Distressed buying opportunities have been slow to emerge since commercial real estate values peaked in 2007. A predicted “tsunami” of distressed assets never hit the market. But today—five years after values peaked—investors are expecting more opportunities in the nonperforming market as loans underwritten at the peak of the market hit maturity dates.

That’s one of the findings in Ernst & Young LLP’s 2012 real estate nonperforming loan investor survey.

The report, entitled “At the Crossroads,” finds that even though many banks have repaired their balance sheets, increased their earnings and seen declining loan loss reserves, the volume of commercial real estate loans coming due in the next five years could lead to banks putting more nonperforming loans (NPLs) on the market.

To date, the distressed market has not been as robust as many expected as banks have employed “pretend and extend” strategies. Financial institutions held assets on their books to buy time for a recovery in the broader economy and the commercial real estate sector. “As a result, banks have sold only a small percentage of their NPLs, and with approximately US$300 billion in non-accrual and restructured loans still on their balance sheets, they still have a long way to go to alleviate the problem. Going forward, banks could accelerate their sales activity due to impending maturities,” according to the report. Overall, commercial maturities in the next five years could be between $800 billion and $1.2 trillion. Up to one-third of these loans may not be able to be refinanced. Financial institutions will be left with a choice of foreclosing, restructuring or disposing the loans.

One way opportunities could materialize would be in the form of the FDIC selling individual loans or portfolios. According to the report, “The relatively high level of FDIC-designated problem banks suggests that the FDIC will continue in 2012, and perhaps beyond, to sell individual NPLs or portfolios of NPLs and other assets. Its sales generally are either cash transactions or what are known as structured transactions, in which the FDIC maintains an ownership interest in the portfolio.”

A factor affecting what kinds NPLs are hitting the market is the makeup of affected financial institutions. Overall, according to FDIC data, 7,445 banks have $13.8 trillion in total assets with $1.53 trillion of that in the form of commercial real estate loans, or 11 percent. For the top 100 banks, the percentage is just 7 percent—$784 billion out of a total of $10.9 billion. But the remaining banks’ commercial real estate loans are a much higher percentage of the total: $750 billion out of $2.9 trillion in total assets, or 26 percent.

In addition to the difference in volume, the loans at the books of the largest banks “tend to be on large, high-profile properties such as office towers, regional shopping centers and high-rise apartments in gateway cities and other leading markets in the U.S.,” according to the report. These assets, while not immune to changing fundamentals, are less prone to swings and therefore are the most attractive assets for investors. In contrast, regional and community banks portfolios generally consist of construction loans or acquisition and development loans on smaller and riskier commercial real estate assets in smaller markets.

Survey findings

Nearly half the investors in the survey indicated that their investment activity in 2011 was about the same as in the previous two years: 46 percent. Overall, 28 percent were less active, a significant increase from 2009, when just 5 percent said they were less active. Investors who said they were more active declined to 26 percent in 2011, down from 36 percent in 2010 and 49 percent in 2009.

According to the report, “Part of the reason for a greater percentage of investors being less active could be that deal sizes have inched up, thus leaving out the smaller investors who can’t afford or choose not to commit larger amounts of capital. The FDIC, which has established programs that cater to smaller investors, was a less active seller in 2011, as larger banks have stepped up their sales volumes, including portfolios of larger loans.”

The survey also found that in 2011 investors allocated more capital for buying NPLs from banks and investors experienced a higher rate of success in closing transactions than in previous years.

Investors also continue to seek leverage, with 67 percent of survey respondents expecting to use some level of financing for acquisitions. This figure, however, was down from 84 percent in the previous year. Of respondents who expected or required leverage, about a third aimed for leverage of 51 percent to 60 percent. Only a few expected to need financing for more than 60 percent of the purchase price.

Chris Seyfarth, a partner in Ernst & Young LLP’s transaction real estate practice, spoke with NREI about the survey and its findings.

An edited transcript follows.

NREI: What is the overall situation for investors looking to acquire NPLs?

Seyfarth: There has a been a slow and less than satisfying pipeline of transactions. Last year was more active than earlier years. But you’re starting with such small transaction numbers that 2011, while better, was not what investors were looking for. From an investor’s standpoint, however, 2012 could be a far stronger year.

NREI: What are the reasons for that?

Seyfarth: There’s the often quoted amount of maturities coming up, which is the roughly $1 trillion in maturities coming due in the next handful of years. And that’s been discussed for a few years now, frankly.

But the key thing is that we’re five years into this process if you consider 2007 to be the high point of the market and when a significant number of originations occurred. So now we’re hitting the maturities of loans done in those years. Those LTVs were fairly high and the real estate values were, some could argue, higher than they should have been.

So if you consider the drop in LTV rates and the drop in values since that time, as those loans mature, borrowers are going to have a struggle. What are their options? They can refinance and put more equity in or they can pay off the loan. And both of those options will be tough for some borrowers.

NREI: How are financial institutions approaching those maturities? We’ve talked about “pretend and extend” for several years. Is it more of that?

Seyfarth: With those five-year loans—and seven-year loans that are also coming down the pike—they’ve got property values somewhat less, and in some cases far less, than when the loans were originated. So financial institutions have to take a hard look and figure out what their best course of action is. They have limited options. They can restructure. They can extend the maturity. They can negotiate a discounted payout. They can foreclose. Or they can sell the loan. To the extent that those maturities are for loans where the real estate value has decreased, none of those options are particularly satisfying for the bank.

NREI: So will we see more loan sales, either as one-offs or through portfolios?

Seyfarth: We did greater sales activity in 2011. In that respect, financial institutions are taking advantage of market conditions. The issue has always been price—can they get the price that makes sense to them to sell the loan? That’s a constant struggle between buyers and sellers in the NPL market.

Pricing has increased in part because real estate values have held out and even increased for better-quality assets. … There are some markets where values on strong office properties are almost back to where they were at the peak of the market in 2007. That will significantly help the banks’ positions. But that’s only a slice of the real estate assets.

The lesser-quality assets—those in tertiary markets, development or land deals, smaller retail assets, industrial, etc.—are still struggling.

What are investors’ options in trying to tap into the opportunities?

Seyfarth: Investors can try and negotiate exclusive transactions with banks. Banks may also make portfolios available through various auction processes—either online or through an auction brokered by a loan sale advisor. Those are the traditional ways financial institutions get loans off their balance sheets and move on. … Investors can also come in and help prop up borrowers through an injection of capital. They can help borrowers renegotiate with lenders. But, by and large, what you see are whole loan sales.

Are there particular areas of the market that may be more active this year?

Seyfarth: There has been more activity coming from international banks that have U.S. exposures. We saw some of that last year with the large transactions from Irish banks. There is some expectation that will continue in 2012. European banks are struggling with capital positions and are being pressured to raise capital. So a strategy has been to reduce U.S. exposures in attempt to raise capital.

NREI: One thing the report points out is that the smaller and regional banks have larger exposure to commercial real estate and its generally lower-quality assets. Meanwhile, larger banks have less exposure and better-quality assets. How does this affect the NPL market?

Seyfarth: In addition to the difference in assets, larger banks tend to have well-organized workout and restructure departments. … Smaller banks just don’t have internal resources to do that. So, in some ways, the exposure to troubled loans can be a significant distraction for smaller banks. It’s not only a financial distraction, with declining expectations in terms of collections, but it’s also a resource drain in terms of the necessity to redeploy people. That’s one difference.

Another difference is by the sheer size of the larger banks’ capital positions, they can better weather the storm from the financial impact of bad loans. Thirdly, the percentage of CRE loans to total assets for large banks is far less than it is for the smaller banks. As things go bad, it impacts a bigger portion of smaller banks’ total assets, which is a significant concern for regulators.

In fact, when looking at the banks that have failed, you often see that the percent of their balance sheets that are real estate loans is well over 50 percent. So that has hit the radar screens of regulators and it’s not a positive trend.