The Distressed Asset Market Is Already Hot, If You're Willing To Spend

Though many in commercial real estate are still waiting for distressed asset sales to peak late in the year, the market has already heated up for those willing to take risks and spend cash upfront.

Even though the bulk of distressed loans are still in some form of forbearance or otherwise in a pre-foreclosure holding pattern, debt funds started looking to deploy capital as early as last summer, Nuveen Managing Director Jason Hernandez said during Bisnow's Deal Flow and Investment Strategies digital summit on March 10.

“What you saw was that anybody who didn’t have to transact didn’t transact for the first three to four months [after the start of the pandemic]," Hernandez said. "But eventually, more people had to transact, so we saw a lot of opportunities in the bridge-to-sale space. The banks were still focused elsewhere, so our debt fund sort of stepped up in that space.”

By the end of the year, banks had begun getting more comfortable originating new loans and liquidity returned to the market. In the interim, banks that didn't want to deal with foreclosing on delinquent loans were giving good prices on note sales, especially for hotels, Lubert-Adler Real Estate Funds principal Jessica Morgan said — deals that require cash upfront and don't allow enough time for much due diligence.

“It’s a more challenging place to play, like you need to put up $1M hard cash in 24 hours, close in two weeks and you don’t have lots of information,” Morgan said. “You could purchase a note, work with the borrower, restructure [the loan], change the term or get into some equity upside. And the downside in that scenario is just getting repaid. So you ultimately have a good risk-adjusted return.”

As the calendar turned to 2021, more traditional foreclosure sales and debt transactions began to gain momentum, but the first such deals available were for the properties that had the least margin of error, Morgan said. Especially in a time period when the causes for distress are still in effect, chasing returns has required having capital at the ready.

For retail properties, new owners have to reckon with the fact that the previous use may never be viable again, meaning that a redevelopment of some sort will be needed to turn a profit long-term. Buying a hotel before potential customers gain comfort in the safety of travel and tourism or before business travel returns in any meaningful quantity means signing up for a business that is losing money even before accounting for debt payments.

“There are three kinds of hotels: select-service, full-service and big-box, and they’ll recover at different rates,” Arden Group Chairman and CEO Craig Spencer said. “So it’s a puzzle, but if you get the puzzle right and buy properly and project your negative cash flow, there will be some real opportunity.”

Already, the window to maximize returns on distressed hotel deals might have closed, with spreads on new debt deals narrowing considerably in the last two months, Spencer said.

“There’s a real view out there that people are going to start traveling and staying in hotels again soon,” Spencer said.

As with any high-yield investment, the risks will likely be higher for early distressed-asset deals, and not just because of the greater need for capital on the front end. Buying before the long-term effects of the coronavirus pandemic have come into view at all risks misreading the recovery.

“Even if demand returns with some shifts on the margin, there will be some value adjustments,” Morgan said. “The question remains how much these dynamics will change values — will there be cost distress, or will it be a minimal change where people can make it through with the financing they have?”