Distressed Commercial Real Estate

With interest rates spiking, cap rates moving higher and building valuations therefore trending lower, commercial building owners may be facing some significant headwinds when the time comes to refinance the mortgage on their building.

In business, finance and the economy the John Templeton phrase ‘this time it’s different’, is typically invoked to justify situations that may not in fact be sustainable. For instance the wildly narrow spread between junk bonds and treasury yields that had existed in a 0% interest rate environment, needed in some way to be justified. Insert ‘this time it’s different’. So too did real estate prices that in some cases doubled or more due to the demand created by Covid. Insert ‘this time it’s different. You get the idea.

Well because what goes up must come down, or rather interest rates artificially held down must at some point move back up, borrowers who entered into loans at lower rates will now be facing higher rates and higher cap rates leading to lower building valuations, all when it comes time to refinance.

The result will not be pretty for many, as banks may only offer them a loan amount (based on LTV and other factors) that’s less than what they owe, requiring owners to come-up with the difference to make the lender whole.

This leads us to the article below written by Bruce Stachenfeld, Chairman of the firm Duval & Stachenfeld. It describes what had been the case in some past market ‘crises’, and then what will likely be the case in the near future when borrowers face reality with their lender, in this case called ‘Fulcrum Capital’.

It is definitely worth the read!

Distressed Real Estate and Fulcrum Capital

Let me get right to it.  There is going to be distressed real estate – I mean it is already here.   Here is the background and some thoughts about what to do:

First – some history – during the Global Financial Crisis, many thought there would be tons of real estate distress.  I recall meetings and seminars planning for an enormous wave of distressed real estate.  However, the Fed and other governments printed a lot more money, which lowered interest rates.  This permitted most of the cans to be kicked down the road.  There was some distress for sure, but not nearly the expected level.

Second – came COVID – and there was again a major expectation of distressed real estate.  However – other than retail, hotels, and a few other places – the crash and distress were a flash that lasted a little over 60 days, and the dip quickly disappeared to be replaced by a boom.  This was again due to interest rates continuing to fall – plus the government continuing to print dramatically more money. 

However, this time it is quite different. 

Let me start with a ridiculously simple hypothetical, and I do apologize for insulting everyone’s intelligence that this hypothetical is too simplistic.  I want to set the table here, and I promise more intellect later in this article:

The borrower owns a building – e.g., multifamily – worth $100M as of the end of last year – with that valuation being based on trading at a 3-cap, which was pricing at the time.  It had a nice safe 70% LTV mortgage on it for $70M. 

However, now due to interest rates rising, the 3-cap is now a 4-cap or even a 5-cap, so the valuation is no longer $100M.  Maybe it is worth $80M, and now the mortgage comes due. 

The lender can hardly extend (whether or not it pretends) because it would now be $70M out of $80M, which is an 87.5% loan to value.

To stay at 70% loan to value (i.e., 70% of $80M), there needs to be a pay-down to $56M to get to a 70% loan to value, which requires a $14M payment to the lender.  I am going to call this “ Fulcrum Capital.”

There are solutions, of course that could avoid the need for Fulcrum Capital, but they may not be easily palatable.  Obviously, the borrower could just reach into its pocket and make the payment; however, the borrower might not have the dollars and/or might not want to make the payment.  Equally obviously, the lender could foreclose, but the lender might not want the property, or the borrower might not want to give it up so easily.  Or maybe the borrower could just walk away and give the keys to the lender despite the lender not wanting it. 

This is a classic distressed real estate situation.  It is the simplest one I could devise, and of course, there are super-complicated situations where there are multiple tranches of debt, preferred equity, different investors, and other stressors on the system.  Sometimes it is a true Gordian Knot to figure it all out.   

However, one way or another, there is often going to be a need for Fulcrum Capital, based, quite simply, on the property valuation adjustment, which makes a previously healthy property become overleveraged. 

Notably, some irony here struck me that the erstwhile safest assets are the ones most likely to be in this situation.  This is because super-safe assets – e.g., multifamily, industrial, SFHR – were trading almost like bonds on a cap rate basis.  Yet those are the ones where the valuation hit is most obvious because – just like a bond – when the interest rate goes up, the valuation goes down. I may be missing something, but the safest funds – i.e., core funds – may take some of the biggest hits here.

Having said that, of course, rents can potentially rise faster than inflation, so to some extent, this result may not be as bad as it seems.  My crystal ball has a cloud for this specific question. 

So I have set the table – now what happens?

First – non-bank lenders will eagerly step into this kind of situation.  It is essentially their raison d’etre, to provide – expensive – Fulcrum Capital in these situations.  From their perspective, if they provide the missing $14M, they will be paid extremely well for these dollars.  I won’t specify a number, but it is a heads-they-win-tails-they-win investment as it is largely equity returns with a solid equity cushion.  Indeed, depending on the level of distress, sometimes the Fulcrum Capital primes part of the first lien debt at heady interest rates.

Second – making it even more interesting, is that the parties providing this capital will only partially be non-bank lenders.  This is because many non-bank lenders that provide high-yield debt don’t want to go up to 87.5% in the capital stack as it is too risky for them. 

However, since the returns for this Fulcrum Capital are equity-like, the many private equity funds in the business will be putting in the dollars instead of the non-bank lenders.  From the point of view of private equity funds, Fulcrum Capital is not a (bad) over-leveraged loan but a (good) equity deal with a nice equity cushion that they typically don’t get. 

Notably, many non-bank lenders are also private equity providers, so it just may be one pocket of funding versus another.  Either way, you will see real estate private equity funds providing this Fulcrum Capital through their debt funds, equity funds, or both. 

As an aside, Fulcrum Capital will have various guises, including:

• A new mezzanine loan
• New preferred equity
• Splitting up the debt into an A and a B piece
• New common equity
• Foreclosure and a new loan
• A recapitalization
• A deed-in-lieu with a new loan and the lender potentially converting a portion to equity
• More bespoke structures

I sense that a large amount of money is available to provide Fulcrum Capital, which will keep a (moderate) lid on the pricing of this Fulcrum Capital.  I predict that initially, the pricing of this capital will be very high; however, over time as Fulcrum Capital becomes more de-rigueur and the markets stabilize, pricing will settle into a place where it is high but not crazy high. 

Now I am trying to simplify things in this article; however, these deals are rarely simple.  There are many concerns since the parties have so much at stake. 

The borrower might lose its property which could be a calamity

The lender – if a regulated bank – may find itself in a desperate situation with its regulators depending on how it handles the workout.   

There are potential litigation risks if any of the parties become hostile – as opposed to analytical – and distressed situations sometimes bring out the worst sides of parties. 

And, let’s not forget the tax implications of a foreclosure or workout or bad outcome.

To conclude, I urge the following:

Dispassionate and unemotional analysis of how market conditions brought the asset in question to the situation it is in;

Assessment of whether the troubled situation is due to just a change in market sentiment with interest rates rising or whether the owner’s lack of competence caused the trouble;

Assuming the counterparties are competent, they should start out by trying to work together – borrower and lender and Fulcrum Capital provider — to achieve a win/win/win result, utilizing the different guises of Fulcrum Capital to mutual advantage;

Be creative.  This is a time when brainpower and creativity can make a major difference. Fortunes can be won – as well as lost – in turbulent times; and

And no matter what, don’t blow your reputation up.  I guess a little chest-beating and brinkmanship is okay, but that old saying about a lifetime to achieve a reputation and fifteen minutes to lose it is apropos.  Further to that point, during good markets, new partners or investors typically do their due diligence for your track record in the last downturn.  Your future self will thank you if you always act with honor and integrity.

I wish everyone the best possible outcomes as the markets have changed.