Global Commercial Real Estate Debt: Deleveraging into Distress

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Global Commercial Real Estate Debt: Deleveraging into Distress

Executive Summary

The quantity of distressed commercial real estate (CRE) will continue to increase globally as the deleveraging process unfolds over the coming years. Implosion of the global financing market coupled with the economic recession has increased stress on both properties and their owners. Seizure of the commercial mortgage backed securities (CMBS) market is increasing the demand of properties needing to refinance but the dislocated financing market is limiting the supply of new loans available.

Global real estate market fundamentals continue to deteriorate in light of the prolonged economic recession placing significant stress on the ability of buildings to generate cash. A number of assets purchased during the peak years of 2005-2007 were underwritten with aggressive lease-up and rent growth schedules. The investment strategy for these assets involved considerable building vacancy which in the current economic downturn has put a number of loans in default of their interest coverage covenants. The markets furthest along in their economic contraction are already seeing signs of distress and should experience higher levels of property liquidations over the next 12-24 months, barring significant government support.

Downward pressure on asset values globally and the limited financing available are placing significant stress on borrowers needing to refinance loans at the lower loan-tovalue (LTV) ratios available. Balance sheet lenders across the globe continue to provide new loans, albeit at higher margins and lower LTV ratios; however, the bulk of their lending activity is focused on existing clients and legacy loan books. Lack of new CMBS issuance has halted conduit originations creating a glut of maturing CMBS loans which will struggle to refinance given the limited appetite and stricter underwriting standards by balance sheet lenders. As a result a number of loans securitised into the CMBS market will enter various stages of distress and will likely be foreclosed upon over the next few years with a second wave occurring in the peak maturity years of 2010-2013.

While it is clear that distress will continue to emerge this paper focuses on the regions and financial structures that will experience the most near-term distress. The paper begins with a review of recent financing and highlights key trends in the global CRE debt market. It is then followed by a regional analysis of the areas of distress emerging in the US, Europe and Asia Pacific. We conclude that recent vintage and maturing CMBS loans in both the US and the UK will show this distress first with liquidations expected to begin later this year. This is largely due to the degree of asset repricing which has occurred, the deteriorating fundamentals and the increased growth and reliance on CMBS.

Given the likely increase in distressed opportunities expected to occur over the next 18 months it is not surprising that there has been a surge of interest from investors seeking to exploit this. Preqin recently reported that US$30 billion (bn) was raised in private equity funds globally during 2008 with investment plans targeting debt and distressed debt opportunities. As fund raising in the segment continues, this wave of capital will likely help reduce the funding shortfall and, in due course, competition among investors seeking to close on distressed opportunities will intensify.

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