This week, MortgageOrb spoke with Edward A. Mermelstein, a real estate attorney and the founder of Edward A. Mermelstein & Associates, about the increasingly worrisome amount of current and expected distress in the commercial mortgage market. Mermelstein examines both the plights of borrowers and lenders left in the lurch, and the potential opportunities for advisory firms and other providers poised for opportunity in this market.
Q: With the projected increases in distressed commercial mortgages, there have been several new firms jumping into the fray recently in hopes of benefiting from this distress (via direct loan purchases, advisory services, etc.). Do you think there is enough room for all of them?
Edward A. Mermelstein: There are plenty of new players, with many mom-and-pop shops opening on a daily basis. Every managing director who got laid off in the last six months is opening an advisory firm, and many real estate investment firms and funds are gearing up for an explosion of activity starting later this year.
Small niche funds, such as Oaktree's, Madison W's Madison Value Fund and newly formed North River Opportunity Partners, offer means for individuals to invest in distressed real estate. On the smaller side, the Barker Pacific Group, an investment and development firm in Los Angeles, has raised about $300 million to buy debt that would deliver control of properties. The Carlton Group will be rolling out a new $300 million facility aimed at financing or recapping first mortgages.
The volume of potentially troubled commercial properties, including those with loans maturing in 2009, could top more than $80.9 billion, according to Real Capital Analytics. That's in addition to the $25.7 billion of commercial mortgages that have already defaulted in the past few months.
The distress spans all asset classes and geographies, although office and retail appear most in distress. Office vacancies in most major cities are expected to top 10% where they have not already done so. As an aside, because there is no credit available in today's market, the banks are forced to either take the property back or consider a workout.
Q: A recent report from Fitch projected that most CMBS loans will be extended. Do you see this pattern occurring? Are these extensions likely give the market enough time to recover before the next wave of CMBS refinances arrives?
Mermelstein: Lenders have no choice but to extend – especially in the short term, as there is no liquidity. Short-term extensions through the end of this year are a given.
Anything past 2009 is going to test the resilience of the market as a whole. If liquidity does not return in 2010, we will begin to see a huge collapse of the CMBS market. Defaults will escalate to levels that have never previously been seen.
Foresight Analytics and the Real Estate Roundtable estimate that between $160 billion and $400 billion need to be refinanced in 2009. In addition, Fitch Ratings' CMBS loan delinquency index rose to 0.64% in November 2008. The agency projects that delinquencies will continue to rise, reaching approximately 2% by year-end 2009.
Q: Investor confidence in U.S. commercial real estate seems now to be almost universally low. Are there any bright spots, aside from distress opportunities? Any regions more resilient than others? When might those investors on the sidelines begin re-entering the market?
Mermelstein: Unfortunately, there are no bright spots, but we are seeing a lag in the delinquency of office properties. Major markets – such as New York; Washington, D.C.; Chicago and Los Angeles – are holding up better than the rest of the U.S., but they, too, will get hit in the next six months.
Investors on the sidelines will begin re-entering the market when banks start to discount sharply and credit starts to flow.
Q: CMSA and other industry groups have sent requests to Congress urging inclusion of CMBS in the Fed's TARP or similar programs. Do you think this sort of intervention would help get the commercial real estate lending markets working again?
Mermelstein: Maybe, but don't hold your breath. The government will have to address the CMBS market at some point in the near future, and there is a wide-ranging agreement that the government has to start purchasing the troubled assets from banks in order to stop the bloodbath.
What we are seeing is that the banks are using government funds to prop up balance sheets rather than to loosen the credit crunch. Currently, the government is simply putting off the inevitable by infusing cash directly to the banks instead of forcing the banks to lend the money they are given through TARP.
What is needed is to require the TARP funds to be directly used to make loans and for the banks to shed the troubled assets. In addition, we have to address the psychology of the spender. If the U.S. economy does not start to recover in the near future, we will continue to see an increase in layoffs, which will prolong the drop in the commercial real estate market.
Q: What are the best pieces of advice you can give to a commercial mortgage borrower seeking to renegotiate a loan? What about for the lender? What should both parties keep in mind during the transaction?
Mermelstein: Work with good attorneys and advisors that know the lender and bank officer well. For the lender, we suggest that you know your borrower – including both fully verified credit and the financials of the property.
Don't be hardheaded; flexibility in this market will move a deal forward. No one can afford to stand their ground in this market.
To reach an agreement that will benefit both parties, you must remain open-minded and flexible in a negotiation. Time is of the essence for both the borrower and the lender, but not always in the same way. With the changing market, interests of each party can change dramatically.
Neither party should forget about new investors waiting for the right moment. As soon as the market stabilizes at its low, new players will step in the game – making a foreclosure or a forced buy-out more attractive to a lender than any refinancing options that are affordable to a delinquent borrower.