Holding pattern for distressed funds to break soon?

<span style="font-style: italic;">Investors are still in hurry-up-and-wait mode, but expect that to change by 2010</span>

The hurry-up-and-wait mentality that has engulfed many of New York’s distressed asset funds for the last year is still in effect. But the holding pattern could break soon.

In this month’s Q & A, brokers, developers and finance specialists told The Real Deal that despite the fact that distressed asset funds have not been making the highly anticipated buys everyone was expecting, they will probably begin doing so at the end of 2009. And, they said, purchasing will really ramp up in 2010.

Part of the delay, they said, is that the supply of distressed real estate is not all that plentiful yet because banks have not fully figured out what their assets are worth.

Some said that banks have recently started becoming slightly more realistic about prices. As one broker put it, they have learned to “swallow the big pill, which is a loss.” But most others noted that banks have been waiting on a host of things, including government bailout programs, and, as a result, “have had a difficult time determining the right course of action.”

Investors, too, have been leery. Sources said they are not looking for “good deals,” but are instead looking for “great deals” with returns of 15, 20 and even 25 percent.

“Would you buy something today that you think you can get cheaper six months or a year from now?” one broker said.

Some predicted that prices will come down by as much as 30 percent before funds start making a play for property. They also said private families are less likely to be as concerned with near-term prices as institutional investors because they don’t have the same commitment to anxious investors to deliver set returns on an investment.

Meanwhile, almost everyone said that the number of real estate professionals who are now working on some sort of distressed deal has ballooned. That’s largely because short sales, non-performing loans and other forms of distress are just about unavoidable at this point.

For more on prices, activity levels and investor expectations we turn to our panel of experts.

David Schechtman senior director in loan sales and turnaround group, Eastern Consolidated

How much longer will investors wait before we’ll actually see an uptick in activity among distressed asset funds? Will it be in 2009?

I think that the third and fourth quarter of 2009 will be the beginning of significant growth in activity, and that 2010 is going to be a terrific year.

Are banks more realistic about selling properties for a loss than they were six months ago? What are you seeing on that front?

On the whole, banks are much more realistic than they were even a few short months ago. Part of the reason they are more realistic is because they have had a significant amount of time since the summer of 2007 to gradually swallow the big pill, which is a loss.

What sort of returns do investors want on distressed assets today, and have those expectations changed from a year ago or even six months ago?

It depends on the investor, but in many cases the expectations have changed. Private families are willing to reach a higher price point than institutional investors because they tend to view real estate investments as a longer-term commitment. So a lot of private investors are not as concerned with the bottom of the market. They are more concerned with just making sure the deal works. Most institutional investors have not, and cannot, change their criteria because they have made commitments to their investors.

What’s the most challenging aspect of starting up a distressed asset fund now?

Achieving return hurdles for the investors. People today want 10-plus percent returns from day one — even more after what’s happened, because the misperception is if Rome is burning then I want a fire sale price. The choicest locations with actual income, which are being sold for reasons other than infirmities [that are] present in the actual real estate deal, are not being sold at those levels.

Bob Knakal chairman, Massey Knakal Realty Services

What’s the most challenging aspect of starting up a distressed asset fund now?

Finding distressed assets to purchase. Supply is not there at the moment.

We’ve heard a lot about distressed asset funds since the economy turned, but there still doesn’t seem to be all that much activity. Why aren’t we seeing the activity yet?

The main reason is that lenders who would be the source of much of the distressed assets are still determining the value of those assets. There is a gigantic pipeline of potentially distressed assets but, to date, those assets have only been trickling out. We expect that the pipeline will open up. There will be a lot of product coming to market by the third or fourth quarter of this year. Banks are still figuring out how to deal with their distressed assets.

How much further do prices need to come down for there to be movement among the funds?

It’s more of a supply issue rather than a demand issue. I don’t believe that most investors are sitting there waiting for prices to come down. Clearly some are, but more evident is that they are waiting for opportunities. For instance, we marketed a note for a foreign bank, collateralized by a portfolio of apartment buildings, and we had 52 offers within 30 days on that note. We have another project selling the senior debt on a condominium development in Williamsburg. We have been in the market with the note for three weeks and we have over 200 packages out to people who are interested in buying that note. There is not a lack of demand but rather a lack of supply.

What sort of returns do investors want on distressed assets today, and have those expectations changed from a year ago or even six months ago?

It’s difficult to say because I think the yield expectation differs based on the property. I find it interesting that some investors say they are looking to buy a note at 50 cents on the dollar. I don’t understand that approach. How can you say you want to buy at 50 cents on the dollar when you’re not considering the value of the underlying asset? If the underlying asset value is 30 cents on the dollar, why would you pay 50? In addition, if the underlying asset value is 90 cents on the dollar and you are only willing to pay 50, you will get outbid every time. You have to look at each situation separately.

What are the biggest fears and concerns investors still have about the market that may be preventing them from making these buys?

There are a lot of economic indicators to look at, but I think unemployment is the most important to watch. We believe that the fundamentals of real estate, in both the residential and commercial markets, are tied very closely to unemployment, and we don’t believe that unemployment is going to peak until sometime during the first half of 2010. It’s at that point when the fundamentals will be their weakest, that value is likely to be at its low point and distress will be very, very acute.

Douglas Durst chairman, the Durst Organization

What are you seeing in terms of distressed sales activity, and what are attitudes like among sellers?

We have seen so little activity. [There was the] sale of AIG’s headquarters and talk of the sale of World Wide Plaza. So we do see that sellers are starting to accept the new values, but it’s going to be very slow.

How much further do prices need to come down for there to be movement among the funds? And how much longer will investors wait before we’ll actually see an uptick in this type of activity?

[Prices need to come down] at least 30 percent, and [investors will probably wait] at least six months. For those wanting to make investments, it’s going to look a lot better in 2010.

Are you seeing more investors looking at properties that are nearly finished? Or are they more eager to complete unfinished properties?

Private investors are much more likely to look at — and want to get a good deal on — an unfinished project. That’s where they get the biggest value for their money. The institutional investor is looking for a safer return, so he’s looking for something that is finished.

Marco Lala associate vice president of investments, Marcus & Millichap

We’ve heard a lot about distressed asset funds since the economy turned, but there still doesn’t seem to be all that much activity. Why aren’t we seeing the activity yet?

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It’s a combination of things. Nobody is sure just quite how the stimulus and bailouts are going to help things. The jobless rate is up, taxes are up, water and sewer is up, fuel is up, utilities are up, loan-to-values are down, collections are down, rents are softening, banks are still holding on to non-performing loans and are expecting near or face value [for their properties]. Plus, would you buy something today you think you could get cheaper six months or a year from now? Do I think they are completely right? No. But I can’t blame them.

Are banks more realistic about selling properties for a loss than they were six months ago?

I have really yet to see the banks capitulating. We are still waiting for them to conform to our more conservative pricing models. They may be more realistic, but it hasn’t converted to action yet.

What sort of returns do investors want on distressed assets today, and have those expectations changed from a year ago or even six months ago?

Return expectations are rising. My concern is that some of the distressed funds, for now at least, have very high return expectations. I hear numbers of 15 percent, 20 percent or more being thrown around. But this doesn’t mean much in the distressed world. If you think about it, the idea behind buying a distressed property is that you’ll buy it cheap enough that you may not need to actually know what the return is precisely — if there even is one. The price is low enough to absorb any risk you may incur trying to stabilize or take control of a property. A distressed piece can be in such disarray that there may be no return for a year or more, yet the upside is enticing enough to make the deal.

Can you quantify how many more brokers/real estate professionals are working in the distressed field these days compared to three months ago?

I’ll answer that half jokingly. If you have a real estate license and are still working today, I would say that makes you automatically part of the distressed field. Whether or not you are actively going after REO deals or handling short sales or evaluating and selling non-performing loans, you will run into a client or customer who is involved in one at some capacity or another.

Frank Mancini executive managing director, Grubb & Ellis

We’ve heard a lot about distressed asset funds since the economy turned, but there still doesn’t seem to be all that much activity. Why aren’t we seeing the activity yet?

Holders of this so-called distressed debt have little reason to sell. Banks/lenders are not anxious to take further losses. They have taken the position of holding onto the debt until they are forced to do something. That said, there is some distressed debt being purchased. It’s harder for the market to see this activity. Only when there is a default by the borrower and the debt holders want to get the real estate back does the market really see the activity associated with the debt trade.

Are banks more realistic about selling properties for a loss than they were six months ago?

Many of the banks are still waiting to get the final word from the Treasury Department on how to deal with their distressed assets. I would say that there is a feeling that we are getting closer to increased activity, but it has not surfaced as of yet.

What sort of returns do investors want on distressed assets today, and have those expectations changed from a year ago or even six months ago?

Investors are not looking for good deals, they are looking for great deals. The investment funds are looking for a 20 to 25 percent return. These types of returns are necessary when purchasing distressed debt due to the complicated nature of foreclosing on debt that has turned bad.

What happened to some of the funds that started up last year and made early investments that didn’t do well?

Many of the funds that started up last year did not make big bets or put much capital into this market. This is mainly due to the lack of product that was in the marketplace to invest in. The investments that were made over a year ago may very well be worth significantly less than what the investors paid for them, with some being totally out of the money. Most of these funds have a three-year investment/hold life, so they are keeping their money on the sidelines.

Are you seeing more investors looking at properties that are nearly finished? Or are they more eager to complete unfinished properties?

There are definitely pools of money that will not invest in unfinished properties. They do not have the development expertise or appetite to get involved in such projects. There are definitely investors that are looking for partially completed projects. Finished but not fully sold assets do not have the risk of not being completed. However, there is a risk that the owners of units that are “sold” may have the ability to pull out of purchasing their units if certain covenants are breached by the developer.

What’s the most challenging aspect of starting up a distressed asset fund now?

It is still extremely difficult to raise money in this credit-constrained environment. Only groups that have a solid track record will be able to raise money.

Steven Kohn president, Cushman & Wakefield Sonnenblick Goldman

How much further do prices need to come down for there to be movement among distressed asset funds?

There is not necessarily an absolute price level. What is likely to occur will be a slowly increasing level of trades, which will then reach a tipping point when a much larger universe of investors decides it is time to buy, thereby pushing up pricing and encouraging more owners to sell their assets. I don’t think we’ll see a significant increase in activity until 2010.

Are banks more realistic about selling properties for a loss than they were six months ago?

Not yet. There have been many changes, and there continue to be, with the government funding programs, accounting rules with respect to mark-to-market practices and bank capitalizations. As a result, lending institutions have had a difficult time deciding on the right course of action. As lending institutions improve their balance sheets — through new equity, debt offerings, and earnings — they are more likely to increase their liquidation of real estate loans and properties.

What are the biggest fears and concerns investors still have about the market that may be preventing them from making these buys?

Investors are most concerned about a sluggish economy resulting in declining rents and sale prices for several years to come. In addition, investors are concerned about what the debt market will look like when they want to exit their investments.

What kind of ratio are you seeing of foreign distressed funds versus American funds that are looking to buy NYC assets? Do you think the foreign funds will be the first to start really buying?

I do not have those specific numbers at hand, but my guess is that there are more domestic funds looking to acquire assets in New York at this time. I do believe, however, that we will see a substantial increase in off-shore investment activity from Europe, the Middle East and Asia over the next 12 to 18 months. There have been acquisitions from off-shore groups, but not by distressed funds.

Ari Hirt managing director, Ackman-Ziff/ AZ-Garnet Loan Sale Advisors

We’ve heard a lot about distressed asset funds since the economy turned, but there still doesn’t seem to be all that much activity. Why aren’t we seeing the activity yet?

Sellers are holding back due to the wide spread between bid and ask. That spread was compounded by the announcement by the FDIC and the Treasury [Department] of the Legacy Loans Program, part of the Public Private Investment Program (PPIP). Both sellers and buyers were waiting to see what was going to happen with PPIP. Now that the Legacy Loans Program and PPIP have been put on hold, activity is starting to pick up.

What are the biggest concerns investors still have about the market that may be preventing them from making these buys?

Some investors are concerned that prices may get lower. They are looking for the bottom.

Are you seeing more investors looking at properties that are nearly finished? Or are they more eager to complete unfinished properties?

Demand is higher for properties that are complete rather than properties that need to be completed.

Can you quantify how many more brokers/real estate professionals are working in the distressed field these days compared to three months ago?

We have definitely seen a significant percentage of professionals that were previously involved in the origination and financing area that have moved to asset management and disposition. At some financial institutions, you can see the entire department has moved to those areas, and in others, a majority [of the department has]. It is hard to come up with a number, but there are a lot more than there used to be.