It has been one year since the Federal Financial Institutions Council (FFIEC) released its commercial real estate loan workout guidance on behalf of federal bank regulators. At that time, policy makers were overwhelmingly concerned that aggressive action by banks against delinquent and defaulting commercial mortgage borrowers would undercut the heath and viability of the lending institutions themselves. A degree of prudence was called for if modifications of existing loan terms would serve to mitigate losses at the investment and pricing nadir. Stated succinctly in the guidance, “Financial institutions and borrowers may find it mutually beneficial to work constructively together.”
Across a range of economic and sentiment metrics, short-term conditions in the economy and in real estate markets are more stable now than in the months leading up to the publication of the FFIEC framework. In the largest markets, in particular, transaction volumes have shown sustained improvements while the force of capital inflows and easing credit have afforded sometimes-surprising momentum in pricing measures. On the ground, a spate of recent brokerage reports have described how fundamentals–including rents and occupancy rates–are showing signs of improvement, even if labor markets are lagging. And so, a year after calls for prudence, it might seem that conditions are ripe for policy makers to nudge banks toward asset disposition.
But policy makers’ recent assessments of the market suggest that they remain cautious. Or at least more cautious than many of their industry counterparts. In her remarks at last week’s Urban Land Institute meetings, the chairwoman of the F.D.I.C., Sheila Bair, was circumspect, reflecting a focus on the management of legacy issues on bank balance sheets:
“… Credit availability has … been limited as lenders have tightened standards, issuers have virtually stopped offering commercial mortgage-backed securities, and the credit standing of many borrowers has declined. FDIC-insured institutions hold about half of the $3.5 trillion in CRE loans outstanding, which means we’ve been focused on commercial real estate for a very long time. Lenders will continue to face some tough choices when loans come up for renewal with collateral values that have declined significantly from peak levels …”
The minutes of the Federal Open Market Committee’s September meeting were similarly mixed:
“… Commercial real estate markets continued to face difficult financial conditions, although some further signs emerged that this sector might be stabilizing. The prices of commercial properties appeared to have edged up in the first half of the year, and the volume of commercial real estate sales rose again in August. A few small commercial mortgage-backed securities (CMBS) deals were issued over the intermeeting period and were reportedly well received by investors. … Nonetheless, the volume of CMBS issuance in 2010 remained quite low compared with the levels seen before the onset of the financial crisis, and total commercial mortgage debt continued to contract amid further increases in delinquency rates on commercial mortgages. …”
These lackluster assessments reflect that transaction activity and fundamentals are coming off their lows but that gains remain uneven. It also reflects that investors may be more forward-looking while policy makers are confounded with dealing with investors’ (and their own) previous missteps. As reported by Real Capital in its most recent update on distress flows, the $191 billion overhang of unresolved distress–in part a result of the FFIEC guidance–lingers over the marketplace even as distress sales increase. The next policy move or the ultimate impact of greater sales out of distress on market health are difficult to predict.
Recovery Rates Exceed Projections
While it bears heavy costs in terms of the market’s progress toward balance sheet normalization, greater control over the selection and timing of the supply of distressed assets for sale has succeeded in limiting the losses internalized by many banks in the short term. According to a report released by Real Capital last Thursday, recovery rates on first mortgages, while slightly lower than in the second quarter, remain well above policy makers’ and distress investors’ a priori expectations.
Recovery rates on multifamily and commercial mortgages slipped in the third quarter of 2010, falling to 66 percent for acquisition and refinancing loans and 56 percent for development loans, before costs and fees. The modest decline in recovery rates from the second quarter coincides with a measurable increase in the dollar volume of resolution activity. Of the $14 billion in recoveries recorded since the beginning of 2009, over half have occurred in just the past six months. The rise in resolution activity accords with measurable increases in the volume and share of total sales out of distress, including from bank real estate owned (REO), that may signal a greater readiness among lenders and their supervisors to unload troubled assets.
There is evidence that the broader improvement in credit market health and transaction activity has been instrumental in mitigating loss severities and improving recovery rates. The third-quarter decline in the overall recovery rate has been concentrated in development and redevelopment loans. But the weight of this drop-off on the overall result masks a sharp increase in the number of acquisition and refinance loans resolved at par–with full recovery of the lender’s first mortgage exposure.
Distinguishing full recoveries from the wider market, the former have been weighted toward loans that originated before 2006 and for which the value adjustment has generally been less severe. Split roughly evenly between CMBS and non-CMBS loans, almost all of the full recoveries have been in the handful of major markets where core asset sales have dominated activity.
As recovery activity has picked up, the importance of troubled assets’ means of exit from distress has also become more apparent. In particular, the length of time to resolution as well as the administrative and legal complexities of exit channels correspond with materially different recovery rates. A small but growing number of resolutions via refinancing have enjoyed an average recovery rate of 74 percent. The recovery rate on debtor and trustee sales, which have accounted for 45 percent of resolutions over the past six months, has been lower, at 68 percent. At 61 percent, the more circuitous path to resolution, via sales out of REO, has measured the lowest recovery rate, even before accounting for the additional time and operating and legal expenses that characterize these resolutions.
The current improvement in commercial real estate transaction volumes enhances price discovery and the capacity of lenders to distinguish those cases where distress sales are an appropriate strategy. As such, we now observe a modest increase in the share of sales that are related to distress. In a few markets, the share is large enough that it weighs on general pricing trends. While we have a long road to travel in winding down unresolved distress in the United States–and we must see policy adjust to accommodate changing market circumstances–investors that have grown long in the tooth waiting for distress opportunities should take heart. Current transaction and recovery trends suggest banks and their supervisors will more confidently evaluate options that bring assets to the market.
Sam Chandan, Ph.D., is global chief economist and executive vice president of Real Capital Analytics and an adjunct professor of real estate at Wharton.