This issue of Research Matters from Ross Moore, Chief Economist for Colliers International, delves into the absence (or near absence) of distressed sales. Almost two years into one of the most dramatic downturns to ever hit commercial real estate, the “tsunami” of troubled real estate that was expected to hit the market has largely failed to materialize.
The Numbers to Date
As the chart below shows, total cumulative distressed real estate at the end of July was just over $189.1 billion. Distress is defined as either REO (real estate owned) or troubled real estate. Since the beginning of 2008, monthly additions to distressed real estate have averaged $8.5 billion, although July was just $5.0 billion and the lowest monthly increase since October 2008. This, combined with nearly $4.0 billion of restructured or resolved real estate in July, resulted in a net increase of just over $1.0 billion in distressed real estate. This raises the question whether outstanding distressed real estate has peaked?
And What About the $1.4 Trillion of Maturing Debt?
Many investors have looked at the $1.4 trillion of maturing debt coming due this year and over the next three years, and assumed most would find its way into the distressed real estate market. With market values well below outstanding loan balances the assumption would be $300-350 billion per year, or approximately $25-30 billion, would be hitting the market every month. This is clearly not the case and certainly not when looking at July’s paltry $5.0 billion of new troubled real estate.
Pretend and Extend
The answer is largely because of the much reported “pretend and extend” phenomenon that is being applied to all but the most impaired real estate. Lenders and owners are hoping that the market will rebound, pushing values back up and putting owners back “on side.” To date, the key to keeping loans classified as performing has been adequate cash flow, or at least enough to service current debt payments. Exceptionally-low interest rates and a loosening of rules by banking regulators have made this possible.
The reality setting in is that the “bargains of a lifetime” that many were expecting are now less likely to materialize, or at least not on the scale first anticipated. The 3rd Quarter Korpacz survey released on Friday reflects this new view on the market but it is a consensus that has been building for much of the year. Even lodging, which was the poster child for distressed real estate is starting to show considerable improvement. Residential land and condos, particularly those that are midway through construction, are key sources of distress but beyond these two property types, opportunities are limited. Investors are having to readjust their expectations and are either lowering their proforma returns or just waiting and hoping the market comes to them. Recent evidence suggests the former and not the latter is the most likely outcome. The status quo cannot last forever and certainly there is a growing view that lenders will begin to unload problem real estate in the coming months, but banks and regulators look set to “drip” real estate to the market and not flood it. As the market stabilizes, rising distress sales will be a key feature but will most likely resemble a wave and not a tsunami.
Ross Moore is the Colliers International’s Chief Economist with a focus on providing bottom-up and top-down analysis of commercial real estate markets across the United States. In addition to his North America wide reports, Ross also authors all global research produced by Colliers.