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Urdang Capital Management has come out with a white paper, “The Great Recapitalization: Maturing Mortgage Debt Wave Creates Value Opportunities”, that is a must-read for anyone interested in the emerging trends in the U.S. commercial real estate (CRE) market. Authors David Blum and David Rabin lay out in compelling detail the extent of the current market decline, the historic returns investors have achieved in CRE and the opportunity set for investors in the wake of a massive maturity wall.
The fall in CRE prices was swift and brutal; substantially more so than was seen in the real estate decline of the early 90s. Blum and Rabin note:
As measured by the NCREIF Property Index, property values ultimately dropped by 32% from the market peak in Q1 2008 to the bottom in Q1 2010, equal to the decline of the 1990s real estate crash but recognised in one-third of the time.
Worryingly for many in the CRE market (both investors and lenders), the recovery has been tilted heavily toward the top six U.S. markets (New York, Washington, D.C., Boston, Chicago, San Francisco, and Los Angeles).
With estimates that 60% of loans set to mature through 2015 are underwater, talk of a recovery in this market remains a cruel joke to many.
In many ways, it was the outsized success of CRE investing that laid the groundwork for the current environment of depressed prices. Note the authors:
like the increasingly distant memory of a favourite team’s championship season of days gone by, the real estate equity market never forgot those 20% + equity returns of the 1990s – and spent the next decade attempting to wring similar returns from an asset class not equipped to produce them.
The level of risk-taking in the 00s that naturally flowed from a combination of chasing abnormally high returns and an accommodating credit market not surprisingly led to the excesses that have gotten us to our current situation.
Blum and Rabin believe that a relative stabilisation of the CRE market and a change in FDIC orientation toward workouts will prompt lenders to more aggressively seek long-term solutions to their troubled credits. The authors observe:
With banks increasingly willing to negotiate and CMBS delinquencies at an all-time high, we believe that there will be increasing opportunities to purchase or recapitalize over-leveraged assets, as ‘extend and pretend’ gives way to ‘put up or shut up’.
A fact too often lost on investors is that abnormal returns generally flow from abnormal situations. With an opportunity to acquire properties at a significantly lower cost basis, investors now are presented with just such an abnormal situation. Blum and Rabin lay out the competitive advantage that investors can seize by investing in this market:
basis disparity – and the inherent competitive advantage that it creates – makes it possible for today’s purchasers to add value to properties even as rental rates are flat or declining. We believe adding value to low basis properties will be the operational cornerstone of real estate investment performance over the next several years.
The reset basis at which distressed properties are acquired enables the news ownership to invest capital to cure deferred maintenance needs and upgrade systems and finishes while offering lower rental rates than comparable properties with greater debt burdens – a critical competitive advantage in periods of weak demand.
Fear and uncertainty is the friend of the distressed investor. With lenders increasingly willing to press for a long-term solution to troubled CRE loans, and a $1.7 trillion maturity wall looming, motivated sellers are assured. Aggressive investors have an opportunity to earn outsized returns by avoiding trophy markets and acquiring properties at a cost basis that allows for robust profitability irrespective of the weak job growth the U.S. is likely to experience in the coming years.
About the author:
David Johnson is a partner with ACM Partners, a boutique financial advisory firm providing due diligence, performance improvement, restructuring and turnaround services to companies and municipalities. He can be reached at 312-505-7238 or at [email protected].