By Jim Costello on April 9th, 2019
The worst losses from the U.S. loans originated in the run-up to the Global Financial Crisis are behind us. This said, not every U.S. sector or market is recovering at the same rate. One can see the best recovery in value from defaulted loans in the markets and property types where the RCA CPPI has staged the strongest growth.
While lenders may talk about loss rates on defaulted loans, at Real Capital Analytics we talk (with an optimistic viewpoint) about recovery rates. This recovery rate is simply the ratio of the amount obtained for the sale of an asset in a distressed situation relative to the troubled loan amount. These recovery and loss figures are the same though, with loss rates simply one less the recovery rate.
To help lenders prepare for CECL, the upcoming standard for credit loss modeling, RCA has revived a data set on distressed assets we maintained in the aftermath of the financial crisis. We stopped tracking distress for a while as there was a drastic reduction in distressed assets as the economy improved. There are still fewer distressed situations today, but it is instructive to see the outcomes for these transactions.
The apartment sector is the star performer with recovery rates at 91% in 2018 (see Figure 1). From the perspective of a lender, lenders nationally are only losing 9% of their outstanding balances on apartment loans when a default occurs.
Bank lenders have been outperforming all other lender groups with respect to recovery into 2018 (see Figure 2). This outperformance is not a function of exposure to the apartment sector. As highlighted in our most recent edition of US Capital Trends, the agency lenders tend to dominate lending in the apartment sector. The distressed loans by bank lenders were focused on the industrial and retail sectors.
The retail sector was at the bottom of the pack, with recovery rates only at 66% in 2018. Bank lenders recovered 80% of value on distressed retail loans in 2018. The contrast with the apartment sector is also reflected in trends with the RCA CPPI: apartment prices are at record high levels while retail prices are struggling to reach the high levels seen before the financial crisis.
There is an interesting story with the dip in CBD office recovery rates into 2016. The sample for this sector is thin, with few defaults for CBD office properties. In 2016 though, a distressed CBD office asset in Buffalo, New York gave up the ghost and is now being repurposed as a residential property. Given the record high price levels for CBD offices generally, lenders recovered 81% of value on distressed situations in 2018.
The story on Buffalo, though, brings up an important point about recovery by geography. The RCA CPPI has posted tremendous growth in some markets throughout this recovery and stagnated in others. There is no doubt that a struggling office building in Buffalo would have lived on as an office building had it been located in a market like San Francisco or Manhattan, where the RCA CPPI has posted record high growth rates throughout this cycle.
To highlight the degree to which location matters when recovering value from loans gone bad, we charted the trends in RCA CPPI growth vs. recovery rates (see Figure 3). Importantly, there are two bubbles for each market. The blue bubbles will show the activity for the apartment sector, the orange for commercial properties in total.
There is a clear correlation between price growth and recovery rates. The markets and sectors which have posted the strongest improvement in property prices over the last five years were generally those that had the best recovery of value at default.
Locations and sectors matter. In determining the risks in lending, there are a number of factors to consider when trying to understand the potential to recover value if something goes wrong. To understand the strengths and weaknesses of different locations and property sectors though, the trends in the RCA CPPI can play an important role in that underwriting.
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