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DISTRESSED ASSETS ARE COMING, DISTRESSED ASSETS ARE COMING!

On Sunday, Robert Knakal (of Massey Knakal Realty Services ) posted this article to his blog:

Distressed Asset Update - Here They Come

robert_knakal_nyreblog_com_.jpgWe have all been surprised by the relative lack of distressed assets in the marketplace thus far in this cycle. Two years ago, we were anticipating a significant amount of distressed assets coming to market. This was described in many ways, most notably as a potential tsunami or an avalanche of properties and notes that could be scooped up for pennies on the dollar. However, this condition has yet to occur.

The reasons for this are numerous. Essentially, everything that has happened from a regulatory perspective is allowing lenders and special servicers to not have to deal with their problem assets. Whether it is mark-to-market accounting rule changes, modifications to the REMIC guidelines or bank regulators leniency, distressed assets have not been coming to market in the numbers that we all know exist.

Bank regulators, for instance have essentially said to banks that if they have bad loans on their books at par and they know the collateral is only worth 60 percent of par, they can leave asset values as they are without incurring any write-downs.

The Fed's highly accommodative monetary policy is allowing banks to borrow at close to zero and, if they are lending, they are making whopping spreads of 500 to 700 basis points depending upon the loan type. To the extent they don't even lend, they can simply buy Treasuries and make nearly 400 basis points today. Just a couple of short years ago, spreads were as narrow as 30 or 40 basis points on some loans as the competition to put debt on the street was fierce.

Today's massive spreads are allowing the banking industry to recapitalize itself, which was, after all, the Fed's intention. Tremendous profits are being generated which can be used to write down bad loans incrementally. From the bank's perspective, they are able to wait, make large quarterly profits, write-down bad loans and wait until the write-downs reduce book value close to market value. Once this occurs, distressed assets can be disposed of without incurring losses. For this reason the distressed asset flow has not been nearly what was anticipated.

Notwithstanding this fact, we have seen a significant increase in the amount of distressed assets that have been coming to market recently. During this cycle, Massey Knakal's Special Assets Group has completed over 1,100 valuations for lenders and special servicers, giving them valuations for the underlying collateral of their loans. From September of 2008 through September of 2009, these efforts resulted in only12 exclusive listings. From October 1 of 2009 through the present, we have received 66 exclusive listings from banks and special servicers and we anticipate this flow of distressed assets to continue.

Although the flow has increased, it remains a drop in the, proverbial, bucket compared to what actually exists in the market. But the flow has tangibly increased which is a welcome occurrence for the brokerage community. A major reason for this is the cumbersome foreclosure process that exists in New York. Foreclosure can take two, or three, or even four years to complete in this state. Many holders of distressed notes do not want to go through that protracted process. This is particularly true given the relatively high recovery rates on note sales relative to collateral value. Therefore,  selling distressed paper has become a much more viable option.

As interest rates start to increase, as evidenced by the recent rise in the 10-year T-Bill based up on the Fed's halting their asset buying program, these increases will put additional stress on distressed assets and could be a motivating factor for potential sellers to act quickly. If interest rates continue to rise, it will create more pressure on holders of distressed assets to sell as the opportunity cost of not doing so becomes greater and greater.

Adding to the increase flow of distressed assets is the fact that advantageous mortgage terms are beginning to expire. On an increasing basis, we have seen interest-only periods provided on 2006 and 2007 vintage loans start to evaporate. Interest reserves, which have carried many properties which have been fundamentally under water for quite a while, begin to burn off and floating rate loans originated in 2005 and 2006 are either at or nearing maturity. If these loans were floating over LIBOR, debt service rates may only be 2 or 3 percent today and, clearly, there are no lenders that will renew or extend a loan at these extraordinarily low interest rates.

We, therefore, expect the flow of distressed assets to continue to increase as we move farther into 2010 and into 2011 and, perhaps, 2012. Time will tell, but this recent trend is a very encouraging sign for those of us in the transaction business.

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty in New York City and has brokered the sale of over 1,050 properties in his career having an aggregate market value in excess of $6.2 billion.

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