Distressed Debt Reaches for Fair Value
January 18, 2010
NEW YORK -- It's difficult to determine what something is worth if no one is buying or selling it.
While cryptic mortgage-backed derivatives stymied the markets at the beginning of the credit crisis, industry experts predict commercial real estate will be the next shoe to drop. Even though the stock market continues to mend, distressed commercial real estate and bank debt need to regain value before the economy recovers for real, they said.
"Transactions haven't been happening," said Constantine Korologos, managing director of real estate consulting at Deloitte Financial Advisory Services. "There has been a 30% to 40% decline in value in commercial real estate, but in the absence of liquidity, it's hard to really determine where the value has gone."
It can be very challenging for money managers who cover a lot of different sectors to become an expert on every sector, he said. It's far easier to trust the market price and assume that things must be getting better if prices are going up, but prices don't always reflect the fundamentals of supply and demand, and the resulting herd mentality of traders and fund managers can further skew the true value of assets.
"Asset managers need to understand the fundamentals of what's driving prices," Korologos said. "Markets are currently ahead of the curve in optimism. What we've seen is less-worse news, but at some point, it has to actually start getting better."
Commercial real estate will finally rebound once employment numbers begin to stabilize, regional banks resume lending and retailers see stronger sales, but that could be a long way off if the industry remains in denial, Korologos said.
"There is an amazing amount of energy in the capital markets," said Randy Reiff, founder of Spartan Real Estate Capital. "The market rallied back, but unfortunately, the fundamentals haven't gotten better. Everything rallies in tandem, and the market seems to move on a relatively small amount of trading." He said everybody has been chasing a small number of relative-value transactions.
"The real issue with commercial real estate is not a lack of capital, but a lack of transactions," Reiff said. "No one really knows what the value is because no one wants to sell at these bottom-feeder bids." the Spartan Real Estate founder said.
'Mark to Make-Believe'
Mutual funds are required to report the daily net asset value of their holdings, but how should managers invested in real estate or distressed debt value their assets if current market prices are illogical or unrealistic?
The concept of marking prices to market values works under normal conditions, but during distressed periods as in 2008 and 2009, the fair-value price can become anything but fair. The old investment mantra of "buy low, sell high" is contingent on another party on the other side of the trade willing to foolishly buy high and sell low, but this theory ceases to apply when prices become so ridiculously out of whack that prudent sellers stop selling.
When the price spread between buyers and sellers becomes too great, transactions freeze and trading slows to nearly a halt, such as with securitized assets. These assets may still have a listed price, but if there's no trading going on, mark to market becomes what some managers have dubbed "mark to make-believe."
"If Citi was forced to mark to market right now, it would be a bust," said Barry Ritholtz, CEO and director of research at FusionIQ. He added that Bank of America would almost be a bust as well.
In the case of distressed debt, the huge drop in value is often for good, fundamental reasons, such as a bank having a large number of delinquent, subprime mortgages on its books. Even bullish speculators are very careful before buying a house on fire.
Chris Reilly, managing director of the U.S. real estate group at UBS Securities, thinks the former investment banks are largely marking to market right now and the problems are concentrated in the domestic regional banks that aren't getting government help.
The extra money the Federal Reserve and Treasury Department printed may have boosted capital reserves, but it didn't boost lending. Most of the big banks that received 0%-interest TARP loans didn't actually loan the money out. Instead, they self-servingly repaid the loans before the end of the year so they could give their executives bonuses without government interference.
"The overall volume and pace of loan activity is at very diminished levels," said Michael Levy, managing director of the merchant banking division at Morgan Stanley. "There are significant pools of capital on the retail side that are eager to invest, but the buy/sell spread is too high."
If prices aren't trading at the levels managers want and there's no pressure to buy or sell, it makes sense to wait it out and hope for a change.
"If you can afford to hold, that's probably a pretty rational thing to do right now," said Richard Walsh, managing director of the real estate group at New York Life.
Industry leaders have coined several catchphrases to describe this inactivity, such as "kicking the can down the road," "extend and pretend," "pray and delay" and "a rolling loan gathers no loss."
"This is still a stimulus-driven recovery," said Jason New, senior managing director and co-head of distressed investing for GSO Capital Partners, a Blackstone Group division. "Markets are ahead of fundamentals. The loan market remains broken. I think that last fall was the best buying opportunity we will see in our lifetimes. When you don't have desperate sellers, it's hard to get things for dirt cheap."
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