Some commercial real estate experts had foretold a slowdown in 2020, but none could have envisioned a total economic shutdown. Across the United States, local economies are floundering in the aftermath of the coronavirus crisis. States are steadily starting to open again, but mysteries abound as to the lingering repercussions on commercial real estate. This article is a follow up from Five Keys to Investing in Distressed Real Estate.
One point all experts can concur on is that real estate will be reshaped, in one way or another. How profoundly it is affected remains to be seen. Some areas are expected to bear the brunt more than other classes, namely hospitality and retail. Still, it’s just too soon to know for sure.
In this piece, we examine opportunities for distressed real estate buys in 2020. Read on for more.
What is distressed real estate?
Distressed real estate is typically used in relating to properties that are in deteriorating or substandard conditions. Yet distressed real estate can also include properties that have a distressed capital stack. This customarily occurs when a borrower can no longer pay the mortgage. From a lender’s viewpoint, as soon as mortgage payments become 30 days late, a loan is deemed in default and, therefore, may be categorized as distressed.
Which borrowers are most likely to go under duress?
The COVID-19 crisis will impact two types of borrowers.
The first is a crop of otherwise highly-qualified borrowers. These sophisticated loanees have considerable assets, in great locations, with strong sponsorship and competent operators.
These properties can be found across asset classes, including hotel and retail, office, and multifamily. These borrowers may be downgraded singly due to the pandemic influences but would otherwise have no challenges concerning meeting their debt obligations.
Veteran debt servicers like these will undergo a different path to recovery than their peers, as banks will be more inclined to work with them (via forbearance, restructuring, and the like) as they get through this momentary crisis.
The second crop of debtors is those who were already dancing on a knifes edge and are highly levered, having put only 2-3% equity into the deal. Borrowers like these can make a ton of money when the market is healthy, 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 disintegrate. The pandemic will start to bring these loanees inadequacies to the forefront, and lenders may be less prone to work with them to restructure their debt. It is from these borrowers whom we might anticipate seeing the most distressed debt in 2020.
When will distressed debt opportunities emerge?
Debt markets lag considerably behind liquid equity markets. April and May’s defaults are not a go-to indicator. June and July 1 will be slightly more indicative of the rate of default, but this will only represent the first wave of deals. It is plausible that most distressed opportunities hit the market this fall, or even into 2021.
Distressed Debt Opportunities in 2020
Distressed debt opportunities will likely come in cycles.The first surge of distressed debt will be amongst prime assets. This is the space where borrowers can free up the most liquidity. This is similar to the trend we saw in 2009 and 2010. The first influx of distressed real estate will be fast and furious. This initial wave presents excellent buying opportunities: these are likely to be stable loans on prime real estate but are on assets where the borrower needs capital for other purposes, such as a margin call or another deal they may have just written.
The next round of distressed debt will come after the onslaught of CMBS defaults. These properties are anticipated to be found in secondary or tertiary markets and will have less seasoned sponsors.
With each succeeding wave of distress, the quality of the opportunity will weaken. The deals to come behind will be smaller balance deals that take a prolonged time to trade off the books.
In terms of asset classes, the most notable opportunities will undoubtedly be in the retail and hospitality sectors. Retail was already faltering pre-COVID. It will be forever transformed post-COVID. Hospitality had been performing well going into 2020, was expected to be flat this year. Nobody had a pandemic in the cards when working out the Internal Rate of Return. It will take some time for hospitality to recover, though most believe it eventually will. There will likely be notable distressed debt buying opportunities between now and then, particularly among less skilled operators who may not make it through to the other side.
Office, industrial, and multifamily are presumed to have the least distressed debt circumstances. Multifamily is traditionally the most dependable product type, and we expect it still will be moving forward. There is much froth in the CRE space; flat or reduced rents and discounted fees might wipe out enough equity in some deals to cause distressed debt buying opportunities. It’s too early to tell how sectors might be impacted to the point of creating widespread default.
Identifying Distressed Debt Opportunities
Folks often ask how to recognize whether a “deal” is a “steal.” There aren’t any “steals” hitting the market just yet. As indicated above, most early distressed debt circumstances are likely 90 to 180 days down the road. The first possibilities to enter the market will be loans for sale amongst borrowers who need fast liquidity. This is a moment to invest in high-quality real estate, but it might only be at a negligible discount –not a “steal” per se.
Deals convert to “steals” when a borrower can acquire the debt for far beneath replacement costs. Historically, those deals may take some time to develop during a recession.
Capital is King When Buying Distressed Debt in 2020
Echoes experienced during the Great Recession of 2008-2010 remind us that cash is king. Capital on hand is needed to move quickly. Borrowers in crisis will often arise on a Monday and need to close by Friday. Few buyers can proceed with the lightning speed suggestive of equity markets.
It can seem not very sensible to underwrite a deal in just a few days. But many borrowers do, and with great success. The keys here are: act on a good haunch, thorough due diligence, and limit the decision-making hierarchy.
Conclusion
We shall see how long and deep this pandemic-created recession lasts. There is a vast difference between a natural disaster and a financial meltdown. Stocks are still performing, and countries/regions usually bounce back promptly after a natural disaster. Lay-offs appear to be declining, preempting a rebound.
The positive news is that overall capital markets appear to be healthy. Many buyers have been sitting on the sidelines who are now eager to look at investing in deals, distressed debt, or otherwise. Like those in the past, this recession will weed out the less experienced sponsors to the benefit of the patient, well-capitalized buyers who are now in a great position to invest.