Transcript: Distressed Real Estate: Beyond the Downturn
Deloitte Insights podcast
Welcome to this edition of Deloitte Insights, a production of Deloitte LLP. Deloitte Insights is an audio news Podcast that looks at important business issues. Now is your host, Sean O’Grady.
Sean O’Grady: Hello and welcome to Deloitte Insights. Today, we are discussing a national issue. Real estate sales continue to be depressed as the broader U.S. economy and global economies seemed to have gotten a little bit better. Joining the discussion today by phone from New York is David Williams, Chief Executive Officer of Deloitte Financial Advisory Services LLP. And from Houston, Texas is E.J. Huntley, Principal and Leader of the Real Estate Consulting Group for Deloitte Financial Advisory Services LLP. Welcome Gentleman.
David Williams: Happy to be here.
E.J. Huntley: Thank you Sean.
Sean: Ok Lets begin by understanding the real estate landscape. David we will just start with you. What qualifies something as distressed and how much distressed real estate is really out there right now?
David: Well Sean, there are a lot to definitions as to what constitutes to distress. I would like to think about distressed real estate as real estate that is under either foreclosure or serious delinquency due to an insufficient level of income production for that piece of income producing property. There is usually also some sort of financing involved, either a mortgage or some sort of securitization. As to volume, I think everybody would agree that the volume is significant, and there are lots of different ways to measure it. One way to think about it is look at those financing transactions that I talked about. There are estimates floating around that by the end of the year we will be at an 11% delinquency rate related to our commercial mortgage backed securities, which are one of the main financing vehicles for such properties and that translates to about 80 to 90 billion dollars in property value.
Sean: E J, Can you give us your impression on what the current state of the real estate debt market is like?
E.J.: Certainly, the good news is that the debt markets are clearly better today than they were a year ago.
What we have seen over the last couple years of this recession is a bifurcation of market place. We have clearly got a two-tiered market. We have Class A properties in top tier markets, and then we essentially have everything else.
When you think about financing ability and liquidity today, large commercial banks are once again making real estate loans. But, generally, those loans are made only to their best relationship customers. Life companies, real estate investment trusts, finance companies, and overseas investors have stepped in the void left by the commercial banks for the better assets. Fannie and Freddie had continued to make multi- family loans throughout the downtown, and as David mentioned, the CMBS market has begun to strengthen. Expectation is there will be approximately an 11 billion in combined issuance during 2010, which is almost the twice the amount issued during 2009, but only a fraction of the 230 billion that was issued in 2007, which was the top of the market. The common theme through the availability of debt discussion currently is really focused on the top tier of that bifurcation I talked about earlier, the top quality assets in the premiere markets. The big concern that we see going forward is the 1.5 trillion dollars of commercial real estate loans that are due to mature about 2014, and really just thinking through how borrowers and lenders are going to manage these maturities and refinance or recapitalize those assets
Sean: So, if you coin this situation, if you have distressed real estate, how can you work with lenders to address those obligations head on?
E.J.: Sean, the good news for a borrower is that banks don’t really want to own real estate, and they are working hard to not pursue foreclosure as their primary course of action. As a borrower, you know, we see it being very important that you make a realistic assessment about the situation at your end, including determining what the real value of the collateral is versus the face amount of the debt. And that borrowers approach lenders with a cooperative attitude and the willingness to provide a reasonable solution. The big complaint that we hear from our banking clients that are dealing with distressed situations is that borrowers too often come to the table with antagonistic “us versus them” view towards the negotiations. What we would really recommend is that borrowers come to the table with a realistic expectation and a realistic restructuring proposal, which often serve as a starting point to accelerate the negotiations. But at the end of the day, the important thing for borrowers to remember is the banks don’t have the staff, nor the expertise, to own and managerial real estate. They have been encouraged by the regulators to work loans out rather than foreclose them. And, they understand the negative value implications of their taking back assets and REO. So, by being realistic and by bringing a cooperative attitude to negotiations, we think borrowers have the best chances of achieving a successful restructure.
Sean: David, do you agree?
David: I could not agree with that anymore. I just believe that relationships, as E.J. pointed out here, are very important. If you think about the notion that two-thirds of the distressed property is either going to be commercial bank financed or securitized, and E.J.’s notion that folks were working with, you know, top properties; those are relationship-driven activity, and we are talking about a longer term relationship that the Bank is looking to establish because most of the banks, in addition to the distressed real estate problem, have problems of their own from a customer base stand point. So, they are all looking to maintain those sorts of blue chip relationships. So, building that relationship and coming with a viable solution is important. I would also say that building the relationship works fast when you start early, when you make a realistic assessment of where you are and don’t wait until the very last minute to go into your financing source and try to do this re-negotiation.
Sean: Winding the clocks back a few years, most of us thought “real estate, sure fire asset” - clearly much has changed. What have the past two years taught as about real estate as an asset, and what do you think are some of the ways companies are going to adjust their strategies to address those recent changes in the market?
E.J.: Well Sean, I think some us might take exception with the concept that most investors thought real estate was a surefire asset. Some certainly did think that, but I think what this last recession has really shown those that have been in the market place and have seen these transaction cycles before is a validation of what we already knew - that real estate markets and the general economy are cyclical in nature. Now, we have seen a number of common themes hold true throughout this recession. And principally, the real estate markets and values are highly dependent on jobs and consumer spending. The Class A assets and top tier markets, as we talked about, are less risky than lower quality assets, and in times of disruption, it leads to a real flight to quality. One of the really interesting things we saw leading up to this current recession was the level of underwriting, the level of leverage that was put on assets. As owners work through the current economy, we see that realistic underwriting and reasonable levels of leverage are clearly a big benefit to owners as they try to weather market place disruption, and we are also seeing a higher quality assets recover faster and generate higher demand. Now, the difference that we saw in the last recession is how far and how sharply the market fell from by all measures a tremendous bull market in ’07 to a market in 2008 that saw an 80% decline in transaction volumes over ’07. It continued into 2009 that saw again an 80% decline in transaction volumes in ’09 versus 2008. It’s been an incredibly steep fall, and in the mist of that fall in transaction volumes, you saw commercial real estate property values across the U.S., on average, fall of 40%. One of the other big things I think was a little bit different in this recession was really just how broad the recession was. It was global in nature, and it really covered virtually every asset class.
Sean: And David Williams, anything you would like to add?
David: Sure, I would like to add a couple of things. I do also agree with E.J. especially around the cyclicality of the market and lenders are cyclical as well, and as you see them under pressure given the recession, you see things that happened relatively prolifically in the up market that are not going to happen anymore, at least not in the near future. So, in my mind, gone are the days of 100% financing deal for spec development; gone are the days of underwriting as E.J. pointed out with high loan to value. We are going to see some significantly tightened lending standards. In fact, we are seeing them already, and that is going to have an impact on the market. What people who would transact in this market should understand is that cyclicality and that we’re now in a spot were flight to quality is real.
Sean: Now David, what is your take on regulatory reforms, and how might it impact on lending to commercial real estate companies in the future?
David: Well, I think my take on regulatory reform is despite the passage of Dodd-Frank, still some uncertainty. We have seen Dodd-Frank, and we understand its premises, but we have not seen rules that were or will be implemented. And this happens as we see, as E.J. pointed out, a recovery, although a nascent recovery, in the commercial real estate market based on coming out of the recession and the related financial crisis that we saw in 2008. What has regulation done? It has done a couple of things in my mind that will change the commercial real estate market. First, the requirement for lenders, banks in particular, to have some skin in the game, a 5% rule as it is commonly called. We will see a deeper level of underwriting. We will see more scrutiny. We will see more documentation around real estate loans, and we will see tightening lending standards. We also have another set of circumstances going on, and that is the fact that most banks will now be required, through at least two regulations that I can think of, to carry more capital reserves. The whole set of Basel accords is making it much more difficult for banks to operate at the reserves levels that they did previously, and one thing that will mean is, perhaps, we will see a decrease in the overall amount of lending capacity that is possible relative that the equity capital in any institution. So, we could also see a problem with the supply of capital, making this wave of renegotiation that we expect to see in the next couple of years even more difficult to deal with.
Sean: And E.J. your thoughts?
E.J.: I certainly agree with David. The Dodd-Frank act was just signed on July 21. It contains 2,319 pages. So, I think it is going to be sometime before we really know the true implications of what that legislation is going to bring to the debt market, and specifically, the real estate debt markets. I think what we do expect is an era of higher scrutiny, more regulatory oversight enforcement for financial institutions, specifically focused on the larger bank holding companies of 100 billion dollars of assets or more. I think what we don’t know so much now is what the impact is going to be on the smaller community and regional banks, which is really were a significant amount of debt financing takes place for a lot of the assets that don’t fall in that kind of top tier class A bracket we talked about earlier. And, the other thing I think that is uncertain is really what the impact is going to be on Fannie Mae and Freddie Mac, which together account for about 9% of the multi-family lending through both direct loans and the issue of insurance on loans. So, I think there are still more to come on that, and I think it will be quite some time before we really know the true impacts.
Sean: This final question is for both you. E.J. we will start with you first, and David if you could follow up after that, and that is what is the future like for real estate? Are we seeing light at the end of tunnel; is there a glimpse of light; what is going on gentlemen?
E.J.: Sean, great question. We have got a bit of a schizophrenic market right now. I am not sure it knows which direction it wants to go, but I do think we are seeing a glimmer of light. We are seeing liquidity returning to the market place in terms of available debt. Transaction volumes are increasing as we talked about earlier. Property values appear to be bouncing along the bottom. Different surveys present different views, but there is generally a consensus of belief in the market place that we found the bottom. There was a lot of uncertainty around the Dodd-Frank act before it was enacted. That is beginning to calm down some I think, and we are really beginning to see some signs of additional movement by the larger banks of restructuring and aggressively trying to clear their portfolios of some of this distressed assets, still a lot of issues to come, such as the significant looming debt maturities, as we talked about earlier. There are significant amounts of distressed assets sitting at regional and community banks. There is a proliferation of weak property performance across the country. All that said though, I do think things are getting better. They are better than they were a year ago. Expectations are there will be a better a year from now than they are today, and hopefully, we will continue to see the market improve and the availability of debt increase.
David: I would agree with the idea that the markets are getting better. Markets generally get better when the participants in those markets have some certainty about the conditions that they are dealing with, and we are now starting to get to the point where we have some certainty. They are certainly problems out there - the amount of distressed debt, the refinancing wall that we have talked about. The potential impact of legislation, but I think market participants now have all of the pieces in place to sort of make judgments as to what should happen in the markets going forward, and I would expect this nascent recovery that we are seeing in real estate to continue with one exception, which I think is still looming and is largely unpredictable in the market participant’s mind, and that is the economy. As we start to see better news about the economy and the things that drive the economy, business investments, availability of capital jobs, those sorts of things, I think the picture will finally be painted in such a way that we can have some ultimate predictability, but I am bullish about things getting better, and I do believe, in fact, we have seen bottom and we are in way up.
Sean: So, hopefully confidence will breed more confidence.
Sean: David Williams, chief executive office of Deloitte Financial Advisory Services LLP and E.J. Huntley, principal and leader of the real estate consulting group for Deloitte Financial Advisory Services LLP. Thank you both very much for your thoughts gentleman.
David & EJ: Thank you Sean.
Sean: You are very welcome. That’s all the time we have for this episode of Deloitte Insights, but if you would like learn more about David, E.J. or distressed real estate, you can find it at www.deloitte.com. For all the good folks here at Deloitte insights, I am Sean O’Grady, will see you next time.
You have been listening to Deloitte LLPs production of Deloitte insights, the program that looks at today’s important business issues. We want to hear from you. Visit deloitte.com/us/podcasts to give feedback, ask questions, or discuss the issues with fellow listeners. This podcast contains general information only and is based on the experiences and research of Deloitte practitioners. Deloitte is not by means of this presentation rendering accounting, auditing, business, financial, investment, legal or other professional advice or services. This presentation is not a substitute for such professional advice or services not should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor.
As used in this document, “Deloitte” means Deloitte & Touche LLP and Deloitte Services LP, separate subsidiaries of Deloitte LLP. Please see www.deloitte.com/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries.