The retail sector may be moving to the next stage in the cycle of distress resolution. In the second quarter of the year, the volume of new retail centers entering distress fell to $1.6 billion, the lowest figure since the third quarter of 2008, according to Real Capital Analytics (RCA), a New York City-based research firm.
At the end of June, the level of outstanding distress for U.S. retail properties was $26.7 billion, only 3 percent higher than a year earlier.
RCA’s definition of distress includes properties that have been delinquent on their mortgage payments, defaulted on their loans, have been foreclosed on, experienced an owner bankruptcy or are in lender REO.
At the same time that the number of new retail properties entering distress has begun to taper off, resolutions have been on the rise. In some cases, lenders’ improved financial state has allowed them to realize the losses from bad real estate bets.
In other instances, involving centers in primary markets, retail real estate values have recovered enough that the lenders were able to get most of their money back.
Lenders have already worked through $27.8 billion in distressed retail assets over the past three years, representing more than half of the $54.4 billion in total retail distress situations that occurred during this market cycle.
Barring the possibility of a prolonged economic downturn, those numbers will continue to improve in the coming months, according to Dan Fasulo, managing director with RCA.
That’s good news for retail property owners looking to sell or refinance their centers, but bad news for investors looking for steep discounts on core properties, Fasulo says.
Below, Fasulo talks about the current state of distress in the retail sector.
Retail Traffic: How significant are the improvements RCA recorded in retail distress resolutions this year?
Fasulo: We’ve definitely seen some major changes in the retail sector. Obviously, the Centro portfolio, while not officially troubled, was an overhang in the market for some time. Now that it’s in the hands of opportunistic investors that’s a positive for the market.
Also, when a savvy investor comes in and makes such a tremendous sector bet, it really gives a lot of other investors confidence in that property sector. That is a major macro bet on retail, the first one we’ve seen post-Lehman Brothers.
To look at some of the statistics, I think it’s clear that we are at somewhat of an inflection point in the distress market. For the first time we are starting to see more [retail] properties exit distress than enter. In the second quarter, we recorded the lowest amount of newly added distress since the downturn began, so it’s a very positive sign.
Another good metric to look at is the sale of distressed properties as a percentage of overall property sales. It’s [now] up to about 15 or 16 percent [of overall sales]. That means that lenders are finally being proactive about liquidating some of their bad loans.
The market is finally starting to clear. If investors don’t act quickly, there is a chance that many of the opportunities that exist today won’t be around for much longer.
Retail Traffic: So lenders are moving away from the extend-and-pretend approach?
Fasulo: I don’t think it’s too ridiculous to say that extend-and-pretend is over, especially with the balance sheet crowd. As far as retail is concerned, more than half of outstanding distress is sitting in commercial mortgage-backed securities (CMBS).
CMBS lenders have been the slowest to resolve their issues because it’s hard to round up 100 bond owners versus getting one bank officer to make a decision. But even CMBS servicers are starting to get a little more aggressive.
Domestic, national and international banks have been very aggressive in reducing their exposure to bad retail loans in the first half of this year. Some of this is opportunistic as well.
We have seen a recovery in values, especially in the major markets, which in some cases allows a lender to exit the troubled situation with a solid recovery rate. All bets are off if we go into a double-dip recession, but in my mind, we are heading toward the later innings of the distress cycle.
Retail Traffic: Does geography play a role in how quickly the retail distress situation is getting resolved? Do you see a clear difference between certain states and cities?
Fasulo: Yes, the market does vary around the country. As far as the dollar value of outstanding distress, the biggest markets for that are places like Phoenix, Las Vegas, the Inland Empire, Chicago, to some extent. These are really the markets that got hit by the housing bust the hardest.
But then again, some markets have been able to work out a lot of their issues, like Denver, Northern New Jersey, Dallas, even Miami. They’ve been able to work out more of their properties than the national average.
It might come down to the individual assets — a handful of big transactions might move the distress statistics. Part of it is that investors have started to move out of the major markets, which have gotten expensive. They’ve started to look elsewhere in search of higher yields. I think that long term, Miami is a very good market in which to have retail exposure.
Retail Traffic: You mentioned the possibility of a double-dip recession. Given the stock market performance in recent weeks, how worried are you about that possibility and its impact on distress resolutions?
Fasulo: I am less concerned than most, but then again I just happened to be watching CNBC a moment ago and we are down 500 points today. I think it will only reinforce the viewpoint that many investors have that prime commercial real estate is somewhat of a safe haven in this environment.
Where it might hurt and might slow down the recovery that has started is in the secondary markets and more challenged properties. It might affect people buying vacant buildings where they have to execute a lease-up strategy, or people buying assets that might need additional capital.
They might pause on that, given the economic uncertainty. Those are assets that are directly linked to the health of the underlying economy. If consumers aren’t spending, there is not going to be a retailer to fill your shopping center.
But that’s a different universe of assets, in my view, than fully leased properties, which will remain in high demand.
Retail Traffic: How does this down cycle compare to the one the industry went through in the 1990s?
Fasulo: This cycle has not played out the way the down cycle did in the early 1990s, when investors were able to buy great core properties for cheap. This time, the market has recovered very quickly for core properties in the U.S. — if you blinked, you missed 50 basis points of cap rate compression.
The discounts are currently on assets that have property-level challenges, such as leasing or capital needs, or both. And that requires risk taking, which a lot of investors aren’t willing to do right now, but that’s where the opportunities are. And land — there are some good values in land as well.
Retail Traffic: In your opinion, when did that sweet spot occur? When could investors really make a killing in this cycle by purchasing distressed centers?
Fasulo: Certainly the low point was in early 2009. There was very little liquidity on the equity or the debt side, so there were massive discounts available if someone was willing to take the risk. Those people are going to be able to make a small fortune.
Retail Traffic: We are still a year or two away from the point when the bulk of retail CMBS loans that were originated during the boom years are scheduled to come to maturity. How worried are you about all those CMBS maturities?
Fasulo: From my understanding, the really big numbers don’t come until 2015, 2016 and 2017. We slightly increase every year going forward to 2015. I can barely see six months out, let alone 2015, so I think it’s way too early to make a judgment on those loan maturities.
There are a whole lot of scenarios I can see where values will continue to increase over the next couple of years, and where refinancing won’t be a problem. Some people have been talking about that and some of them have their own agendas.
There are a lot of frustrated investors out there who are looking for those assets to buy and can’t buy them. But in my mind, the wave of defaults is over. The only way those CMBS maturities will become an issue is if we have an extended downturn, including a double-dip recession and absolute chaos.
Retail Traffic: Anything else that retail real estate insiders should keep in mind right now?
Fasulo: Yes. We are starting to see nice year-over-year increases in transaction volume for retail, but to continue to see growth we are going to need a healthy CMBS market. So, I would have everyone make sure to watch that source of debt capital because it will have implications over the next few years on whether this recovery can go to the next level.