LFI’s Special Situations team attended last week’s IMN Distressed CRE Forum in New York featuring a range of speakers and attendees across the commercial real estate landscape including property owners, investors, developers, lenders, brokers, lawyers, special servicers, and more.
Panels focused on distressed opportunities in an environment of tightened financing conditions, elevated operating expenses, impending debt maturities, and changing regulatory pressures. Below are LFI’s top takeaways from the event after attending each of the nine panels and chatting up fellow attendees.
The Fed’s interest rate cut was the topic of the day following Chairman Powell’s announcement of a 50 bps reduction to the policy rate last Wednesday. As a highly leveraged asset class dependent on favorable financing conditions, real estate performance ebbs and flows with monetary policy. Moreover, real estate loans are often made at floating rates, meaning the impact of Fed cuts will be immediately felt. It was noted more than once that the Fed’s 50 bps cut does not offset 11 rate hikes since the beginning of 2022, which, together with inflationary operating costs, have resulted in widespread distress. Properties purchased in earlier years are still due to be reset at significantly higher rates, while the market may be discounting the possibility of inflation reemerging.
Investing in an election year is particularly fraught given the wide divergence in political platforms likely to affect the real estate industry—namely the path of interest rates, corporate and SALT taxes, remedies for housing affordability, and more. The 2017 Trump tax law was especially favorable to real estate investors, and its expiration or extension is likely to be a deciding factor. The election is one example of non-operating drivers of performance—i.e., outside influences often overlooked in standard investment analysis—that can create distress and/or investment opportunities, someone said. Other such variables include the stage of the real estate fundraising cycle, lender psychology, media attention, and incentives to participate in workouts.
An impending maturity wall sees $2tn of debt maturing over the next two years, without enough liquidity in the system to replace it. Much of that debt was issued at pre-2022 interest rates, creating a refinancing gridlock that must still be navigated. Maturity defaults comprise more than 50% of CRE distress, and the financing issue is compounded by reduced property valuations, leading lenders to reduce exposure. The “Survive til ‘25” mantra is beginning to sound dated, with lenders acknowledging that some debt restructuring is needed to buy operators more time. Bank lenders with little appetite for taking over operations will be forced to compromise with borrowers, though no immediate liquidity issue has forced lenders to realize losses, dragging out the restructuring cycle.
Good Asset, Bad Capital Structure is a twist on the corporate creditor’s search for the elusive Good Company, Bad Balance Sheet. A lack of price discovery the last two years, which saw real estate transactions postponed repeatedly, will be crystallized as financing issues come to a head. Though real estate is a slow-moving asset class, buyers of distressed debt portfolios have emerged, including Fortress’s purchase of a $1bn office debt portfolio from Capital One last year. The market is likely to see increased activity over the coming year in the form of refinancings, recapitalizations, and property sales as lenders are forced to realize losses. A tax attorney emphasized the role of taxes in workouts—dictating strategy, structuring, and negotiation, with COD being key to a successful restructuring. In an industry characterized by personal relationships, aggressiveness can backfire in terms of reputation and deal flow—”holding hands with borrowers” is the better long-term approach, said a friendly-sounding guy.
Multifamily properties are trading as smaller scale operators are forced to cough up assets. Elevated operating costs in the form of materials, labor, insurance, and taxes have pressured smaller, more concentrated operators in addition to the financing shock. The Sunbelt in particular suffers from an oversupply of new development, where investors concentrated their bets in the 2020-2021 financing boom. Comparing multifamily supply to market fundamentals—and historical rates of absorption—led one panelist to believe that high-growth markets are especially susceptible to recession. In the Northeast, local regulations such as rent regulation and extended foreclosure processes have made many multifamily properties unprofitable. Still, from the banks’ perspective, multifamily is the favored asset class given ongoing cash flow and the ability to extend maturities.
Office conversions may be the only option in NYC and other dense markets, where there is no viable alternative for unused space. An uneven distribution of tenant demand sees Class A buildings near transit hubs performing well, while the bottom 50% of buildings will be forced to adapt. Office conversions are “devilishly difficult,” according to an architect, featuring high barriers to entry, massive capital costs, and a raft of regulation. That makes conversions difficult to pencil, often requiring government assistance in the form of tax incentives. Office vacancies have reset property valuations, though owners and special servicers have so far been unwilling to acknowledge the distress. Meanwhile, limited capex in those properties—where tenant improvements are typically demanded—accelerates valuation declines. One lunch eater observed that distressed NYC office properties represent a buying opportunity for a family office with a long-enough time horizon.
Lack of experience prevails in the institutional market, where professionals under 40 have not lived through a full cycle. In the meantime, property loans have grown significantly more complex, while control in default requires a specialized skillset. Loan documents drafted in peak financing environments mean mid-career professionals have never had to take precautions, experiencing only soaring property valuations, and therefore have not earned the wisdom of hard experience. But with foreclosures now beginning to catch up from the pandemic moratorium, the distressed opportunity set is once again compelling.
Evan DuFaux
evan.dufaux@levfininsights.com
+1 917 654 0333
