Over the past few years we have been anticipating a significant amount of distressed assets coming to market. After all, there are over 3.5 trillion dollars worth of Commercial loans currently outstanding in the US and over a trillion dollars worth of these loans will be ballooning between 2010 and 2012. Only half of these commercial mortgages will be able to qualify for a refinance and at the same time there are hundreds of millions of dollars worth of Pay Option Arms and other types of non-conventional loans due to reset.

So, why aren’t all these distressed assets on the market? There are two primary reasons for this. First of all, everything the government has done from a regulatory standpoint is allowing lenders and special servicers to avoid dealing with their problem assets. Regulators have essentially said to banks that if they have bad loans on their books at par and they know the collateral is only worth 60 percent of par, they can leave asset values as they are without incurring any write-downs.

The second reason banks are not selling is that the Federal Reserve’s monetary policy is allowing banks to borrow at close to zero and, if they are lending, they are making huge spreads of 500 to 700 basis points depending upon the loan type. Even if they don’t lend at all, they can simply buy Treasuries and make nearly 400 basis points.

Just a couple of years ago, spreads were as narrow as 30 or 40 basis points on some loans because there was intense competition to put debt on the street. Today’s massive spreads are allowing the banking industry to recapitalize itself, which was, of course, the reason for the Fed’s intervention in the first place. Tremendous profits are being generated which can be used to gradually write down all those bad loans.

The banks are able to make huge quarterly profits, write-down bad loans and wait until the write-downs reduce book value to market value. Once this is accomplished, distressed assets can be disposed of without incurring losses. This is why the banks have been holding on to assets that they would ordinarily write off and dump on the market.

In spite of all this, we have seen a significant increase in the amount of distressed assets coming to market recently. Although the flow has increased, it remains a drop in the bucket compared to what actually exists in the market.

As interest rates start to rise it will put additional stress on under water loans and could motivate sellers to act quickly as they realize that holding on to distressed assets is causing them to miss other opportunities.
Adding to the increased flow of distressed assets is the fact that advantageous mortgage terms are beginning to expire. We have seen interest-only periods provided on loans originated in 2006 and 2007 beginning to evaporate.

Floating rate loans originated in 2005 and 2006 are either at or nearing maturity. If these loans were floating over LIBOR, debt service rates may only be 2 or 3 percent today and no lenders are willing to renew or extend a loan at those extremely low interest rates. We, therefore, expect the flow of distressed assets to continue to increase as we move farther into 2010 and 2011.

The last recession put many of the large syndicators that had been dominating the landscape out of business. Those syndicators were mostly replaced by the REIT. The sheer size of today’s REITs, combined with new technology has changed the way Multi-Family Real Estate is structured.

To help understand this change, consider the broad impacts of information technology. Technology has transformed the operating side of the business—yield management, resident screening, procurement, online apartment finders, maintenance scheduling, online rent payment and accounting are now managed online even by small investors who have made only a modest investment in a piece of land lording software.

These technologies were practically non-existent fifteen years ago, but today they have transformed the business. Now, systems that were once available only to the largest firms are quickly becoming an industry standard.

Technology alone is not what has made such a huge difference. The sophisticated operating platforms made possible by these technologies have allowed the redesign of core business processes. New operating platforms have changed the management structure in what was once a highly decentralized business.

The REIT structure of consolidated ownership has given unilateral control to what were previously fragmented portfolios suffering from a combination of third party management and different partners on different deals.

This change in structure encouraged the evolution of a unified business platform where the overall structure is controlled centrally and decisions are made based on what is in the best interest of a group of properties as well as the platform itself. Benefits of size, scale and centralization have followed this fundamental structural change.

The combination of a centralized operating structure and new technology has allowed corporate leaders to have information at their fingertips and the industry is now courting employees with the sophistication and training to use these systems and the information they provide to make key decisions.

The apartment industry is still in a recession and suffers along with everyone else, but it is in better shape than the other sectors of commercial real estate. The combination of new powerful platforms and positive demographic trends paints a positive picture several years out. In many ways the ‘90s are repeating themselves, but this time, the winners will end up with rock solid balance sheets and world class operating platforms.

Is cash still king? Yes, when negotiating with a seller, money always talks, but there is something else going on in the Real Estate market right now. The person with the cash is not the only one with something everyone wants.

Many big money players have pulled their cash out of the stock market and other risky investments and are looking for a place to put it. There are hedge funds with piles of cash looking for a good profitable home.

The person with access to a steady source of deeply discounted investment properties is now in a strong position. There is so much cash flowing around in search of a good return that there is pressure to maintain deal flow and the person who can consistently deliver safe, high return investments is golden.

I have recently been involved in several conversations with hedge fund managers and they are all extremely busy competing to find and purchase millions of dollars worth of solid income producing assets. They have a great deal of cash flowing to them and they need a steady flow of high dollar, high yield investments to keep their customers happy.

Cash will always be king, but every king needs his advisors. If you can position yourself to provide the kind of high quality, high yield, high dollar investment properties all that cash is searching for, you will feel like you are a king and you can earn a king’s ransom.

This has created a huge disconnect between the market value of a real estate note and the amount a bank is willing to sell the note for. This is a wonderful opportunity for investors who have cash available because they can buy these notes at a deep discount.

Lending companies have exhausted their credit lines due to the “Sub-Prime Meltdown”. Major sectors of the mortgage industry, especially the stated loan and sub-prime lenders have completely disappeared. Most of the loans those sectors generated are being sold at greatly discounted prices.

Today, banks all across the U.S. have huge portfolios of REOs and defaulted loans and they are under pressure from federal regulators to get them off of their books.
When a borrower defaults on their mortgage, the bank starts the foreclosure process. That mortgage note is now considered non-performing and becomes a liability on the bank’s balance sheets. The bank must hold a reserve to cover their loss and their lending power is decreased because they cannot lend those funds out to make money.

Aside from the loss of income, the bank must also pay attorney’s fees; keep up the insurance policy, pay the property taxes and maintain the property. At this point the bank just wants to sell the loan and get rid of the property before it sucks them dry. That is why an investor who offers cash can practically name his price.