Understanding Opportunities for Distressed Real Estate in 2020
This article is based on my podcast conversation with Gregory Freedman of BH3 that you can find here.
Many commercial real estate experts had predicted a slowdown in 2020, but none could have anticipated a total economic shutdown. From coast to coast, economies are reeling in the wake of the coronavirus crisis. States are gradually beginning to open again, but questions abound as to the lingering impacts on commercial real estate.
One thing all experts can agree on is that real estate will be impacted, in one way or another. How deeply it is impacted remains to be seen. Some sectors will likely be hurt more severely than others. Hospitality and retail, for example, may bear the brunt of this crisis. It’s just too early to know for sure.
That said, we can also anticipate the impacts will be felt differently than the 2008-2010 recession. There are many underlying differences between today’s recession and the one that occurred a decade prior. In this article, we examine those differences as they relate to opportunities for distressed real estate buys in 2020. Read on for more.
What is distressed real estate?
The term “distressed real estate” is, in many ways, a misnomer. Most often, the term is used to describe what is actually distressed debt. There’s a big difference here. The underlying collateral, in this case, real estate, may be perfectly fine - but the underlying capital stack is distressed.
Here’s another way to look at it:
Distressed real estate, or distressed debt, is when there’s a dislocation between the asset value and the actual loan exposure anywhere in the capital stack. Most senior loans tend to be made for 65-70% of a property’s value. That value is based on the property’s value when the loan was originated.
Let’s say the property was worth $150 million at the time of loan origination. At a 70% loan-to-value ratio, that would indicate a senior loan of approximately $105 million. Now, let’s say that property is a hotel. The hotel industry has been walloped during the COVID-19 crisis. Some are running at single-digit occupancy; others have closed altogether.
Few people will want to invest in hotel properties for the foreseeable future. That $150 million hotel deal may now only be worth $100 million. In this case, the significant drop in value has created a situation of distressed debt. The underlying paper is no longer worth par because the asset itself has decreased in value.
In instances of distressed debt, to establish the right level of debt and equity in the new capital stack where there’s been a significant decline in asset value, there needs to be a resetting of basis based on new underwriting conditions. Herein lies opportunity for those able to recalibrate values, debt ratios, and recapitalize real assets.
How will distressed real estate today be different than in 2008-2010?
To answer this question, it’s worth looking back at what caused the distressed debt crisis in 2008-2010. By way of background, or as a refresher, let’s start with the who behind the how. Leading into 2008, traditional banks like Lehman Brothers, HSBC and Countrywide had been lax in their underwriting. It was almost as though anyone with a pulse could get a loan, no questions asked. When the credit crisis emerged and the foreclosure crisis took root, new regulations were implemented that changed how banks could lend moving forward. As a result of Dodd-Frank and other federal policies, these more traditional banks deferred to making “safer” loans to better borrowers, mostly on existing, stabilized commercial properties.
This left a void in the marketplace for construction loans and other “high risk” debt. This void was then filled by private equity, hedge funds, and other non-traditional lenders on that second or third tier – roughly 90% of whom weren’t lenders back in 2008-2010. It created a new class of debt providers.
So why does this matter?
In 2020, the who behind the distressed debt crisis is going to look different than it did back in 2018-2010. The risk has essentially shifted from banks to these alternative lenders. Some of these non-traditional lenders won’t be equipped to deal with the stress, complexities and litigation that emerges from non-performing loans. Now it will be bondholders, institutional investors, and individual investors who had invested through funds who are left with distressed debt on their books.
The breadth of distressed real estate will depend on how well capitalized these non-bank lenders are, and their ability to weather this economic downturn. Traditional banks, meanwhile, are relatively well positioned and in otherwise healthy shape.
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Which borrowers are most likely to become distressed?
There are two types of borrowers that will be impacted by the COVID-19 crisis.
The first is a crop of otherwise highly qualified borrowers. These experienced borrowers have great assets, in great locations, with strong sponsorship and good operators. Their properties can be found across asset classes, including hotel and retail, office and multifamily. These borrowers may be downgraded solely due to the impacts of the pandemic but would otherwise have no issue meeting their debt obligations.
Experienced borrowers like these will experience a different path to recovery than others, as banks will be more likely to work with them (via forbearance, restructuring and the like) as they get through this momentary crisis.
The second crop of borrowers are those who were already operating on the fringe. Most of these borrowers are highly levered already, having put only too little equity into the deal.
Borrowers like these can make a lot of money when the market is good, but they can only ride that wave for so long - when the market dips, as it’s doing now, their highly structured capital stacks begin to fall apart.
The pandemic will start to bring forth these borrowers’ inadequacies, and lenders may be less likely to work with them to restructure their debt. It is from these borrowers who we might expect to see the most distressed debt in 2020.
When will distressed debt opportunities emerge?
It is going to take some time for distressed debt opportunities to emerge. April 1 defaults are not a good indicator, as it can take some time for an economic crisis to ripple through the commercial real estate markets. May 1 and June 1 will be slightly more indicative of the rate of default, but even then, this will only represent the first wave of distress. It is more likely that distressed opportunities hit the market this fall, or even into 2021.
CMBS loans are indicative of this trend. A CMBS borrower typically must be in 30-day default before their loan will move into special servicing. The special servicer will then evaluate whether the borrower and deal is worth renegotiating, a process that can easily take another 60 to 90 days.
Before making any decisions, the special servicer will typically want the property to be re-appraised. This will prove difficult because nobody knows how to value any right now given the unprecedented nature of this medical crisis. This easily brings us into late summer, early fall and beyond before CMBS loans begin to default at scale.
As such, it’s reasonable to expect there to be an elongated period of distress that creates opportunities over time.
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Distressed Debt Opportunities in 2020
Distressed debt opportunities will likely come in waves.
The first wave of distressed debt will be among quality assets as this is where borrowers can free up the most liquidity. This echoes the trend we saw in 2009 and 2010. The first wave of distressed real estate will be fast and furious.
This initial wave presents a good buying opportunity.
This initial wave presents a good buying opportunity: these tend to be good loans on good real estate but are on properties where the borrower needs liquidity for other reasons, such as a margin call on another deal they may have just written. There will be some interesting yield plays where investors can get double-digit yields on capital when buying up this “safe” debt in the first wave of distressed debt.
The next wave of distressed debt will come after the onslaught of CMBS defaults. These properties are likely to be located in secondary or tertiary markets and will have less seasoned sponsors. An important caveat: this is not always the case. It may take some time for certain distressed debt situations to emerge. For example, an office building might perform well in the short-term under existing leases, but if those leases are set to mature in the next year or two, if the tenants don’t renew their leases, it could cause another wave of distress among otherwise high-quality assets.
With each subsequent wave of distress, the quality of the opportunity will decline. The deals to follow will be smaller balance deals that take longer to trade off the books.
A savvy investor will want to focus on quality, particularly in the first round of distressed debt. Investors should keep an eye out for deals in the $15-50 million range, as these deals tend to be too big for mom and pop shops, but too small for institutional investors.
In terms of asset classes, the biggest opportunities will certainly be in the retail and hospitality sectors. Retail was already struggling pre-COVID. It will be forever changed post-COVID. Hospitality, although it had been performing well going into 2020, was expected to be flat this year. Nobody expected it to fall off a cliff the way it has. It will take a long time for hospitality to recover, though most expect it eventually will. There will likely be significant distressed debt buying opportunities between now and then, particularly among less experienced operators who do not make it through to the other side.
Office, industrial and multifamily are expected to have fewer distressed debt situations. Multifamily is historically the safest product type, and we expect it still will be moving forward. There is a lot of froth in the space, so a 10% pullback in rents might eviscerate enough equity in some deals to cause distressed debt buying opportunities.
Meanwhile, on the office front, there’s some speculation that more people will work from home, thereby reducing office demand. On the other hand, when employees return to work, most companies will need more square footage per person to accommodate safe social distancing protocols – so the impact on office could ultimately be a wash. Again, it’s too early to tell how these sectors might be impacted to the point of causing widespread default.
Identifying Distressed Debt Opportunities
People often ask how to identify whether a “deal” is a “steal.” There aren’t really any “steals” hitting the market just yet. As indicated above, most distressed debt situations are still probably 60 to 120 days away. The first deals to hit the market will be loans for sale among borrowers who need immediate liquidity. This is an opportunity to invest in high-quality real estate, but it might only be at a marginal discount – not a “steal” per se.
Deals become “steals” when a borrower can purchase the debt for well below replacement costs. But again, these deals may take some time to emerge during this downturn.
Access to Capital is Key When Buying Distressed Debt in 2020
One of the lessons learned in 2008-2010 is that cash is king. Investors need to have the capital on hand to move quickly. Distressed borrowers will often come forward on a Monday and need to close by Friday. Few buyers can move with such lightning speed.
It can seem unrealistic to underwrite a deal in just a few days. But some investors can and do, and with great success. The keys here are to:
a) trust your gut;
b) do as much due diligence as possible; and
c) limit the decision-making hierarchy.
Here’s an example. A borrower is looking to sell distressed debt but needs that liquidity by end of week. A prospective buyer will want to pull out all the stops. One, in particular, taps his code consultant to gain access to the property. The building seems solid. He underwrites the project quickly, doing full due diligence on the entire loan file. He gets aggressive with the offer, including a deposit that goes hard upon signing – something the seller appreciates given their cash crunch.
Despite it being a competitive bidding situation, this investor is successful because the banks and other buyers were caught up in analysis paralysis. This investor was able to move quickly, which again, is a nod to the preference for all cash deals and a reminder as to why it’s important to be well-capitalized in order to jump on distressed debt opportunities as they arise.
It remains to be seen how long and deep this economic recession lasts. The extent to which the federal government provides stimulus funds will certainly impact distressed debt buying opportunities. The good news is that overall capital markets appear to be healthy.
There are a lot of buyers who have been sitting on the sidelines who are now eager to invest in deals, distressed debt or otherwise. This recession, like those in the past, will simply weed out the less experienced sponsors to the benefit of patient, well-capitalized buyers who are now in a great position to invest.