Defining the 'New Normal'

It's difficult to gauge exactly where we are in the plummet from peak to trough, though after several tough consecutive quarters, the industry is hoping we're standing at the bottom and looking up. That was the over arching sentiment among panelists at the inaugural RealShare Distressed Assets conference in Dallas last month, which drew about 300 attendees to the Hotel Adolphus.

The industry is bracing for a massive amount of commercial real estate loans to mature over the next three years, totaling about 41 % of all current commercial debt, said Mark Grinis, distress service group leader for Ernst & Young LLP in New York City. He compared the current financial crisis to that of the early '90s, calling it "RTC 2.0." Grinis expects this downturn to be "tougher than the last cycle," with unemployment already surpassing that period and delinquencies continuing to trend upward.

At press time, there were about $135 billion of commercial mortgages in default, with another $10 billion being added to the distressed markets each month, said Robert M. White, Jr., founder and president of Real Capital Analytics in New York City. And CMBS loans are defaulting faster than any others.

There haven't been any true new CMBS issuances this year, or really since 2007, said Everett Greer, a managing member of Los Angeles based Greer Advisors. And if this is, in fact, RTC 2.0, then the industry could see a new CMBS-type vehicle emerge from this financial crisis, much as the RTC made it possible for the development of that model in the early '90s. "Most banks are not in the business of holding long-term debt," Greer said.

The upside to CMBS loans is their transparency and the fact that historically they have performed much better than other classes, said Patrick Sargent, president of Washington, DC-based Commercial Mortgage Securities Association. He said the CMBS market will certainly return, though it will appear a bit different from last issuance.

"When Treasury Secretary Timothy Geithner announced the TALF program, he said about 40% of consumer and business credit will be financed through securitization. Any investment in this market will include a resurgence of securitization," Sargent said. "Banks and other companies are not able to fund all of the maturities coming due, so they'll have to go to the capital markets."

But because of CMBS, the industry is dealing with an increased number of parties in every transaction, further complicating matters, noted Jeffrey A. Lenobel, partner and chair of the real estate department of Schulte Roth & Zabel LLP in New York City. "In the old days, you got the loan modified. But today, you can't get a decision made so quickly," he said. "Doing a workout today in the CMBS world is difficult because you can't find the people to make decisions." Indeed, the complex borrower structures of securitized loans can include 30 different bond classes per pool.

Another concern in the market is the whopping number of loans in special servicing. By year-end, that number could grow to $100 billion, according to Steven E. Pumper, executive managing director at Dallas- based Transwestern. Almost every loan that matures today goes into special servicing, said Brian Pittard, a senior vice president with Atlanta-based TriMont Real Estate Advisors.

Considering that some $800 billion in CMBS loans are set to mature over the next few years, the loan pool in special servicing could balloon to astounding proportions. In fact, any loan not paid off by maturity is technically in default, said Michael Carp, managing director of real estate solutions for Capmark in Dallas.

Many older loans-10-year-old loans, for example-were refinanced at maturity. However, many newer loans, especially five- to seven-year credits that are maturing in the next few years, will not have refinancing options, said panelist Robert Flandrau, vice president and senior asset manager with CWCapital Asset Management LLC in Dallas. In the meantime, Carp said, borrowers may need to face a repricing of their assets and take the losses or write-downs. It's no wonder Pumper believes the smart move in some of these cases is to hand over the keys instead of trying to hold on to the troubled property.

He praised "intelligent players" such as Hines, which gave back a portfolio in Northern California and 333 Bush St. in San Francisco. That's a change from the last recession when borrowers did everything in their power to hold onto their assets, Carp said. On the bright side, investor interest in multifamily loans has picked up in the past 90 days, Pittard noted. He related that his firm recently got outbid for a loan, which is a positive sign that trading in that sector is getting more aggressive.

Still, most in the industry are waiting for deals. There's certainly plenty of capital, and more being amassed every day. There has been a spate of new REIT filings and existing REITs have raised more funds. Even institutional investors are starting to get back into the game, according to Robert Knakal, chairman of Massey Knakal Realty Services in New York City.

"Institutional capital has had to reinvent itself and funds have been raised to buy distressed assets," he said. "On notes we've sold in the city, we get more than 50 offers on every one." Knakal's firm has analyzed nearly 1,000 distressed assets in Metro New York in the past year for hundreds of lenders, he said. "That supply is dripping into the market while the pipeline is chock-full of assets waiting to come into the marketplace."

The lack of financing and liquidity is the main reason more deals aren't getting done in the current marketplace. And the fear of "catching a falling knife" is keeping plenty of players on the sidelines. "There's very little incentive for anyone to sell right now," said Jack Wensinger, president of WillMax Capital Inc. in Dallas, speaking on a panel titled, "What Investors are Looking For." He added, "Nobody is willing to step up and say we're gonna sell an asset today."

Richard Rudd, a senior managing director at boutique firm Allied Advisors LLC in Houston, said buyers and sellers alike need to rethink and redefine before any serious trading can begin. "Those with the equity need to feel comfortable that the market has bottomed," he said. "They need to see some signs the economy has stabilized. And sellers need to recognize that what they have is not worth what it was in 2007."

While some still see a palpable gap between the bid and ask price, Rudd said it is narrowing and by the second quarter of next year, we'll be in a very active transaction market.

Any deals that are getting done today are on the small side, mostly around $5 million and financed by local and regional banks, RCA's White said. He noted that there is greater liquidity for smaller deals and it's difficult to finance anything over $15 million. White also mentioned that the financing makeup for these deals has flip- flopped from the height of the market in '07 when everything was leveraged to the hilt (think Macklowe) and there was little equity capital.

"Another big change is in the mentality of pricing and how people view vacant space," he said. "In 2007, it was viewed as upside and a good thing. Everyone wanted a little upside, and buyers paid up for that opportunity because they were banking on increasing rents. People were paying for it because they were lending against that vacant space getting leased. There's no value attributed to vacant space today, it is highly discounted."

The consensus on pricing assets seems to be that there is no consensus. Performing loans are all over the map and non-performing loans are anybody's guess. There haven't been enough deals to test the market with pricing, either. Still, there's no doubt that we've moved away from the frothy prices of two years ago. In fact, as of July, trades were showing a pricing decline of 37% from the peak, White said.

There's some comfort in the industry's cyclical nature, but Grinis noted that this is an unprecedented moment. "Look at the footprint or the starting point of this recovery," he said. "It's built on a foundation that is untested. That places a level of uncertainty and complexity this go-round."

Several speakers voiced concern over the imminence of mark to market in the industry. "We're the last country that doesn't value assets on a market basis, we still do book valuations," said Jim D. Amorin, president of the Appraisal Institute in Austin, TX. He added that when the change takes place, it will have a huge impact on valuations, both positively and negatively. "At some time when mark to market becomes fully entrenched, everything in public companies will have to be valued on a regular basis, which will change the landscape entirely."

White added, "Investment markets around the world have started to pick up rapidly while we're mired down here. We've seen an uptick in global markets because they've done mark to market. They faced the music sooner."

Greer pointed out that Bank of America's $600 billion in real estate debt would have seen a $420-billion loss or write-down if the industry did mark to market now. "It would crater the bank fivefold," he said. "If they bring in mark to market, they'll phase it in slowly because it could cripple everyone of America's financial institutions."

In the meantime, the government is working to make the TALF, TARP and PPIP programs available for the industry, albeit as a short-term solution. "We don't want a permanent government handout program in place," CMSA's Sargent said. "We want a jump start to the market that is locked up. Most of these programs were designed to be unattractive once the financial markets normalize. That's appropriate. TALF and PPIP should not be out there forever."

But thanks to ongoing talks with the government, TALF has been extended for new issuance until June 2010 and for legacy CMBS until March 2010, Sargent said. As for PPIP, banks have not had any incentive to sell their loans as long as they are performing on par, he said. But, "PPIP is out there. It will be utilized and that will help any vehicles out there," he said.

Some think the government programs are the reason lenders have not begun selling loans. "When the government made the investments in the financial institutions, they were talking to lenders about purchasing assets and the lenders felt good about life," said Timothy Zietara, a senior vice president with ING Clarion Capital In New York City. "That only clogged up the system more."

Zietara also believes regulators need to get tougher and push harder for the banks to get loans off their books, especially when the banks become healthy enough to start repaying the TARP money. He noted that regulators enforced plenty of sales in the last downturn and thinks we may be headed that way again. "Regulators finally got hard and said, 'you're selling this, this and this, " he said. "That hasn't happened yet, but it will. 'Extend and pretend' will stop at some point."

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