Strong investor interest in distressed and performing loans reflects growing confidence in U.S. market.
The commercial real estate sector has had little to cheer about recently, but robust demand for loans is reason for cautious optimism. Liquidity in the commercial real estate loan marketplace is creating opportunities that will benefit the industry.
First, because commercial real estate loan sales are significantly strengthening lenders' balance sheets, their ability to finance new projects is improving. Second, commercial real estate properties that have been in legal limbo are changing hands as investors purchase the loans to own the property, reposition it and generate positive cash flow.
These two trends alone suggest that the commercial real estate market may be poised for a recovery. In addition, loan prices are stabilizing due to modestly improving fundamentals in the commercial real estate market, and that is giving lenders more confidence to sell loans to strengthen their balance sheets.
The aggregate value of more than 55,000 loans within the commercial mortgage-backed securities (CMBS) universe is off the post-crisis lows. Since March 31, 2010, commercial real estate loan prices have risen 5.1% (see chart).
Lenders' balance sheets improve
To be clear, the underlying motivation of institutions is not solely to improve liquidity to originate more commercial real estate loans. Institutions that can fortify their balance sheets will be the likely winners in the next round of financial services consolidation.
In the short term, the cause for optimism for real estate professionals is that commercial banks, insurance companies and other lenders are shoring up their balance sheets by actively selling commercial real estate loans. Strong demand for these loans is helping institutions achieve their most important loan sale objective — maximizing price. Competitive bidding among an expanding base of buyers is creating a deep loan marketplace.
Institutions have taken advantage of that liquidity to sell performing and non-performing commercial real estate loans. In selling non-performing loans, lenders are eliminating the high cost of loan workouts and real estate owned (REO) properties.
By selling performing loans, lenders reduce risk and improve diversification so they can pursue new lending opportunities. They are eager to act now because more than $1 trillion in commercial real estate loans will mature by 2015. About half of those loans are underwater.
The wide range of available commercial real estate product is attracting a diverse pool of investors. Opportunity funds, private equity funds and hedge funds, which typically have a higher appetite for risk, have been significant buyers of distressed loans.
Distressed loan buyers more often than not are purchasing loans to own the underlying assets. This investment activity is benefitting the entire commercial real estate market. New capital and management are unlocking properties that have been in a state of paralysis.
Income-oriented investors also are buying commercial real estate loans, but they are more interested in performing loans. Seasoned performing loans are typically bought at yields ranging from 5.5% to 7%, a big premium over the 2% to 3% offered by U.S. Treasury bonds.
Banks, particularly local institutions, also are active buyers and sellers of commercial real estate loans. That's a positive for commercial real estate lending for several reasons.
First, the secondary market gives banks an outlet to sell loans and strengthen their balance sheets. Second, loan sales by smaller institutions often inject fresh capital from outside the local area. Smaller loans attract more market participants, enhance liquidity, and have an uplifting effect on local real estate markets.
A fundamental shift is under way among loan portfolio managers that will likely lead to further liquidity — not only for commercial real estate loans, but also for all loans. That's a positive sign after the hardship of the recent past.
Kingsley Greenland is CEO of DebtX, a loan sale advisor for commercial, consumer and specialty finance debt. Contact him at firstname.lastname@example.org