The Recovery Will Be Bifurcated

Big Lenders and Big Borrowers Will Be the First in Line as Credit Returns to the Economy
By Mark Heschmeyer

These are the best of times for cash-rich borrowers and lenders, but they continue to be tough times for less well-funded borrowers and lenders. Just as the investment markets are bifurcated with top-notch properties in top-tier cities commanding escalating prices and lower tier properties and cities still fighting uphill climbs, so too does it appear that the capital markets are split between the haves and have-nots.

“There seems to be a dam that is keeping the flood of capital provided by the Federal Reserve from flowing to smaller real estate borrowers and properties,” said Chris Macke, senior real estate strategist for CoStar Group. “Expanding the recovery in commercial real estate hinges on breaking this dam.”

The split between cash-rich businesses and those in need of capital has set the stage for a bifurcated economy, with growing challenges for small- and medium-sized companies.

“Depending on where you stand, the debt maturity crunch ahead could either look like a crack in the pavement or the entrance to the Grand Canyon,” Deloitte LLP reported in a new paper this week entitled: A Tale of Two Capital Markets.

In it, lead researcher Dr. Ajit Kambil, research director, CFO Program, Deloitte United States, reported that cash is also unevenly distributed across industries, not just among companies within a particular sector. Unless the financial services industry lends or invests its cash in varied industries, companies outside of financial services could face potentially severe credit constraints.

Deloitte said the convergence of growing demand for debt with supply constraints has created a new normal in the capital markets. A more accurate descriptor would be two new normals – reflecting dramatic differences between cash-rich and cash-challenged companies. Competition for capital will most likely favor investment grade companies over non-investment grade companies as both seek to refinance debt obligations.

What is true across industries is also true within the commercial real estate industry, according to CoStar Group. Last September, CoStar’s Property & Portfolio Research (PPR) subsidiary “delved into how larger banks are much better positioned than smaller banks to “earn their way out” of the current cycle,” said Mark Fitzgerald, a CoStar debt strategist. “And as they recover, with life insurers in better shape as well, this contributes to the bifurcated market, as both of these sources of capital tend to lend on larger, coastal assets, whereas small banks are in worse shape, and this will hurt the recovery in secondary and tertiary markets.”

Since the downturn began, earnings for larger banks, while far from strong, have outperformed their smaller counterparts, CoStar reported. Perhaps the most important reason why this is so is the portfolio composition for larger institutions. The 20 largest banks hold 61% of all bank assets but are underexposed to commercial real estate loans. The bigger banks also have been more aggressive in taking write-downs.

CoStar’s Fitzgerald projected that large banks will “earn their way out” of the Recession in about two years, while regional and community banks could take two to four times as long.

As the economic recovery develops, CoStar Group projects that it will bring mixed blessings to CRE investors.

On the one hand, economic recovery enables banks to earn their way out faster, achieve better execution on poorly underwritten or nonperforming loans, and therefore sell distressed CRE assets at a faster pace.

On the other hand, such economic recovery minimizes the attractiveness of the distressed asset opportunity, as pricing is firmer and disposition of assets is likely to be at a controlled pace.

Furthermore, the modest pace at which banks return to health will minimize the amount of “fuel” (leverage) available to propel a robust rebound in asset values.

With limited leverage, borrower liquidity now also matters. And in that regard, big firms hold the edge. The 9,000 largest companies hold $9 trillion in cash reserves and that level of liquidity makes them more fundable.

An analysis of non-investment grade debt and changing credit spreads finds smaller companies are especially vulnerable to increasing spreads and volatility in credit markets. Differences in cost or difficulties in access to capital can be a key source of competitive disadvantage.

Deloitte research said that most non-investment grade debt is generally concentrated among small companies with market capitalization of less than $5 billion while larger companies’ debt is almost completely investment grade. For the most part, smaller companies tend to have lower credit ratings and company size is a key variable in credit ratings.

Deloitte research found that prior to the recession, companies in the aggregate were accumulating cash in excess of what they needed to grow. This was fortunate as many companies entered the recent recession with unprecedented amounts of cash on their balance sheets – allowing them the flexibility to navigate the worst of the credit crisis.

These cash reserves are unevenly distributed and mainly reside in the financial services industry, with about $2 trillion of cash outside financial services. Unless this cash is deployed to refinance companies, there is a potential deficit in refinancing non-financial service industry debt.