The real estate market is facing material distress on a number of fronts. A rapid rise in interest rates has led to an increase in financing costs and made refinancing more challenging for property owners, while geopolitical events, uncertainty in the banking sector, inflation and high treasury yields have constrained lending activity. Changes in work habits post-COVID and the “flight to quality” have left many office spaces vacant and retail and service businesses without a steady flow of customers. A general slowdown in real estate transactions has created difficulties for investors in valuing commercial properties and debt investments.
Not all distressed real estate is created equal. While many older office buildings are simply obsolete given current demand and may need to be repurposed, many cash-flowing, viable properties across asset classes face capital markets distress due principally to the recent rise in interest rates and subsequent increase in financing costs. In response, institutional investors have begun to marshal capital in order to take advantage of the opportunities created by such distress.
In particular, many investors who have historically focused on equity investments are now considering opportunistic debt investments, either through new loan origination or debt acquisition in secondary markets. These investors are often attracted to distressed debt because of its priority of repayment within the capital stack, fixed payment stream with the potential for equity-like returns in a higher interest rate environment and—in secondary markets—favorable cost basis. Operating as a lender, however, presents different challenges than equity ownership. This article focuses on the key questions that traditional real estate equity investors and others should consider before investing in distressed real estate debt, with a particular focus on non-CMBS debt opportunities.
Capital Position
For parties who typically invest on the equity side, debt investments present new relationships to negotiate. While equity investors may already be fluent in the various types of control and liquidity rights that can exist between equity partners, as debtholders they must consider additional dynamics, including the rights among lenders and the various agreements between the lenders and the borrower.
For example, if an investor seeks to acquire debt and join a bank group as a senior lender, it should have a clear handle on the lender syndicate and how the property’s capital stack operates, including any mezzanine loans or preferred equity holders. What rights and obligations does the agent or lead bank have with regard to the syndicate? Do the non-lead co-lenders have generally equal rights and/or any transfer rights? A lead lender will typically make most decisions among a group of pari passu co-lenders except for certain critical items, such as changing the maturity date, which could require a majority, a super-majority or all of the co-lenders to agree. Furthermore, if there are mezzanine or preferred equity positions in place, a debt investor should be mindful of any additional control and approval rights those lenders may have.
Oftentimes a potential debt investor in search of higher returns for greater risk will consider entering the fray as a subordinated lender, whether in a mezzanine, B-Note, preferred equity or other subordinated role. It is critical for these investors to review the relevant intercreditor, participation and/or co-lender agreements to understand the rights and remedies of all lenders in the capital stack. Certain lenders may have approval rights that could impede a workout or loan restructuring, the right to cure senior loan defaults or the right to buy out senior positions either at par or at a premium. Subordinated debt investors must be especially focused on protecting their investment from being de-valued by the rights held by other lenders—particularly preferred equity investors, who often have minimal protections—and should be prepared to spend significant time and resources in diligence upfront.
Equity investors pursuing mezzanine debt opportunities should be aware that their collateral is not the property itself, but rather a security interest in the property-owning entity. A foreclosing mezzanine lender thus steps into the shoes of the borrower and must contend with the senior loan on the property, including a possible mortgage foreclosure, but will lack standing in any bankruptcy of the property owner. Senior or non-mezzanine subordinated debt holders should be cognizant of this right, as a mezzanine lender could become an owner of the property by curing a default and thus become responsible for servicing its debt.
Regardless of the investment strategy a prospective lender intends to pursue, it should evaluate the quality and experience of the property’s sponsorship and ownership structure and the potential for liquidity events and/or changes in control among its co-lenders and borrower. With several parties involved, interests and objectives can often diverge. Debt investors should also be prepared to consider the conditions under which they would allow a change in the ownership of the property and a modification of the debt.
Diligence Challenges
While equity investors may be accustomed to having substantial access to a property’s financial information and physical access to the property itself, prospective debt investors—particularly those in secondary markets—will likely have to perform due diligence on the property and its sponsor with less information than usual, and thus rely on informed estimates of prior performance. Particularly for properties experiencing distress, information gaps for diligence could be substantial, and debt investors should take a cautious approach to underwriting—especially since comparable data points may be sparse in the current market.
Unlike debt originations, where a borrower generally will pay its lender’s third-party costs, debt investors in secondary markets are likely to have to pay their own diligence and transaction costs. Additionally, secondary market investors are unlikely to benefit from current property-level representations and warranties from a borrower and will have to rely on their own due diligence and general representations and warranties from the selling lender regarding the loan file, which are unlikely to bridge the diligence gap completely. It is also critical that secondary market debt investors understand what prior discussions may have occurred between the selling lender and the borrower or other lenders, as they may be stuck with statements made by the selling lender or precluded from certain recovery efforts by a selling lender’s prior actions (such as under New York’s “one action rule”).
The Ultimate Plan
Debtholders have a different set of options available to them which can help to lower the risk profile of a debt investment. Prospective debt investors should consider these scenarios and develop an understanding of which options in their toolbox may prove the most efficient for their investment.
Note sales and payoffs: While an equity investor will most likely look to a sale or recapitalization of a property for an exit, debt investors will commonly either sell their debt to a third party or accept repayment via a refinancing or property recapitalization. Debt investors should understand their rights to sell their note and whether doing so will require the consent of the borrower or any other lenders, or whether there are net worth or liquidity requirements for a permitted transferee under any applicable loan documents.
A sponsor looking to refinance its debt could present a welcomed opportunity, especially if the property is struggling and the loans are backed by meaningful guarantees. Lenders should recognize, however, that a borrower may seek to repay its debt at any time, potentially before a debtholder has held the loan long enough to achieve its target returns. Potential debt investors should be prepared to leverage prepayment premiums, yield maintenance provisions or defeasance to ensure that, in the event of an early prepayment, their debt investments are worth the risk, time and effort.
Foreclosure: A debt investor should be well-versed in the mortgage foreclosure process within the property’s jurisdiction if it contemplates a “loan-to-own” strategy or decides to exercise its right to take over a struggling property from a defaulting borrower. The mortgage foreclosure process can vary widely in cost and complexity across localities, and differences could be especially stark for portfolios of assets distributed across different states. A deed-in-lieu of foreclosure could offer advantages in speed, cost and discretion. A mezzanine debtholder could have an easier time foreclosing more quickly and, in some jurisdictions, avoid transfer taxes.
In evaluating any foreclosure or deed-in-lieu, a debtholder should consider the potential for transfer tax liability, particularly in certain jurisdictions such as New York where transfer taxes are so high as to effectively prohibit foreclosures or deeds-in-lieu. Defaulting borrowers likely do not have the resources to cover transfer taxes even if there may be a contractual responsibility to do so, so debtholders may need to look to guarantees to cover borrower liabilities (though a guarantee from a sophisticated sponsor covering transfer taxes is rare). A foreclosing debtholder desiring to sell the property should pay close attention to the prescribed local foreclosure sale process to avoid any potential post-sale liability to the former borrower (which can also raise concerns about the conduct of a prior lender).
Guarantees: In addition to relying on the property itself for repayment—as with a foreclosure—debt investors should understand what other types of credit support might be available to them. Many real estate loans include repayment, carry and completion guarantees (for construction loans or development projects) which could provide avenues to recovery. So-called “bad boy” guarantees typically function as deterrents for bad acts from the borrower without which the borrower could easily file bankruptcy or impede the exercise of lender remedies. Guarantors and their financial resources should be evaluated as part of the sponsor diligence process both for investors originating new loans and those acquiring existing debt.
Other Concerns
Regardless of where they enter the capital stack, debt investors should be cognizant of any applicable regulatory requirements for lenders. For example, certain states may require a lender to be licensed in their jurisdiction, or there could be Committee on Foreign Investment in the United States (CFIUS) restrictions for non-U.S. entities investing in certain types of U.S. real estate. There may also be tax issues depending on a debt investor’s capital sources or the other parties involved in the transaction.
Debtholders should always be mindful of potential lender liability issues to the extent they may be found to have harmed the property owner’s business and/or pushed it into bankruptcy. Lender liability is especially a risk if a debt investor has a participating mortgage or other equity component, which gives it some control over operations at the property and marks a key point of distinction between debt and equity investments.
Conclusion
This article has provided an overview of key considerations and differences for traditional equity investors considering investing in real estate debt, particularly distressed debt. A myriad of other issues could arise during the course of such investments, though, from reputational risks to environmental problems. Equity investors looking to enter the debt market should be strategic in looking for opportunities to do so and enlist the support of experienced advisors to help assess pitfalls and risks that may be hidden in their business plans.
The Private Equity Report Fall 2023, Vol 23, No 3