Document 187835

PCCP Market Commentary
How to Make Billions of Soured Real Estate Loans Disappear
July 2011
Today’s prevailing market conditions appear daunting: GDP growth is anemic, economic forecasts are
weak, and unemployment remains above 9%. Commercial real estate prices are down 49% from peak to trough
over the course of 42 months, and the Moody's CPPI index for May stands at its lowest point ever. Trepp
reports that half of all loans maturing in 2011 are over 100% LTV. If that weren't alarming enough, it is
estimated that a whopping 63% of loans maturing in 2012 are troubled. As a result, PCCP believes that
compelling commercial real estate investment op
portunities will arise over the next several years as commercial
banks and borrowers alike are forced to de-lever.
In order to assess the size of the looming opportunity, PCCP focused on commercial bank holdings as
banks dominate the United States loan m
arkets, holding approximately 50% of the outstanding commercial real
estate loans. Interestingly, however, reported loan delinquency statistics do not support the distressed “story.”
So, then, where are all of the non-performing loans? PCCP began to research banks’ underlying holdings to
uncover the size and scope of the imminent distress.
While many veteran investors compare the current cycle to the Resolution Trust Corporation period of
the 1990’s, bank delinquency rates1 are markedl
markedlyy lower today: 7.2% now, versus 10% in the early 1990’s (when
values dropped only 27% over a much longer period, and the economy bounced back much more quickly). So
how can it be that the bank real estate loan delinquency rate is significantly lower today? Certainly the banks,
with the blessing of the regulators, have used extend and pretend as a temporary band-aid. Analysis reveals
that the delinquent loans we would expect to see are still on the banks’ books: however, under favorable
purchase accounting rules, acquired loans considered credit impaired are re-classified as performing, even if the
borrower is not making contractual interest payments. In short, the delinquency rate is artificially low due to
the fact that the entities with the worst statistics are no longer reporting (survivorship bias), and the entities
that hold these loans now, whether through market acquisitions, or FDIC-assisted takeovers, do not count the
loans as non-performing.
By our numbers, in this cycle, the real estate loan inventory of the 16 largest failed and acquired banks
totaled over $125 billion. Using Trepp’s estimates that 50% - 65% of commercial banks’ current, maturing
inventory is over 100% LTV, we can assume that at least half of the loans held by failed or acquired banks are
also troubled. If even 50% of the outstanding balances of loan inventory in acquired portfolios is being held
under purchase accounting rules 2 , $63 billion of delinquent loans have disappeared, and today’s real
delinquency rate is 11.4% ($171 billion), over 50% higher than the officially reported 7.2% ($108 billion). If 75%
Delinquent loans are defined as 30+ days past due or in nonaccrual status.
As a check on our number, we looked at public reports on the largest bank merger conducted without government
assistance, which reveal that 45% of the acquired bank’s portfolio was treated in the manner described herewith.
PCCP Market Commentary – July 2011
of the loans were impaired, the delinquency rate would be 13.5%. And our methodology does not account for:
(1) the remainder of failed banks or those that have been taken over; and (2) the estimated $3.4 billion in
commercial real estate assets still held by the FDIC, which doesn't follow GAAP accounting. Clearly there is
much more than $108 billion in distressed opportunities than the headline numbers lead us to believe.
Looking at another metric, in order to bring commercial real estate debt as a percentage of GDP back to
the 30-year historical average, we need to de-lever by $1 trillion. As of 1Q2011, only $270 billion of
deleveraging had occurred, which leaves a $700+ million funding gap.
Regardless of which metric is considered, there is not nearly enough capital in the marketplace to
address the hundreds of billions of looming distress. Preqin reports that U.S. private equity real estate funds
only have $86 billion of dry powder available as of June 2011, across all strategies. Even if massive fundraising
occurs on the private equity front, there will not likely be enough capital to solve the problem. While REITs will
be a factor with their easy access to capital, they comprise only 10% of the market. Borrowers will need to pay a
premium for scarce capital and investors will face reduced competition for distressed opportunities. We believe
there are strong tailwinds poised to move returns upward.
Are we at the edge of a precipice, or on the verge of a massive opportunity? We believe that there are
indications that investments made in this volatile environment will be strongly rewarded. As the banks work
through their problem loans, firms with dry powder, strong relationships, speed, and flexibility are positioned to
prosper. The decline in the CPPI is evidence of increased volume of distressed transactions. So, while
fundamentals remain flat, increased transaction activity in the distressed area will continue to drag down the
CPPI index: i.e. commercial banks are electing to move through inventory. There have been sufficient
transactions over the past year, allowing for price discovery to take hold. Remember investments made in 2009
(if you were bold enough)? 2012 is the new 2009. Now is the time to be considering strategies that will be
investing in the commercial real estate markets into 2012.
William R. Lindsay
[email protected]
(310) 414-7868
Yon Cho
[email protected]
PCCP Market Commentary – July 2011
Greg Eberhardt
[email protected]
(310) 414-2004
K.C. Boback
[email protected]
(646) 308-2102