2023 Will Be The Year Of Distressed Debt No One Wants To Buy

Despite apparent consensus across commercial real estate that 2023 will be a year of hard times, conditions still may not be right for the distressed asset market to kick into gear.

Since the pandemic’s outbreak, opportunistic investors have salivated over the prospect of building owners stuck between a rock and a hard place on their loans.

But the private equity funds set up to buy distressed assets need debt of their own to deliver the returns promised by their sponsors — and they aren’t getting it.

"The first question is, ’Is there going to be distress?’” said Jason Hernandez, who leads Nuveen’s debt practice in the Americas. “And if there is but there’s no liquidity, it’s very difficult to have a functioning distressed asset market. There are very few unlevered buyers.”

The Federal Reserve has all but rejected optimism it could start lowering interest rates before the end of the year, ensuring that floating-rate debt will keep getting more expensive. Loans due to mature this year or next have become virtually impossible to refinance without a borrower putting much more equity into a property, multiple sources told Bisnow.

Meanwhile, the share of commercial mortgage-backed securities in delinquency rose above 3% in December for the first time since July, according to Trepp data released on Jan. 5. Though still much closer to historic lows than the pandemic-high 10.32% in June 2020, Trepp projects delinquency rates to rise significantly this year based on the number of loans set to mature without much hope for refinancing. 

Yet in order for a distressed assets market to materialize, mortgage holders have to decide to pull the plug on a borrower. And as in 2021, when private equity funds raised huge sums to spend on a distressed asset wave that failed to materialize, there is seemingly little appetite among creditors to take that final step.

“From our history, we see this stuff can just linger and linger and linger,” Trepp Senior Managing Director Manus Clancy told Bisnow. “You can go back to the Great Financial Crisis — you have assets from there that blew up in 2008 and weren’t resolved until 2016 and 2018. Borrowers can extend and pretend and keep hanging around forever.”

In 2020 and 2021, some lenders cited the unprecedented nature of the pandemic and the low cost of capital in offering forbearance or renegotiations on debt. Now, the reluctance to foreclose on properties is likely due to what appears to be a paradox: Despite the billions in investor funds waiting to be spent on distressed debt, the buyer pool is suffering from a lack of liquidity. 

Across North America, 53% of markets experienced a drop in liquidity in Q3, Real Capital Analytics reports, while only a couple of the 64 markets it tracks showed a liquidity increase.

RCA gives markets a liquidity score based on a combination of transaction volume and the depth and makeup of the buyer pool, RCA Chief Economist Jim Costello said. Anecdotally, Q4 doesn’t seem to have gone much better.

“We’re finding that working with our borrowers and getting them to modify and recapitalize their position is better, since the loan sale market has such a huge disconnect that you’re not seeing people play there,” Hernandez said. “Right now, there’s a liquidity crisis.”

Sponsors of funds targeting distressed assets and debt rely on leveraging their acquisitions to deliver the returns they promise to investors. The current financial environment makes it close to impossible for that class of distressed asset buyers to obtain the kind of debt financing they need to put all their cash to work.

“People raise money and promise certain return levels around that money, and it’s just not possible to get those returns based on all the assumptions that were in place,” Costello said. “So the only way you’re going to get to those numbers is if you underwrite heroic rent growth assumptions, get cheap debt somehow or get owners to sell at a much higher cap rate.”

Interest rates are making it difficult for borrowers with floating-rate debt or maturing loans of any kind, while also suppressing the activity of potential distressed asset buyers.

That means 2023 has the makings of a year in which properties are stuck in debt limbo.

Professionals who manage troubled assets, such as special servicers and receivers, have already seen an increase in business the past couple of months. Further increases are anticipated throughout the year.

“I definitely hear the phone ringing more these days,” said Chicago Homes RE Business Development Officer Courtney Jones, who manages properties in receivership in the Chicago area. 

Even if the distressed asset buyer pool remains disappointingly shallow, conditions may force lenders to run out of patience with borrowers and foreclose on properties more often this year, said Locke Lord partner Mark Silverman, a receivership attorney who regularly works with Jones.

“I don’t think that lenders are necessarily moving toward enforcement right now,” Silverman said. “Everything is sitting in defaultland, and there will be far more defaults in the coming months for which we haven’t scratched the surface yet.”

Aside from the absence of liquidity, the stumbling block for the distressed asset market is the same as it is for the overall commercial real estate investment market: Buyers and sellers are miles apart on valuations. It amounts to a reinforcing cycle in which no transaction data means no sales comparisons — the basis for most forms of valuation, Costello said.

Periodic valuations released by open-ended funds like nontraded REITs are one of the only alternative methods available to market watchers looking for a sense of how properties are being valued in general. Because they own an outsized portion of office buildings in major urban cores, such funds’ appraisals would produce data on the sector of greatest interest to distressed asset hunters, Hernandez said.

In general, office is the asset class being watched most closely for signs of distress, Costello and Clancy said.

Unlike with industrial and multifamily, the long-term demand prospects for most office properties aren't promising. Long-term leases provide enough cash flow for many office buildings to remain moneymakers on a monthly basis, removing the short-term pressures that lead both borrowers and debt holders to sell for the kind of deep loss that would make an acquisition feasible in the current debt market. 

“If you look at what has happened with malls over the past five years, everybody was expecting huge distress, and there was [distress],” Clancy said. “There was an enormous rise in delinquencies, values were cut and some defaults happened, but there was a lot of extending and pretending too. Borrowers kept up some payments and zombied along, even as assets were underwater. And I think that’ll be the case with office as well.”

Because appraisal data from open-ended funds often lags the market by six months to a year, the second quarter of 2023 could be when appraisals begin to reflect the new reality that capital markets began facing in the back half of last year, Hernandez said.

“You’ll start to see a trend at that time, and that’s one way that people could get confidence [in valuations],” he said.   

Considering the Fed seems wary of lowering interest rates until the economy has slowed considerably, liquidity from the debt market seems unlikely to improve until something else changes. For anyone to be interested in buying distressed loans or properties, those holding such loans and properties may need to be willing to eat a loss. 

“If the Fed is tightening to restrain the overheated nature of the economy, that can detract from fundamentals,” Costello said. “That would certainly take wind out of the economy, and that can impact both the income and the capital side of price expectations.”

As loans come due or become too expensive to keep up with, it may fall primarily to lenders — or even bankruptcy courts, in some cases — to decide when to cut bait.

“I think 2020, 2021 and even to some degree 2022 was a time when lenders were giving lots of options to extend, forbear or otherwise move things along,” Silverman said. “I think you’ll see some of that, depending on the curve of the asset value going forward, but I do think that lenders are generally trying to figure out potential strategies other than kicking the can down the road.”

Even if distressed asset funds can finance an acquisition, the deals that shake loose may be for buildings that don’t have a future. Few buildings are in dire straits simply because their owners weren’t maximizing their value enough. 

“There is a lot of dry powder on the sideline, but the stuff you are seeing people buy is not the easiest to pull off — it’s conversions of office or malls to multifamily,” Clancy said. “In order to get returns, people need to do backflips. ... The distressed buyer opportunity that we saw in 2010 is really a dog that doesn’t hunt anymore, or at least hasn’t hunted for the last four or five years.”