Distressed Assets May Be The Tonic A Stressed CRE Market Needs

The commercial real estate market continues to be plagued by fears of a recession. Driven by inflation and the heightened cost of capital, investor sentiment is diminishing. According to a survey from Lightbox, nearly 70% of CRE investors said they are concerned for the future of the market as the year comes to an end.

The Federal Reserve has raised interest rates six times so far this year to combat one of the market’s most pressing challenges: inflation. When asked recently about further rate hikes, Chair Jerome Powell hinted that the Fed will continue to increase rates until inflation is curbed. Consequently, CRE assets are experiencing decreased demand, ultimately lowering property values and minimizing lenders’ willingness to participate in transactions.

But not all is doom and gloom. Investors who are eager to take risks in the face of market uncertainty may see more opportunities to acquire distressed assets, properties that are undervalued because of market dislocation, unstable economic conditions or mismanagement. 

Distressed assets may be a wise investment with the potential for a high rate of return. For Money360, a bridge lending firm, finding these opportunities during turbulent economic periods is second nature.

“The current economic climate is flashing several of the factors that may produce distressed opportunities in the CRE market,” said Tom MacManus, president and CEO of Money360. “While a downturn of some sort is likely, the severity and duration have yet to be determined.”

Money360’s executive team has been engaged in a vast array of CRE lending and other capital markets transaction restructurings over the past 40 years. During those four decades, there have been at least four moderate to severe turbulent economic periods during which time CRE deals had to be restructured, refinanced, recapitalized or otherwise negotiated to optimize transaction outcomes for various parties including lenders, borrowers and investors.

John Maute, CEO of M360 Advisors, which manages private investment vehicles focused on niche segments of private credit, said that distressed investing has come in waves over the past several decades. However, it should be thought of as a “seasonal business” that comes about when considerable economic turmoil and pessimism in the financial and business markets cannot be fixed quickly or easily, ultimately forcing institutions to sell assets.

Brett Koelliker, credit officer at Money360, said it is important to be ready to pursue unique situations and distressed opportunities when they come to fruition. However, entering this market too early is not always the best option.

“A few investors launched distressed funds in the early days of the pandemic, projecting higher-yielding internal rate of returns,” Maute said. “However, the federal government, banks and the CRE industry chose to work with CRE sponsors and business owners to find solutions other than selling loans. At that point in the pandemic, it appeared this was a better solution than disposing of the assets.”

He said that while there is still uncertainty with office properties, distress has been reduced in many other property types. There are, however, individual properties and loans that are distressed, defaulted or in foreclosure. These will be worked through at a reduced speed, slowed down by court moratoriums and caseload backups in addition to repricing in the current capital markets, he said.

When it comes to financing deals in uncertain times, market dislocation always creates opportunity, MacManus said.

“Market volatility requires a more cautious and disciplined approach to lending,” MacManus said. “Many assumptions for bridge loan takeout analytics were quite aggressive until a few months ago, including growth in rental rates, absorption and lower assumed refinance rates. Until the market disruption finds the ‘new normal’ and liquidity improves, we can anticipate a slower growth in deal origination as well as execution.”

MacManus said that for loans being considered under these more turbulent times, it’s important to pursue an appropriate and realistic deal structure. Cautious underwriting measures may include a more conservative approach when calculating reserves, evaluating absorption and stressing exit loan refinance assumptions, he said. 

Maute and MacManus said once the market uncertainty abates and markets stabilize, they anticipate deal volume will increase and lending opportunities will return to more normal levels. In the near term, investors should remain ready for distressed opportunities to arise. Rescue capital will be an opportunity during these times.

“We want to be realistic in all of our assumptions and remain highly transparent with our clients when we size and quote transactions — avoiding subsequent surprises that could’ve been avoided,” MacManus said. “Given the inverted yield curve, short-term floating rate loans remain challenging until interest rates and capitalization rates settle, establishing a new equilibrium. We may decide to pursue different loan structures to seize opportunities that provide attractive risk-adjusted returns for our investors.”

This article was produced in collaboration between Money360 and Studio B. Bisnow news staff was not involved in the production of this content.

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