One example of what might become an all too common phenomenon this year occurred on Jan. 6 when a court ordered the 509,000-square-foot Shenango Valley Mall in Hermitage, Pa. into receivership at the request of its lenders. Receivership is a strategy often employed by lenders for assets in financial distress, whereby the lender asks the court to appoint a third party to manage the property and get its finances in order until a longer-term solution could be found. The Shenango Valley receivership came after the mall’s owner, New York City-based Lightstone Group, defaulted on $74 million in cross-collateralized mortgages, including one on Shenango Valley, in September. To help the lenders deal with the fallout, Jones Lang LaSalle’s value recovery services group has stepped in to assess the condition of the mall and advise on the best course of action, be it a discount sale, a capital infusion, a joint venture or some other method of recouping lost value. The mall is in decent shape, compared to some other properties he’s seen, according to Greg Maloney, CEO and president of Jones Lang LaSalle Retail, an Atlanta-based third party management firm, with an occupancy level of between 70 percent and 80 percent. Current tenants include American Eagle Outfitters, Bath & Body Works and Bon Worth. Over the next several months, the company will review the mall’s revenues and operational expenses, pay all outstanding bills, make sure the asset is being managed properly and come back to the lender with a recommendation for the best solution going forward. “We will just sort of monitor it for them and manage and lease it, as with all of our assets, and will try to advise the lenders on what our opinion is of the property,” Maloney says.
Shenango Valley is one of four malls to come into Jones Lang’s value recovery group’s hands since December. The others are 478,000-square-foot Mount Berry Square, in Rome, Ga., 335,000-square-foot Bradley Square in Cleveland, Tenn. and the 556,000-square-foot Martinsburg Mall, in Martinsburg, W.Va. Altogether, Jones Lang LaSalle now has 16 commercial properties under receivership and 7 additional properties in various states of distress that it’s monitoring while the lenders decide on what to do next. For the company, this isn’t a new business. It’s always had professionals with receivership experience on staff, according to Maloney, who himself has a 15-year receiver track record, but after last year’s RECon conference in Las Vegas, the firm decided it was time to consolidate its forces into a new unit. The creation of the value recovery services group was announced this November.
“It was right around the Las Vegas time that we started to hear all the rumblings [about upcoming defaults] and decided to get all our ducks in a row should the lenders need our services to take these properties back,” Maloney notes.
Jones Lang isn’t alone in attempting to tap what could become a booming business during the next few years, as the commercial real estate industry experiences a steep downturn. Other companies have started new distressed asset businesses or bolstered existing operations. Savills LLC, a New York City-based real estate investment banking firm, launched a distressed real estate division. Cushman & Wakefield, the New York City-based international brokerage firm, formed a resolution group. Grubb & Ellis, a Santa Ana, Calif.-based real estate services provider, started a financial services asset management practice. And Sperry Van Ness, an Irvine, Calif.-based real estate investment brokerage firm, put together an asset recovery team. In addition, CB Richard Ellis and Marcus & Millichap Real Estate Investment Services, each consolidated existing distressed asset networks.
“We are going through a cycle where there is going to be a tremendous amount of distress in virtually every [real estate] sector and to ignore that would be impossible,” says Jeffrey W. Baker, executive managing director with Savills. “The only transactions that are happening are the ones where there is some level of distress, whether a broken capital structure or an asset with an underlying issue.”
Increasingly, it appears commercial real estate will face a reckoning not unlike what has occurred in the residential real estate market. Much of the commercial real estate boom in recent years was fueled by cheap and freely available debt. Often, commercial real estate loans were structured on interest-only payments for years, with balloon payments at the end of loan terms. However, in many cases, borrowers simply refinanced before those payments came due, in a strategy similar to what subprime borrowers on housing loans did after teaser periods on their mortgages expired. On the residential side, when house prices stopped rising and the availability of mortgages decreased, delinquencies and defaults spiked. A similar scenario is now facing commercial real estate, where $3.4 trillion in debt is outstanding, according to the Mortgage Bankers Association (MBA). Borrowers facing balloon payments are either finding they can’t get refinancing at all or when they can, the terms are much more conservative, with lower assessed values and loan-to-value ratios requiring new infusions of equity.
That’s where distressed asset specialists plan to come into play. Most of the firms currently offering distressed asset solutions aim to be full-service providers for the lenders—after evaluating a given asset and advising the lender on how best to recoup value, these firms have the capability to manage distressed properties long-term in an attempt to raise cash flow, arrange capital infusions in the form of joint venture partners or, if need be, take the asset to market through an auction. Many, including Jones Lang LaSalle, also offer advisory services to owners who suspect their assets might be at risk of distress. How the firms get paid depends on the scope of the services offered—for example, Marcus & Millichap, which does not offer property management for distressed assets to avoid conflict of interest, gets compensated only when it has closed a sales transaction, according to Bernard J. Haddigan, managing director of the national retail group with the firm and head of its special asset services division. But a company that secures a contract to manage and lease a distressed asset could also gain revenue that way, according to Jones Lang LaSalle.
So far, the need for such services has been moderate, but things will get worse before they get better. The bulk of the loans made at the height of the market, in 2005 and 2006, has not yet matured, according to Haddigan. But many of the mortgages closed during those years featured floating rates and will put significant strain on commercial real estate owners over the next five years, he says. For example, almost half of the CMBS loans due to mature in 2011 will be floating rate loans. according to research from Marcus & Millichap and Standard & Poors. Altogether, approximately $45 billion in CMBS mortgages will come due in 2011, $60 billion in 2012 and $43 billion in 2013. Another issue is that real estate fundamentals have begun to degrade as a result of the broader recession facing the U.S. economy. In the third quarter of 2008, the national retail vacancy rate stood at 13.3 percent, according to Property & Portfolio Research (PPR), a Boston-based real estate research and portfolio strategy firm. By the third quarter of 2009, however, that number will likely rise to 17.3 percent. PPR bases its data on surveys of retail properties greater than 30,000 square feet across 54 U.S. markets.
With virtually no new money available, some owners have been unable to refinance their properties, increasing the number of assets that have been put on watch lists by the lenders or have been relinquished to special servicers, says Arthur M. Milston, managing director with Savills. In the third quarter of 2008, the most recent period for which data is available, commercial/multi-family mortgage originations fell 53 percent compared to the same period in 2007, according to the MBA. Originations for retail properties fell 30 percent. The commercial mortgage-backed securities (CMBS) market, in particular, which accounted for up to 70 percent of all real estate lending during the boom years, has remained stagnant since June. Since then, there has been no new issuance of CMBS bonds, according to Commercial Mortgage Alert, an industry newsletter.
Currently, there are already 134 retail assets across the nation with a total value of $4.7 billion where owners have filed for bankruptcies, defaulted on mortgages, or had the property enter foreclosure, according to Real Capital Analytics, a New York City-based research firm. Of those, 18 properties, valued at $217 million, have reverted back to lenders. In addition, the firm identified 1,225 properties, or $23.5 billion, in retail assets that show potential for distress.
Milston estimates that in the past month, Savills received four or five foreclosed retail properties from special servicers. Once the damage from the 2008 holiday sales season is tallied, however, the volume could rise significantly. In 2008, the retail industry experienced a virtual flood of store closings, at 8,117, according to J.P. Morgan. In the aftermath of a particularly brutal holiday season, that trend will likely intensify, says Al Williams, principal with Excess Space Retail Services, Inc., a Huntington Beach, Calif.-based real estate disposition and restructuring firm.
In December, same-store sales declined 1.7 percent compared to a year earlier, shows data from ICSC, following a 2.7 percent decline in November.
Glen Esnard, president of the Grubb & Ellis capital markets group, estimates that going forward, retail might make up from 25 percent to 30 percent of its distressed asset management business.
“I think everyone is looking at retail right now because our economy is two-thirds consumer spending,” says Milston. “When you see the kind of job losses and economic issues we are seeing across the board, obviously the biggest impact and the first [to emerge] you will see in retail.”
Not your father’s downturn
But the new crop of special services professionals will face some challenges in handling the wave of distressed assets now coming along, according to Frank Liantonio, executive vice president of capital markets with Cushman & Wakefield and part of its resolution group. The last round of massive commercial real estate dispositions happened in the 1990s. Then, the government took bad assets from defunct savings & loan associations and formed the Resolution Trust Corp. to dispose of almost $400 billion in real estate. At the time, the securitized debt market for real estate properties was virtually non-existent. It was the Resolution Trust’s own success in creating and selling shares in limited partnerships and securitizations to work through the bad debt that contributed to the explosion of mortgage-backed securities later.
Today, after a decade of uninterrupted growth, there is approximately $812 billion in outstanding CMBS loans, according to Reis, Inc., a New York City-based real estate information provider, and the MBA. Retail properties account for about $240 billion of those loans. The issue that creates is that loans that have been securitized have multiple claims to the cash flow as opposed to when there was a more straightforward one-to-one relationship between lender and borrower. The multitude of claims will make it difficult to reach consensuses on how to handle distressed assets.
What’s more, the real estate crisis of the early 1990s was not exacerbated by a global recession and a global credit crunch, notes Liantonio. “This financial crisis starts at 5:30 in the morning, when I turn on the news and hear what happened in Europe, and ends at 9:00 in the evening, when the Asian markets are about to open,” he says. “It’s clear this is a global issue.”
This matters because one of the most common vehicles for disposing of troubled assets is to sell them at a discount, according to Milston. But with the current freeze in capital markets, few players have enough cash and feel confident enough about estimating the true value of for-sale assets to invest heavily in distressed properties, at least not yet. In November, investment sales volume for retail totaled $600 million, representing an 83 percent decline from November 2007, which was a slow month in itself, according to Real Capital Analytics. Offerings outpaced closings 5:1.
“There is an unfortunate high level of uncertainty out there,” says Spencer Levy, senior managing director with CB Richard Ellis’ restructuring services group. “A lot of the buyers can’t say what they would buy today, or what they would pay for that.”
As a result, a lot of banks have been staffing up their asset management teams in case they end up holding properties longer than anticipated, says Esnard. Among strategies they might consider are capital infusions and bundling up distressed assets into more attractive for-sale portfolios, according to Milton.
Putting all of these factors together, it will likely take up to three or four years to resolve the current logjam, says Milston. One bit of bright news for the real estate industry, however, might be the fact that the U.S. is expected to emerge from the recession earlier than the rest of the world, which is why some foreign investors have started to express interest in U.S. properties.
“What’s happening is that people are beginning to mark to the right market,” says Baker. “The opportunities are beginning to emerge and they are beginning, in isolated cases, to look more attractive. You will see capital flow back into the sector sometime in the middle of this year.”