Dog Days of Distress

By: Mark Grinis, Ernst & Young L.L.P.

Long lines of cash-rich investors, including REITs, are forming around what some believe could be the biggest distressed debt sales market since the days of the U.S. savings-and-loan crisis, but Ernst & Young L.L.P.’s latest survey of those investors suggests this market won’t follow quite the same pattern it did in the 1990s.

Certainly, we are in the dog days of distressed debt right now, with very few deals happening today other than one-off distressed sales, the government’s PPIP initiative largely falling on deaf ears, sellers weighing their options and a broad spectrum of buyers simply waiting for the dam to burst and unleash a highly anticipated wave of deals.

When will the dog days end? Most survey respondents (47 percent) believe that a significant increase in commercial mortgage defaults will begin before the end of this year’s fourth quarter, but slightly more than 30 percent believe the market is already witnessing significant default activity. About 20 percent are looking to 2010 before major default pressure comes to bear on the market and distressed sales begin in earnest.

A small majority (53 percent) of respondents to the survey have purchased distressed or nonperforming loans in the past 18 months, with 47 percent inactive. However, 45 percent of respondents who have not yet purchased any distressed assets believe it is simply too early in the cycle of distress for them to even attempt to purchase nonperforming loans right now. This strongly suggests that many investors, at least, believe seller “ask” pricing on the few deals that are coming to market is still too high.

Commercial whole loans were overwhelmingly the primary investment of choice for respondents, with more than 45 percent eyeing the asset category. Residential and land loans were the next most popular categories, each selected by 18 percent of the respondents as being a preferable investment, followed by residential acquisition and development and construction loans at 11 percent. Commercial and residential mortgage-backed securities (CMBS and RMBS) and loans backed by hotel assets each attracted less than 10 percent of respondents.

One reason why the current distressed market has the potential to play out differently than the RTC model is that there has been a highly competitive market from the outset of this era of distress. Unlike the gradual development of competition during the RTC days, this time there are some very large and experienced distressed debt investors sitting on piles of cash and waiting for opportunities to unfold, according to Chris Seyfarth, one of the authors of the report. At the same time, almost 50 percent of survey respondents were smaller investment groups allocating U.S.$100 million or less to distressed loan
purchases. He believes this presents the potential for a deep, highly competitive market in the near term, which could impact pricing and execution quite heavily from the outset.

On the plus side for sellers, the survey indicates that investors’ return expectations are not unreasonable. Only 35 percent of those investors polled claim to have return requirements above 20 percent, and an equal number actually are shooting for returns in the 10 to 15 percent range. The balance of investors sit in the 16 to 20 percent range, suggesting that the spread between bid and ask pricing may narrow quite quickly once deals begin to flow to the market.

Mark Grinis is the leader of Ernst & Young L.L.P.’s Real Estate Distress Services Group.