash flow, the receiver also has to take into account how today's decisions might affect future ownership. NAI Tampa Bay recently sold a 120,000-square-foot retail property where a large percentage of the leases reached their expiration dates. Tenants started asking for lower rents and some relocated to better-managed centers. The property is a solid shopping center in a good location, according to Lance, and NAI Tampa Bay was able to convince two of the bigger tenants to stay put with rents that were in line with the market. But the firm was careful to sign three-year leases instead of the more standard five-year contracts to give the investors that eventually purchased the center more flexibility.

Yet even minor improvements take time and money that lenders may not be able to spare. Last year NAI Tampa Bay sold a multi-tenant retail center where conditions had deteriorated so badly it would have taken at least two years and several hundred thousand dollars to stabilize it, according to Lance. The firm sold the property for $2 million, or about half of what it would be worth under normal conditions, Lance says. “There was no short-term band-aid solution,” he notes.

That's a point at which many receivers encounter resistance from the lenders, according to Littrell and others. Given the dearth of investment transactions in the marketplace, NAI Tampa Bay combines property appraisals with broker opinions to gauge how a given center might be valued. That's because an appraisal based on statistics that were valid a few months ago can already be out of date today.

To ensure the accuracy of its predictions, NAI Tampa Bay then tracks the properties as they go on the market and are sold. The predictions turn out to be within 10 percent of the final sales price in 90 percent of the cases, Lance notes, but that's not enough to convince some lenders.

In one instance, after the team provided its value estimate for a Florida retail center of approximately 20,000 square feet, the special servicer told the firm to put out a listing at a price that was more than 30 percent above NAI's suggested price. The special servicer held out for about eight months and in the end, sold the center close to NAI's original suggestion.

“I think some of the valuations are still a little shocking” to the lender, Lance notes. “It takes time for them to seep in. But the lender may come back in 30 or 60 days and make the determination that our [recommended price] was accurate.”

In some cases, however, the lender may simply refuse to approve the sale, according to Littrell. The receiver, after all, is a temporary, court-appointed guardian of the property and when there is a dispute about how to best preserve value the judge is likely to give precedence to the wishes of the lender.

The waiting game

Lenders' lingering hopes that the market might rebound sooner than people think might account for the low volume of distress resolutions. Today's investors are much more experienced than those who bought properties at the peak of the boom, says Haddigan. They know that when they buy a center out of receivership under current market conditions they are taking on risk. Yet most lenders have yet to account for risk in their listing prices.

Buying properties out of receivership does not come with the same guarantees as traditional investment sales, notes Walter. Receivers need the court's approval before they can close the sale and objections from either the previous owner or the lender could derail the process.

Once the receivers' job is done, they will also no longer bear any contractual obligations to the buyer, unlike a seller in a private transaction. A good example would be a center that might have had a dry cleaner as a tenant several years ago, Littrell notes. If an investor buys the center as is, he might become responsible for environmental clean-up.

Another danger to look out for is the possibility that the buyer might become responsible for leftover loans that haven't been paid.

Plus, with centers that have already lost tenants, there are concerns about how lease agreements will affect long-term occupancy and cash flow. “Part of what's happening now is all these tenants have co-tenancy clauses and they are very, very dangerous and difficult to understand,” says Birdsall. “You have to understand that if Talbots goes away, Gap is going to go on percentage rent.”

Meanwhile, investors continue to have difficulty securing acquisition financing, adds Lance. With distressed properties, banks might refuse to finance the deal at all.

As a result, current conditions favor investors with long-term experience in managing retail properties. Walter estimates that today, buying a property out of receivership can offer long-term ROI returns of up to 20 percent, but you have to be a savvy property manager to realize them. “When people say there is a lot of money on the sidelines, yes there is, but a lot of that money is not necessarily prepared for the process,” Walter notes.

Because of the remaining bid/ask gap, most prospective buyers are still uncomfortable with the level of risk they are expected to take on, says Maloney. Receivers are finally starting to put assets on the market. However, most of the sales taking place are under $10 million.

“Personally, I think there has to be a realization of what it's going to take to move the asset and the banks are going to have to make it a little bit more attractive to the investor,” he says. “Right now, it's little reward for a lot of risk and that's why things aren't moving.”

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