Investors seeking to capitalizeon the distressed real estate market would be wise to expand theirfocus beyond commercial mortgage-backed securities, which no longeraccount for the bulk of troubled loans inthe US.

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That's according tonew data fromReal Capital Analytics, which is warning that CMBS-based investmentstrategies that worked during the last downturn probablyaren't the best bet at the moment. 

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In 2007, at the start of thefinancial crisis, 64% of distressed commercial real estate loans inthe U.S. originated out of the CMBS market. But in 2019, that samemarket accounted for just 21% of the risky lending, while banksissued 53% of the distressed loans. 

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"From what we've seen in the CMBSworld, it's only the tip of the iceberg," JimCostello, New York-basedsenior vice president for RCA, said in aninterview. 

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International banks issued 11% ofthe distressed loans last year, while national and regional bankseach issued 21%, according to RCA. 

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Meanwhile, much of the riskylending came from investor-driven lenders, which had an averageloan-to-value ratio of 69.1% for office, industrial and retailproperties from 2010 through April2020. For regionaland local banks, national banks and international banks, theaverage LTV was between 65% and 67%, while it was 63% forCMBS. 

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"Banks of all scale have captureda larger share of all commercial mortgage activity than the CMBSmarket. These bank lenders were also more aggressive atorigination, with higher LTVs than CMBSlenders," Costellowrote in a report for RCA.

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"However, the aggressiveness of bank lending is tame compared towhat some of the investor-driven lenders (a grouping that includesdebt funds) were doing with their leveraged lending platforms," headded.

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When borrowers default on CMBSloans, a special servicer typically steps in, which makes it easierfor investors to identify distressed properties. Finding troubledbank-issued loans is more difficult.

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"It's a less transparent marketthan CMBS," Costello said.  

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"The banks don't have the sameincentives to clear stuff out," he added. "They're also chock fullof capital. And regulators are telling them, 'Don't worry aboutcapital reserves at the moment.' So they're naturally inclined atthe moment to pretend and extend … and effectively kick the candown the road." 

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Costello recommended thatinvestors do additional research to figure out which banks havebeen making risky loans then build relationships with thosebanks. 

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"You can step in and start providing capital to buy out some badloans or work with current borrowers to try to reposition theproperty," he said.

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Phillip Bantz

Phillip Bantz is a reporter for Corporate Counsel. Follow him on Twitter @PhillipBantz.