The average loss severity rate for CMBS loans resolved in 2009 was 57% compared to a rate of 43% in 2008. The cumulative historical average is 37.2%.  Analysts with Fitch Ratings expect the loss severities to remain above the cumulative average through 2011.

Assets liquidated today will be those unlikely to see a cash flow improvement as a result of an extension or modification. Concurrently, special servicers are continuing to see a high volume of underperforming loans further slowing the process for resolution (think high stakes divorce proceedings). With a continual stream of excess inventory and a declining frequency of modifications, there appears to be no relief in sight.

In a booming market, a collateral liquidation could recover fully the interest shortfalls and possibly even the total outstanding balance. But in today’s environment, where commercial real estate values are well below the 2007 peak, it will take much longer to return to the value at the time the loan was secured.

A study conducted by CoStar Group showed that among liquidated loans, 91% of properties had at least one reappraisal done and 87.5% of those experienced a reappraisal value lower than at the time of securitization, triggering appraisal reductions for those assets with loan amounts more than 90% of the new appraisal value.

During the First Quarter of 2010 there have been $270 million in losses through liquidation. Among the $17.7 billion in loans added to special servicing this year thus far, 7% saw appraisal reductions. This means the rate of loss severity is sure to worsen.

Certain property types are expected to yield higher loss severities than others.  Here’s the breakdown for 2009:

• Retail – 48.2%
• Industrial – 48.8%
• Office – 56.9%
• Multifamily – 58%

source: CoStar

For the past 2+ years distressed property offerings have sat pretty much untouched while buyers tried to determine the best time to re-enter the market (ie. when values hit bottom and stabilized).  It looks like 2010 is it.  In the First Quarter,184 transactions closed compared to 102 in the First Quarter of 2009, a nearly 45% increase year over.  2010′s number is more in line with transaction volume during the first quarters of 2008 (187) and 2007 (189). A good indicator that buyers with cash have decided the timing is right to pursue deals.

While the activity level among distressed properties is a good sign, it must be noted that  assets in good standing are not moving without considerable discounts. Take, for instance, the recent sale of One Main Place in Portland. This Class A office tower had 97% occupancy and a strong tenant roster. It was purchased in 2006 for $69 million and recently sold for $59 million. 

OFFICE AND INDUSTRIAL PRICES – CLOSING THE GAP

Distressed office prices have been trending down from their 2007 peak.  But lately the price gap has narrowed with top prices declining and bottom prices slightly increasing. Since late Third Quarter 2009, distressed office properties have sold for anywhere from $70 to $140/SF.  During the same time period, nondistressed office properties sold for between $110 and $200/SF.

Three years ago, distressed industrial properties were trading anywhere from $20 to $80/SF.  In late 2008 and early 2009 there was a brief rally in industrial prices, but today the price bottom is back around $20/SF.  The top of the price scale is around $40/SF, narrowing the gap between high and low by $40/SF.  Nondistressed flex and industrial properties have been selling for between $40 and $85/SF.

THE ACTIVE BUYER POOL TENDS TO BE LOCAL/REGIONAL

The mix of buyers of distressed office properties during the recession years breaks down as follows:

• Regional developer/owners – 26%
• National developer/owners –  17% 
• Individuals – 14%
• Corporations – 14%14% 
• Investment managers – 11%

Over the last six months, investment managers have decreased their share to less than 5%, while banks and government entities have increased their share of purchases. No doubt a portion of the  government increase comes from assumption of numerous corporations with considerable real estate holdings.

The mix of buyers of distressed flex and industrial properties since 2007 breaks down as follows:

• Regional developer/owners- 23%
• Corporations – 20%
• National developer/owners – 16%
• Investment managers - 11%
• Individuals – 11%

Over the last six months, corporations have become the most active buyers accounting for 3 out of every 10 purchases. Regional developer/owners follow closely at 28% while investment managers’ share has fallen to 8%. Individuals now account for less than 4%.

source: CoStar

According to latest Fitch Ratings’ weekly report on the status of the CMBS mess, larger batches of U.S. CMBS loans are moving to special servicing (meaning they are in default) at alpine downhill speeds.  In January 2010, 248 loans worth a total of $4.27 billion moved to special servicing. This figure is more than four times the amount transferred in January 2009.  The size of specially serviced loans increased 2.4 times from $17.2 million in 2009, with five loans greater than $100 million. Fitch’s index suggest CMBS will continue to decline despite any bottoming-out by the residential market, typical of the lag between the two markets.

As the practice of “pretend and extend” on loan calls has diminished, more of them are approaching final maturity without available refinancing, even for performing loans.  This wave of financial trouble is a long one with momentum building behind it over the next two years.

Here is the distribution of property types in special servicing  along with the total loans

Office

• Total in special servicing: 509 ($7.5 billion)
• Rated universe: 6,559 ($141.5 billion)

Hotel

• Total in special servicing: 275 ($11 billion)
• Rated universe: 2,131 ($49.5 billion)

Multifamily

• Total in special servicing: 872 ($9.8 billion)
• Rated universe: 9,320 ($62.2 billion)

Retail

• Total in special servicing: 842 ($15 billion)
• Rated universe: 12,837 ($127.3 billion)

source: The Watchlist Newsletter, CoStar

Most analysts predict the increase will continue in the coming months. The delinquency rates compared to last month’s number are below:

Property Type            This Month              January 2010

Hotel                             16.44%                         9.13%

Multifamily                      8.33%                         7.54%

Retail                              4.94%                          4.25%

Industrial                       3.73%                          3.57%

Office                             3.06%                          2.66%

source: CoStar

In 2009, the FDIC sustained losses of over $36 billion due to the  failure of 140 banks.  For comparison, the FDIC incurred losses of $29.6 billion from 1987 to 1992, when 1,049 banks failed during our previous financial  downturn ( the infamous S & L crisis).  Much has been said about that crisis being worse than the current one due to the number of failed institutions.  However, the problem this go around is not the number of banking institutions failing, but the value of them. 

In 1989, 534 bankes failed, with the average value of  total assets at each institution hovering around $205 million. In 2009, the average total asset value of each failed institution was closer to $1.2 billion.  A nearly tenfold increase.  Also of note, the cost to the FDIC during the Savings and Loan crisis was $28 million per failed bank, whereas that number escalates to $261 million per failed bank in 2009.  2010 does not look better.

Meridian Group (an industry tracker out of Seattle)  suggests that it is difficult to predict the cost of looming bank failures, but given the rate at which the FDIC continues to add staff, it is safe to reasonably expect the worse is yet to come. The good news is most really large U.S. banks are not heavily exposed.  Highly delinquent commercial mortgages were only 0.1% of Citigroups assets and it is believed Bank of America’s exposure is only slighly higher.  Alas, it appears it’s small to medium-sized banks at highest risk of exposure, futher complicating the ability for local communities to improve. Banks with less than $1 billion of assets had, on average, 32.5% of their assets in commercial mortgages.

While some experts feel the early-stage delinquency rate on commercial mortgages peaked in first quarter of 2009, others are not so sure. They believe the commercial mortgage crisis may peak this year and begin improving in 2011. But with numerous loan maturity dates set for 2011-12, the dark cloud in me says to remain cautiously optimistic on that idea too.

source: Mark Herschmeyer, Costar

Delinquency rates by property types:

Office – 2.29%

Hotel – 6.81%

Retail – 3.55%

Multifamily – 6%

Industrial – 3.09%

Office delinquencies increased $557.4 million in October. Industry analysts expect continued job losses to increase pressure on the office sector. With leases expiring over the next 24 months on space not utilized by tenants who have downsized, office performance isn’t expected to trough for a few years.

source: CoStar

The average price per square foot (or per unit for apartments) is either at or less than 2004 price levels:

Property Type                2004                              2009      

Office                         $164.02/SF                $168.05/SF       (even)

Industrial                  $80.90/SF                  $70.66/SF          (13% less)

Retail                         $108.71/SF                $83.70/SF          (23% less)

Multifamily                $86,487/Unit               $70,352/Unit      (19% less)

Bond rating agency Fitch expects real estate fundamentals to continue deteriorating for another 18 to 24 months despite a broader economic recovery. This decline is likely to result in ratings downgrades on otherwise proven CMBS deals. Though these potential downgrades will not have as significant an impact on the economy as post 2006 CMBS deals have, they will continue to delay any sort of commercial real estate stabilization prior to 2012.

Even though the economy has shown some positive momentum of late, several sectors of the commercial real estate industry have continued to drop. The hotel sector, no big surprise here, is the most volatile and has already seen revenues per available room decline by 20% since January 2009, with many industry experts anticipating a 50% decline before bottoming out.

Office vacancies have reached 15% nationwide and will continue to rise in 2010 as layoffs continue to trickle down. Central business districts continue to fair better than suburban submarkets (ex: Portland| CBD – 9%, Westside Suburbs – 17.7%, I-5 Corridor – 20.46%), but all landlords are facing big declines in rent, significant concessions (free rent), and increased vacant sublease space.

Specially Serviced CMBS Loans  – loans that are delinquent or reached maturity without pay off or have ongoing issues with credit problems involving tenants or borrowers.

Jan. 2009 – $8.2 Billion

Sept. 2009 – $46.9 Billion

Number of distressed office buildings in U.S. – Buildings that were 60% vacant or more.

Jan. 2009 – 19,600

Sept. 2009 – 31,000

Plummeting Property Values – Office, retail and industrial/flex properties have lost between 15% and 35% of their value since 2007.

Year         Office Bldgs                Retail Bldgs               Industrial/Flex Bldgs

2007        $219/SF                    $178/SF                     $61.50/SF

2009        $142/SF                    $132/SF                     $52.00/SF

As businesses have disappeared or made major cutbacks, the demand for space has declined significantly. In the first two quarters of 2007, office properties saw a net absorption of 41.8 million square feet. By comparison, in the first two quarters of 2009, tenants have returned 40.9 million square feet of space, nearly wiping out any gains over the past two years. Industrial/flex (think close in Eastside or the Sunset Corridor) properties have faired worse nationally, with net absorption of 94.1 million in the first two quarters of 2007, but gave back even more in the first two quarters of 2009 with 97.5 million.

All of this negative activity has created a swelling inventory of buildings with 60% vacancy or more. Oregon ranks 25th for the number of distressed properties (office, retail, and industrial/flex) by state.  With 994 total properties under distress, we are fairing much better than the number one position holder, California, which has 80,734 total distressed properties. The lowest is Wyoming with 41 distressed properties. Our neighbors to the north (WA)  are number 19 on the list with 1,404 distressed properties.

• Freddie Mac backed multifamily loans overdue by 90 days or greater – 0.09% to 0.11%
• FDIC insured bank and thrift loans overdue 90 days or greater – 2.28% to 2.92%

The commercial and multifamily loan delinquency rate climbed significantly last quarter and should continue this ascent through the end of the year. Industry experts attribute the rise in delinquent loans to lower levels of employment, consumer spending pullback and property devaluations as a result of the market turndown.

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