The estimated $1 trillion in "overleveraged, underwater debt" slated to mature over the next six years overwhelms the approximately $300 billion targeting such deals, Richard Saltzman, president of Colony Capital, said at the ULI Capital Markets Conference, held in Manhattan in June. "The investment opportunities presented by the mountain of distressed debt now on the books of lenders of all stripes continues to be both a major inducement and a considerable irritant to would-be investors," Saltzman said.
"I haven’t seen the opportunity manifested in deals," he said. The situation remains the opposite of that during the Resolution Trust Corp. (RTC) era of the early to mid-1990s when "there wasn’t a lot of capital but there was plenty to do."
Saltzman noted that federal regulators are no longer willing to "look the other way," an attitude that led the practice of "pretend and extend" on bad loans to become nearly universal. In its place, a hardline stance is emerging as banks regain their footing, he said.
Panelists seized on Saltzman’s observation that "we’re dealing with real assets, and at some point the asset needs cash or the building will atrophy." Indeed, said Trepp LLC managing director Matt Anderson, "People tend to neglect properties while decisions are being postponed." Anderson underscored the gap between outstanding distressed debt and deals done, and added that much of what remains to be worked out could yield less-attractive terms for sellers.
Anderson noted that $100 billion in problem debt remains on bank balance sheets—including more than $30 billion in real estate–owned (REO) property. Although larger banks have shed up to 50 percent of their troubled debt, smaller banks have disposed of just 20 percent of theirs, and both have sold off the best nonperformers first, meaning the remainder is typically less attractive to new investors. In addition, said Anderson, "The $80 billion in current troubled CMBS [commercial mortgage–backed securities] assets could be even more difficult" to work through.
Gil Tenzer, partner at Contrarian Investors, said sellers are beginning to change their attitude to "realism, not capitulation." Investors need to be flexible, he said. When Contrarian began investing in a $450 million fund this year, it expected to be doing mostly hotel deals and hardly any multifamily deals. Instead, of 12 closed transactions, only one has been a hotel loan and the rest have been apartment deals. In nine of the deals, Contrarian has taken title to the underlying property.
Both Tenzer and Christopher Graham, managing director for acquisitions at Starwood Capital Group, are looking to the troubled Eurozone and the U.K. "The U.S. has been reasonably good at resetting the basis on deals," said Tenzer, but "not so in Europe. There will be a tremendous opportunity." Graham put it in baseball terms: "Large banks are in the eighth inning, and regional banks are in the fourth inning." Added Todd Liker, managing director of Oaktree Capital Management, "The European banks are still in the second inning" of recapitalization and deleveraging.
Graham also suggested that expectations on the buy side need to be tempered. "The question is the quality of the deals," he pointed out. "It isn’t great, but there’s some solid risk/reward out there. For every five deals, only one might be a home run, he added, "and I don’t think it will change over the next two or three years."
Lenders—whether financial institutions or CMBS—remain vulnerable, even more so than borrowers. "The best deals tend to be borrower-led deals," said Liker. Not only does working directly with the borrower remove bankruptcy risk, but also, he said, "borrowers know exactly the demand in their markets and provide attractive return opportunities" for investors willing to step in with fresh capital. And whereas "bank loan pools also represent good opportunities for IRR [internal rate of return] growth," they also offer "low profit multiples. It’s all about timing, speed, and the recycling of capital."
A bright spot for borrowers facing troubled loans, and another major distinction from RTC-era deals, is that the risk investors faced of being stigmatized for giving back property has largely disappeared because virtually every top-quality buyer has had to walk away from an asset during this cycle.
Still, said Christopher B. Price, partner at the law firm Goodwin Procter, borrowers and lenders need to be on notice, and working together may help both parties achieve reasonable resolution. "Nonrecourse carve-out guarantees are enforceable," he said. "Single-asset bankruptcy rules are now being enforced as well, such as the 90-day rule to come up with a plan or get out of the way."
Tenzer said he believes such realities will spur more deal flow in the context of current economic conditions. "It’s now almost a perfect storm. The economy is not falling off a cliff, but it’s also not that great," he said. "So the lenders know they need to do something."