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Fire Sale: Investing In Distressed Assets

A Reprint from Tierra Grande, a publication of
The Real Estate Center at Texas A&M University








By Mark G. Dotzour

Distressed assets are
investments that are
in trouble.

Some euphemistically call
them investments
“with a story.”

In business lingo, a
distressed deal
is an investment that
“has hair on it.”

In a typical investment, an owner borrows money to purchase a property or
business. Sometimes owners borrow from several lenders, ending up with
second mortgages from mezzanine lenders, who offer short-term, interim loans
to make up for lack of equity. If the investment works, all the loans get paid and
the owner makes a profit.

But if it does not work out, lenders do not get paid and they foreclose on the real
estate loan or force the business into bankruptcy. At that point, the lender
becomes the owner of the property or business. Because lenders generally are
not prepared to operate businesses or buy and sell real estate, they sell these
assets at steep discounts, sometimes for pennies on the dollar. Usually, the risks
of investing in distressed properties are so high that investors demand high returns.

Origin of Distressed Investments

Distressed assets take many forms, from a 2,000-lot subdivision with a golf
course whose owners defaulted on a $100 million loan, to a small business with
three industrial buildings and an office building that defaulted on a Small Business
Administration (SBA) loan. When the economy is strong, few businesses default
on their loans, so few real estate foreclosures occur. From 2003 to 2007, private
equity funds had billions of dollars to spend, but distressed investment deals
were scarce.

In June 2007, however, when Bear Stearns closed two hedge funds it sponsored,
the situation changed dramatically. This early tremor spooked the credit markets,
and 30 days later, funds for risky investments virtually vaporized. The credit
markets locked up. As the magnitude of the credit crisis became more apparent,
the availability of credit for virtually any purpose disappeared.

Many business and real estate investments are funded by short-term loans that
must be refinanced every few years. When the credit markets froze, these
investors were doomed. Loan defaults are expected to skyrocket in 2010,
resulting in a large number of distressed properties. Investors interested in
distressed assets may choose from defaulted business loans, commercial real
estate mortgages, SBA loans, credit card loans and student loans. At a 2009
Distressed Investment Conference in New York City, several speakers commented
that all investments are distressed today.

The Takeaway

Commercial foreclosures should increase in the remaining months of 2009 as
banks refuse to renew loans or require additional collateral on existing loans.
As the banks sell off these distressed assets, prices will decline substantially.
But once the bulk of these assets are sold, prices should rebound.

A representative from a bond rating agency said that junk-bond default rates
are at 4 percent but could skyrocket to 16 percent before the end of 2009.
This means that 16 percent of the riskier businesses in America could fail this
year.

Three issues are causing the increase in defaults: lack of credit at any price;
poor underwriting standards that generated business loans that could never be
repaid; and the number of strong businesses financed with short-term loans
that will be unable to refinance their loans.

Buying Opportunities Ahead

So how do professional investors view commercial real estate loans as a
potential investment in 2009? The overwhelming consensus is that commercial
real estate prices could fall dramatically in the next few years and that a
significant number of commercial real estate loans will default, leading to
foreclosure. This will produce “once in a lifetime” investment opportunities in
the next few years.

Many commercial real estate properties purchased in 2006 and 2007 were
bought at exorbitant prices based on future rent projections that were not
realistic at the time. Now that those rent projections clearly are not coming
to pass, property owners will not be able to service the debt.

Even solid investment properties are not immune in the current lending
environment. Many lenders are not willing to extend existing loans, and few
will make new real estate loans. Therefore, owners of fiscally sound properties
who are currently paying their loans could be subject to foreclosure because
they cannot refinance those loans when they come due.

Many professional investors expected commercial property values to fall by 30
percent or more from 2006–07 prices, when buildings were sold at cap rates lower
than at any time in U.S. history. Properties that sold at an 8.5 percent cap rate
in 2002 sold for a 5.5 percent cap rate (or lower) in 2007. Prices are likely to
continue to fall until cap rates get back to historic norms.

Suppose an investor bought a building for $1,818,181 in 2006 with a 5.5 percent
cap rate. It generates $100,000 net operating income (NOI) per year. Two years
later, rent levels are unchanged, and the NOI is still $100,000. However, buyers
are no longer willing to accept a low yield and demand a cap rate of 8.5 percent.
They offer only $1,176,470 for the same building, meaning the property value has
declined by 35 percent in just two years.

If an investor purchased the same building in 2007 with $118,181 in equity,
borrowed $1.2 million from a life insurance company for the first mortgage,
another $300,000 through a second mortgage and $200,000 in mezzanine
debt from a private equity fund, the investment has $1.7 million in debt.
Selling the property at the higher cap rate (a sales price of $1,176,470)
means the equity is completely wiped out. So are the mezzanine loan and
the second mortgage loan. Those investments become worthless. Only the
first mortgage holder will be repaid.

How much would investors offer the owner for the equity? Nothing. How
about the mezzanine debt interest? Nothing. How much would they pay
for the second mortgage? Nothing. But they might pay the first mortgage
holder $1.1 million to buy the underlying mortgage and effectively become
the property owner.

What About Tomorrow?

What are the implications of this for commercial real estate in Texas and
the rest of the country? Expect cap rates to return to 2002–03 levels, which
were normal rates of return before the bidding frenzy that occurred in 2006–07.
Cap rates probably will not go higher than 2002–03 levels, when the country
was in the throes of a recession, job growth was nonexistent and rents were
falling.

At that time, financing terms were at historical norms. Lenders were maintaining
reasonable underwriting standards and requiring equity in the deal. If cap rates
return historical norms, price declines are likely to occur in the big cities where
“hot” or “smart” money drove prices through the roof. In the secondary and
tertiary markets of Texas, price declines could be much less, or negligible,
because easy money never entered those markets in the first place.

Watch for a sizable increase in foreclosures of commercial properties in Texas
and throughout the nation beginning in 2009 as banks refuse to renew loans or
demand additional collateral on existing loans. As banks sell off the foreclosed
properties, prices will drop. Initial declines could be substantial. Owners of
commercial real estate in Texas who do not have to sell should stay on the
sidelines and wait for the firestorm of foreclosures to dissipate. Once the
selling pressure subsides and the distressed properties are purchased, prices
could rebound significantly. Commercial real estate buyers should get back in
the market as soon as prices realign with 2002 valuation levels.

With another 13 million people moving to Texas in the next 20 years, many
investors will be looking to make smart investments in the state’s bright future.

Dr. Dotzour (dotzour@tamu.edu) is chief economist with the Real Estate
Center at Texas A&M University. Because lenders generally are not prepared to
operate businesses or buy and sell real estate, they sell these
assets at steep discounts, sometimes
for pennies on the dollar.