Volume Of Distressed Asset Sales On Mute As Owners Battle A New Type Of Crisis
This isn't your father's financial crisis.
As distress proliferates across the U.S. and a wall of debt comes due, today's owners are faced with a different — and more complicated — calculus about whether they can hold on to their buildings.
Some are throwing in the towel and choosing to sell. But unlike prior downturns, the velocity of transactions has been slow going amid an air of uncertainty that has negotiations frozen in place.
“It’s a different situation than the financial crisis, where you had buildings with no asset distress — they had good performance, but just because they weren’t leveraged properly, they ended up in default,” MSCI Chief Economist Jim Costello said. “There’s more problems these days on the fundamental distress side, and people are uncertain about the income in the future.”
During the first nine months of this year, only 205 distressed properties traded hands, a fraction of the 309 distressed transactions during the same period in 2009 and close to 1,000 in 2010, according to data from MSCI Real Assets.
Fundraising has also been muted, with Preqin data showing only one fund targeting the acquisition of distressed assets closing so far this year, while nine did so in 2009 and 15 followed in 2010.
Net charge-offs and delinquency rates for bank-held CRE loans increased in the second quarter, with all major property types showing greater distress, according to Trepp. Meanwhile, MSCI is tracking $1.4T worth of CRE debt set to mature between 2024 and 2026.
Lenders wary of adding underperforming real estate to their balance sheets have thus far offered loan extensions in hopes that financial conditions will improve. But with interest rate relief nowhere in sight, lenders may be less amenable to that solution in the future.
“Nobody is going to take a loss unless they're forced to, and that’s why deal volume is low,” Costello said. “What might finally force them to is if their loan is coming due.”
During the Global Financial Crisis, both institutional and private firms flooded the market with plans to tackle distress by rebalancing the capital stack, Costello said.
A credit crunch is also at play today, but Costello said the turmoil is driven more by the underlying weakness of certain assets, an issue that requires more than just money to solve and is greatly distorting the composition of buyers.
Between 2010 and 2012, 42% of distressed asset buyers were institutional, 41% were private and 8% were real estate investment trusts, per MSCI data.
Today, private buyers — smaller, local investors who have a finger on the pulse of the market and are usually developers themselves — make up 80% of the pie, while institutional investors and REITs comprise only 13% and 1%, respectively.
“They know how to swing a hammer,” Costello said of the private buyers. “These are buildings that need to be repositioned in some way so you can grow income again. … That doesn’t happen by a bunch of suits from New York jetting in, putting some new debt on it and flying out.”
BH3 Management, a private investor, operator and developer headquartered in South Florida with offices in New York City and Denver, launched at the height of the GFC and spent its first four years in business buying distressed and restructured debt.
That crisis was fundamentally different from this one in that distress was universal and there was zero debt available to pull owners out of the hole, BH3 Management co-founder and co-CEO Greg Freedman said.
This time around, distress is concentrated in certain asset types and locations, and while there is still some capital being deployed, uncertainty around where interest rates are headed is muddying values and keeping many investors on the sidelines.
“The pain that was being suffered — and the opportunity created from that pain — was all-encompassing,” Freedman said of the GFC. “In this environment, the opportunity set is not all-encompassing — at least not yet. It requires more tactical consideration and evaluation.”
Once GFC distress dried up, BH3 pivoted to ground-up development and buying opportunistic and value-add assets. Fast-forward to today, and the firm is once again throwing owners a lifeline, using its second debt fund.
“The capital markets are severely dislocated,” Freedman said. “We have not seen the illiquidity on the debt side of CRE how it is today since 2008, 2009.”
The vast majority of debt fund lenders weren't in the business during the GFC, and many have never dealt with this level of volatility, Freedman said. BH3 isn't only entrenched in its local markets but also understands what it is like to power through a downturn.
“Borrowers are realizing that it’s good to have a counterparty that understands the business, especially in challenging times,” Freedman said. “As the old saying goes, as the tide goes out, you see who’s swimming naked. … Having the expertise and the history that we do adds real value.”
BH3 also injects equity into struggling properties, but at this time, the debt side of its business is in higher demand and carries less risk, Freedman said. That could change as owners are forced to either put more money into their buildings or hand keys back to the bank.
“From our standpoint, the risk-reward between the returns that we’re getting on the debt side versus the returns you would have to get on the equity side to take that enhanced risk, we don’t see that spread or that arbitrage just yet,” he said. “Do we think it’s coming around the corner? Absolutely.”
Lenders have yet to capitulate and take back properties that are in default, and many are working with borrowers to push out the maturity date on their loans. As of mid-September, about $5.7B in loans had been modified with an extension, according to Trepp. The bulk of the extensions were for term increases of between one and 12 months.
“Extend and pretend” strategies could also explain the lower number of distressed asset sales, Trepp Senior Managing Director Manus Clancy said.
“As long as you have a tenant that is paying rent, you’re OK. You have this risk-free option where you can sit on the property and hope for a miracle,” he said. “That will mean that many of these assets will take a long time to play out.”
Transactions are also being stymied by the gap between what buyers are willing to pay and what sellers are willing to accept. The bid-ask spread has been particularly acute in the office market, where there is a more than 11% difference between buyer and seller expectations, according to MSCI.
Heavy distress could narrow the divide, but thus far, not enough forced sales have occurred for price discovery to unfold.
“There’s not a clear understanding as to where the bottom is. Everybody is trying to find it and find it fast,” said Kevin Santaularia, president and CEO of Dallas-based Bradford Cos. “These are tough times for borrowers and for lenders.”
Despite that uncertainty, Bradford is bullish about the opportunity to snap up challenged real estate, especially in the office sector. The firm launched its second opportunity fund earlier this year and has already raised the money it needs to target $100M worth of office and industrial acquisitions.
Not surprisingly, Bradford’s second fund is unlike its first in that it is backed by private investors rather than institutions.
“We saw the institutional investors move to the sidelines and found that the money is in the high net worth private investor community,” Santaularia said. “There’s a significant pool of capital available in that community that wants to be in real estate.”
Pacific Retail Capital Partners is also seizing opportunities to capitalize on distress. So far this year, the firm has invested around $300M in the redevelopment of retail properties, making it the No. 1 buyer of distressed CRE in the U.S., per MSCI.
The firm’s strategy is to restore value through repositioning underperforming malls and open-air retail centers, Chief Financial Officer Oscar Parra said. It does so by injecting its own equity or partnering with institutional or individual investors.
Redevelopment is a common goal among investors in distressed property. MSCI data shows that 11% of distressed assets purchased in the first nine months of this year were acquired with the intent to redevelop, while 2% of nondistressed acquisitions were made with the same intent.
“We can step in and continue to push value upwards, but it’s going to require an evolution of that square footage from retail to other uses,” Parra said. “In the distressed space, that’s what we are looking for.”
Other investors aren’t ready to take a chance on properties in default. The cost of doing deferred maintenance, coupled with the heightened expense of labor, insurance and taxes, has thus far derailed the bulk of distressed investment activity, and prices in only a handful of markets have fallen enough to warrant the risk, Clancy said.
“People are only going to buy these things at deep, deep discounts,” he said.
Even a building sold for pennies on the dollar could be a bad investment if oversupply negates its chances of ever being filled, which is why Clancy said pockets of distressed investing are more likely to materialize in markets where value dips have been less severe.
“Certainly, a shallower trough and lower risk will invite more distressed capital than an area where things are really falling through the floor,” he said.
Whether distressed properties begin to trade at a faster rate will hinge entirely on how debt maturities are handled, Costello said. Loans will have to be refinanced, and whether owners will choose to take a loss or inject more money into the deal is still to be seen.
“The last chapter of this crisis has not been written yet,” Freedman said. “If this financial crisis is a 20-chapter book, we are probably on Chapter 3 or 4. There’s a lot to continue to unpack.”