Adjusting Expectations: the Mirage of Deeply Discounted Note Sales

What happens when everyone gets ready for something that doesn’t happen?

If you went to a dealership to buy a car that gets 75 mpg, but discovered that the best car on the lot only gets 20 mpg, would you still buy the slower, less efficient car? Or would you sit and wait for the perfect car to eventually come along?

Many commercial real estate investors may face similar questions this year. According to Preqin’s April 2010 report on the distressed debt market, 44% of the closed end funds in the market are targeting distressed debt strategies. Their fund-raising has been based so far on a rational supposition that in an environment of limited asset sales and growing distressed debt portfolios, there would likely be a plethora of distressed note sales and good bargains to be found. To support that case, the charts from Real Capital Analytics on the right point to over $239 billion of distressed commercial real estate debt in the market. But not all of that distress will lead to discounted sales – much less distressed note sales.

Setting aside the FDIC pools being auctioned, the deep discounts gained from past recoveries are not common today. (Even the FDIC auctions, with a large pool of bidders and a “profit sharing” mechanism will diminish outsized yields for buyers versus the RTC returns of the 1990’s.) According to the Wall Street Journal’s Dan Fitzpatrick, “Despite the brisk pace of bank failures this year, the bargain bin of financial institutions is a lot pricier than it was a year ago and the pickings are slimmer.” (Bargains on Failed U.S. Banks Are Over March 30, 2010)

As you can see from the chart on the right, distressed assets are not necessarily put up for sale. The supply of distressed sales of any kind is considerably less than the volume of distressed assets, as lenders are in no hurry to liquidate. More often, lenders are extending maturities and modifying loan agreements in an attempt to recover as much value as possible from their assets. It seems that most lenders have learned the lessons of the 1990’s downturn when buyers of distressed assets were able to recover value in a short period of time. Just as new investors understand that commercial real estate values will rise as the economy gets started again – so do original note holders.

Another point to keep in mind is, as Bruce Cohen, CEO of Wrightwood Capital has said, “Distressed assets, whether they are mortgage notes or real estate assets, may indeed represent large losses for the current holders, without necessarily providing a corresponding windfall to a new buyer. If the asset declines in value precipitously, but does so from an artificially high level, it may simple be reverting back to where it should be. In that case, the asset is merely trading at its market value with no opportunity for excess returns.”

All this contributes to an environment without an overwhelming abundance of distressed note sales and in most cases the notes have been priced very close to the value of the underlying asset. According to Real Capital Analytics, out of the $6 billion in distressed asset or note sales in 2009, note sales accounted for 8.7%. The pace of distressed sales doubled in the first half of 2010 and note sales rose to approximately 20% of that figure, but with all the new entrants bidding for less than $1.5 billion in distressed notes, the risk is higher and the returns are lower than many expected.

Frank Sullivan, Senior Regional Director, Fund Management at Wrightwood Capital is particularly concerned about this gap between investor expectations and the market. “The opportunity is perceived to be much greater than it actually is, and many investors are setting themselves up for disappointment. All these new entrants into the distressed debt market might be getting into a deeper level of risk than they realize. If the note is priced close to the “as is” value of the underlying asset, there is very little protection from the risk of the borrower filing for bankruptcy or for other tactics that can obstruct the note buyers clear path to title.”

As Frank explained, “All these new investors in distressed debt are essentially compounding their risk when they buy notes, and without an outsized return they may not be pricing for that risk. The usual risks of value-add investments, such as leasing, construction or other income issues, have to be added to the bankruptcy risk of the sponsor. Investors are coming into this market assuming deep discounting which is generally only available on non-stabilized or value-add assets. When you invest in the notes of value-add properties, it’s almost like getting two risks for the price of one.”

Why isn’t there more of a rush to unload distressed notes? In the 1990’s, regulatory and rating agencies forced lenders to jettison as much of their distressed portfolios as quickly as possible. For a variety of reasons, that is not happening today, so there is little impetus for the holders of distressed notes to move quickly or to accept deeply discounted prices. Frank pointed out, “Absent a catalyst to liquidate, such as new pressure from regulators or CMBS special servicers, individual notes will continue to trade close to asset values. The opportunity for wholesale acquisitions of distressed notes outside the construct of an FDIC arranged bank purchase is unlikely to happen unless a new catalyst emerges.”

With very little spread between the value of the asset and the value of the note, it is logical then to pursue a more traditional value-add asset acquisition strategy. According to Frank, “Distressed debt investors need to adjust their expectations away from the dream of easy money and towards the hard work of underwriting value-add business plans. If they like the real estate, if at all possible, they should consider direct acquisitions of the property itself, not just the note.”

The question is: In the absence of deep discounts, will investors be flexible enough to adjust their expectations and strategies?

This post was originally printed in the Credit Review blog.