Conquering Debt Mountains

By Steve McLinden

All have heard the staggering numbers. Some $1.2 trillion in commercial real estate debt is set to mature over the next three years, and on mostly overvalued assets — all on the heels of some $200 billion that came due in 2009.

In this dark environment, lenders and their appointed special servicers face undesirable choices in reconciling the ledgers of mounting distressed loans: alter the terms, foreclose, or “extend and pretend” — that is, keep offering loan extensions that may only delay the inevitable.

But some center owners are finding other means of grace. Many lenders have reduced interest rates and softened terms to prevent defaults, while others are allowing and even encouraging owners to purchase their own notes at a discount. Owners with the capital to buy back leveraged property at such a discount can then refinance the asset, says Reza Etedali, who heads Reza Investment Group, a Newport Beach, Calif.–based retail property specialist. “Those are strategies worth exploring if you have the wherewithal,” he said. “Not many can do this, unfortunately.”

Some conduit lenders are granting two- or five-year roll-over extensions for mature loans if no replacement financing is available, Etedali says. But he also points out that some 60 percent of the commercial-mortgage-backed-securities debt coming due over the next three years cannot be refinanced without the introduction of fresh equity.

Smaller owners, particularly in secondary markets, have the fewest options, Etedali says. “Those marginal properties in ‘B’ and ‘C’ markets where rents and vacancies have suffered steep declines are more vulnerable,” he said.

Kris Cooper, managing director of Jones Lang LaSalle’s retail investment sales practice, agrees. “We may see a bloodbath on the small deals — those $1 million to $3 million properties,” Cooper said.

So much of the industry pain is being delayed. “Lenders are reluctant to put more REO [real estate owned] on their balance sheet, because they have to have reserves against it,” Cooper said. Moreover, banks are less apt to sue the holders of guaranteed loans in this cycle, “because they are nervous on the size of the exposure and aren’t taking as aggressive of a position,” he said. Some lenders that have long-term relationships with borrowers are offering them more latitude, Cooper says.

Etedali cautions that lenders are only able to offer workout options to center owners “based on their individual financial positions, and those conditions vary greatly from lender to lender.” Owners should not assume that simply because they have an option to extend a loan, they will receive it. Banks are under pressure and looking at other opportunities to settle or sell loans, Etedali says.

Etedali advises owners to take a fresh look at all loan documents, in addition to major leases and upcoming tenant renewals. In challenging times, a lender’s interpretation of loan documents tends to change along with the lending personnel who handle them. “If you wait until the last minute, you risk being blindsided,” Etedali said. Center owners must be prepared to realistically value their assets for lenders, he said, “factoring in what equity they have in them and what prospects they have over the next three to four years.”

Retail REITS are far better positioned to endure value slides and retain their holdings than smaller owners, lenders say. With most of the country’s prime retail properties in the hands of well-capitalized public companies, “sponsors are able to contribute equity capital, if necessary, to refinance the assets to today’s norms,” said Ted Borter, managing director of real estate investment banking at Goldman Sachs.

Though owners with minimal capital resources hold an abundance of the country’s overleveraged real estate assets, lenders are generally willing to extend loans for a period of time, Borter says. “In these situations, the hope is that some improvement in operating performance will materialize in the short term as the economy recovers from the depths of the recession and that this improvement will enhance value and refinanceability.” The retail sector remains a property type in which leasing leverage truly exists, says Borter, and thus foreclosures are most often a last resort.

Some legislators and corporate decision makers point to the corporate practice of promptly writing down devalued assets in order to reap bigger profits the next year as an example that commercial real estate should follow, says Bruce Pomeroy, managing principal of Evergreen Devco, a Glendale, Calif.–based developer. “That would force massive re-margining, or, more likely, foreclosure, and establish [an even lower] cost basis for properties.” Though that strategy might be prudent for nonperforming retail properties in need of significant repositioning, “for performing properties, it may be tantamount to breaking the rest of the eggs in the carton to prove you are capable of taking decisive action,” he said.

Such a strategy would place even more of the high-performing, viable retail properties at risk of foreclosure, says Pomeroy, who will be among the presenters at the ICSC certification seminar titled “Debt Workout, Transactions and Repositioning of Distressed Assets,” March 23–25 in New York City.

At present, lenders remain inclined to extend performing loans, even if the current value is less than origination ratios or even less than the loan, Pomeroy says. That pattern continues as the primary valuation metrics of the business remain unstable, he says. “Rents continue to be under pressure, vacancies are rising, permanent financing is limited and the consumer is still challenged,” he said. This phenomenon, combined with a scarcity of shopping center transactions, continues to depress real estate values, leading to conservative appraisals that are usually below an asset’s intrinsic value, he says.

Many shopping center owners with nonrecourse notes coming due will not even bother to request workouts on highly leveraged properties, Etedali says. “They’ll look at the parts of their portfolios with nonrecourse debt and just decide to give those assets back because they have no hope to recover equity, and so they will view ownership of these centers as a continuing drain on their resources,” he said.

Expect special servicers — companies that deal with loans that are already in default or about to go there — to be major sellers of CMBS debt properties in the coming foreclosure cycle, Etedali says.

Owners should not count on a quick turnaround, Etedali says. “Be prepared for a challenging environment for up to three more years. At some point, the market has to clear out the distressed assets,” he said.

Despite some positive signs, Cooper also believes the industry is temporarily stalled at the bottom. “How long that bottom continues, I don’t know,” he said. “The only way we’ll know we’re moving up is when we see transactions where cap rates are declining. On the positive side, if you have cash now, cash is king if you can buy at the right price.”

Indeed, Etedali’s Reza Investment Group placed a 190,000-square-foot center in Las Vegas up for bid late last year and got 22 offers, some of them from first-time and foreign buyers, and most, he says, with a significant amount of cash in hand.