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. Richard Saltzman, president of Colony Capital, chaired a refreshingly frank exploration of the topic at the ULI Capital Markets Conference held in Manhattan in June. Saltzman kicked off the conversation with a sobering roundup of current market conditions for investment in the debt space, beginning with the point that the estimated $1 trillion in “overleveraged, underwater debt” slated to mature over the next six years overwhelms the approximately $300 billion targeting such deals. “I haven’t seen the opportunity manifested in deals,” he said. The situation remains the opposite of 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 the willingness of federal regulators to “look the other way” that led the “pretend and extend” practice to become nearly universal has changed, and a “hardline stance” is emerging as banks regain their footing. 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, says Trepp LLC’s managing director Matt Anderson, “people tend to neglect properties while decisions are being postponed.” Anderson underscored the yawning gap between outstanding distress and deals done, and added that much of what remains to be worked out could yield less-attractive terms for sellers.
At present, $100 billion in problem debt remains on bank balance sheets – including more than $30 billion in real estate owned 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 non-performers first,” meaning that the remainder are typically less attractive to new investors. In addition, says 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 tune. “Realism, not capitulation,” he says.
Tenzer also noted that that investors need to be flexible. When Contrarian began investing a $450 million fund this year, it expected to be doing mostly hotel deals and hardly any multifamily deals. Instead, of twelve closed transactions, there has only been one hotel loan while the majority have involved multifamily loans. In nine of the deals, Contrarian has taken title to the underlying property. Both Tenzer and Christopher Graham, managing director 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,” says Tenzer, but “not so in Europe. There will be a tremendous opportunity.” Graham puts 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 delivering.
Graham also suggests that expectations on the buy side need to be tempered. “The question is the quality of the deals,” he points 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 adds, “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 than borrowers. “The best deals tend to be borrower-led deals,” says Liker. Not only does working directly with the borrower remove bankruptcy risk, but also, he says, “borrowers know exactly the demand in their markets and provide attractive return opportunities” for investors willing to step in with fresh capital. And while “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: The reputational risk of giving back property that once stigmatized investors has largely disappeared, as virtually every top quality buyer has had to walk away from an asset during this cycle.
Still, says Christopher B. Price, partner at the law firm of Goodwin Procter, borrowers and lenders need to be on notice, and working together may help both parties achieve reasonable resolution. “Non-recourse carve out guarantees are enforceable,” he states flatly, while “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 says 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 says. “So the lender knows they need to do something.”