Buyers of Distressed Debt Inject Flexibility Into Pandemic-Stricken Real Estate Markets

Buyers of Distressed Debt Inject Flexibility Into Pandemic-Stricken Real Estate Markets

The nation’s private equity giants have marshaled a massive war chest in anticipation of the lower pricing expected to come from the COVID-19 crisis. But these equity investors are not alone. A wide range of companies and funds have also been readying themselves to invest in the distressed debt that the crisis is expected to generate. Among the billion-dollar-fund-club are big companies like Apollo Global Management and Fortress Investment Group.

On the real estate side, companies are also focusing on distressed real estate debt. Goldman Sachs recently closed a $2.75 billion fund of its own while New York’s Northwind Group launched a $220 million fund last month, and Brookfield is planning to start a $5 billion retail fund. The waters are indeed frothy. According to David Fann, Vice Chairman of the alternative investment research firm Aksia LLC, “Everybody and their sister is back in the marketplace trying to raise a distressed debt fund. We’ve been inundated with distressed ideas.”

Distressed debt investors may often be labeled vulture funds, but within commercial real estate in particular, the reality is that taking discounted positions in troubled real assets provides a particularly good opportunity to offer a vital service while strengthening the local community. This is the core of what a well-functioning real estate market is all about. In an excellent article for Global Capital, Owen Sanderson explains that servicing strategies do not need to be about shutting down businesses and sending people to bankruptcy court. For a lot of distressed debt buyers, the discounted price offered allows for more creative loan terms or even principal drawdowns that can help distressed borrowers get out from under the mountain of their obligations. “A fund that mainly buys bonds with ESG characteristics might expect returns in line with a normal bond fund, say five percent optimistically, while a fund playing in NPLs might be shooting for fifteen to twenty percent with leverage,” Mr. Sanderson wrote. “That is more than enough gap to allow for a more sedate approach to servicing, and such an approach would surely attract more capital to the market.” But even if things get hairier, there are still opportunities to bring about good for the community.

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Perhaps a property’s distressed debt does sell to a new investor, and perhaps that investor does force a sale of the asset. This is bad news for the property owner, but for the community, it could be a good thing as well. Moving a commercial building from one owner, who for whatever reason was unable to stay in business, to a new owner offers a chance to reposition the asset into a more efficient, sustainable angle. Sure, there will no doubt be casualties amongst beloved and otherwise well-performing local businesses who just didn’t have the resources to stay afloat through the pandemic. These businesses will be missed dearly by their communities. But there will also be casualties amongst businesses that simply have the wrong model, or distribution system, or product for their geographic market. It’s always unfortunate to see a business go under, but for the sake of strong cities and towns, there’s an inherent value within seeing strong, well-performing businesses on the street corner, and not enterprises that would end up against the ropes for one reason or another regardless of COVID-19.

By the time the outbreak is behind us, we may come away with stronger markets, properties, borrowers, and lenders, as well. According to Keren Goshen, COO of digital syndication marketplace Metechi, there could be differences in the way market participants handle their debt. “Property owners may manage leverage by recognizing that relationship lending may be more amenable to the borrower’s requested accommodations and may pay the additional spread on their refinance. We have already seen a large decrease in commercial mortgage backed securities market share. We have heard of borrowers asking to use their reserves against debt service. From a lending perspective, we expect lenders will be more conservative in their underwriting requiring lower loan to value and upfront reserves.” The outbreak has shown how much unforeseen events can cripple properties around the world, particularly in fields like retail. A little more financial responsibility would not be a bad thing to come out of the crisis.

Of course, all of these good outcomes are going to be up to the investors. It will largely be up to them how to handle distressed properties. Are there opportunities to support a borrower simply going through a tough time? Are there better uses, from a community perspective, for a given space? Or will investors pursue only profit? COVID-19 has touched practically everyone by now. Communities will not forget who supported them, through forbearance, loan restructuring, or otherwise. and who sold them out.

While forbearance is a widely-used tool right now, particularly with retail and hospitality properties, it may not be enough to halt the transition of property debt over to investors targeting distressed investments. Ms. Goshen added that, “From a micro level, forbearance has been known to ‘kick the can down the road.’ During the accommodation period, lenders will differentiate between loans that are expected to cure and loans that aren’t. Banks’ managers who are veterans of the 2008 crisis already know that the longer bad loans stay on the books, the greater the loss when they finally are sold. Metechi expects these managers to sell these loans and clean their balance sheet in Q4.” With that in mind, the distressed investors are coming. Their servicing strategies will no doubt vary, but in a year, when it’s clearer than ever that we need to come together as a community, hoping for good outcomes from these distressed investments is far from foolish. [Propmodo]

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