Many struggling property owners were hopeful that interest rates would finally come down earlier this year. But that no longer appears to be the case. The March Consumer Price Index report showed that inflation rose 3.5% year over year, leading economists to postpone predicting when interest rates will come down. There will likely not be as many rate cuts this year as expected. Some, like JPMorgan Chase CEO Jamie Dimon, believe interest rates may rise again in the future.
If interest rates remain high for a long period of time, it will undoubtedly become even more painful for property owners. Industry players waiting for interest rate reductions may soon consider selling assets, turning the keys back to lenders, or abandoning projects altogether. This period of high interest rates began with the first interest rate hike in March 2022. Since then, there have been 10 more rate hikes. After years of high and low interest rates, the negative effects have lasted longer than the industry would like, and people are seeking relief to weather the negative effects.
Complicating the picture is the amount of commercial real estate debt maturing this year. Newmark estimates that $929 billion in commercial real estate loans will come due in 2024. While the market downturn is unwelcome news for most investors, it presents an opportunity for some to get on the offensive. Peebles Corporation is one of them. The company recently launched a new Miami-based private credit arm, Willowbrook Partners, to provide relief capital to distressed property owners. Willowbrook Partners offers bespoke credit solutions for distressed commercial real estate projects, ranging from $5 million to $50 million. Lending targets multifamily, for-sale residential, retail, industrial and self-storage assets in major cities in states that cross the Interstate 95 corridor.
The market is seeing growing interest from investors like Willowbrook Partners to take advantage of rescue capital deals. Investment data firm Prequin estimates that global real estate fund cash balances managed by private equity firms will rise to a record $544 billion as of the second quarter of 2023 from $457 billion at the end of 2022. Other restructuring scenarios, such as bankruptcies and foreclosures, will still be around as real estate problems spread. But the rise in rescue capital deals is clear and reminiscent of a trend made famous by the 1980s stagflation.
Capital is the savior
Rescue capital is a term used to describe lending to commercial property owners facing financial difficulties. Most rescue capital is tailored to situations where traditional funding channels have been cut off due to heightened risk. It serves as a strategic solution to prevent project failure and foreclosure. Rescue capital injections can come through debt or equity financing from specialized lenders, equity sources, private lenders, or financial institutions that offer this type of financing. Rescue capital is often a better alternative than handing the keys back to the lender.
These capital injections are a more cost-effective way to recapitalize assets than introducing new capital through foreclosure or bankruptcy. With the right partner, rescue capital transactions can increase value and provide the financial flexibility needed to weather tough market conditions. As interest rates remain high, the need for this source of capital increases, as more real estate owners seek financing that can provide quick short-term solutions.
Injections of rescue funds to struggling property owners can help, but they come with strings attached. They typically require a significant restructuring of existing capital structures and may impose new conditions on all investors involved and new entrants, potentially diluting voting power and economic interests. In extreme circumstances, current investors may be relegated to the back of the queue and viewed as “silver lining” stakeholders.
For property owners, these deals require skillful negotiation to succeed, and not all distressed property owners meet the criteria for rescue funds. “This is for marginal properties, not for true distressed transactions,” says Teri Adler, managing partner at Adler & Stuckenfield, a New York City-based real estate law firm. “For true distressed transactions, there are other remedies.”
Many institutions have opened distressed asset funds, but the amount of capital injected will not materially impact the widespread distress in the real estate market. While capital may rescue a significant number of properties, financial strategies do not have superpowers. Of course, financiers do not undertake rescues for altruistic reasons, but because they provide an opportunity to capture market dislocations. As with any form of financing, these transactions carry inherent risks. For the lender, there is the possibility of borrower default and property values declining. Potential benefits for the lender include superior equity returns compared to traditional lending and sharing of profits in joint ventures.
“Falling Knife” Office
One opportunistic investor is New York-based Lightstone Group, which recently launched a $500 million rescue capital platform. Lightstone is seeking investments of $20 million to $100 million in multifamily, hospitality and industrial assets across the U.S. Notably, the firm is not considering office assets. Lightstone plans to allocate capital over the next two years, targeting the top 50 metropolitan areas in the country and helping to reopen stalled developments or properties in need of additional capital expenditures.
Lightstone launched a lending arm called Lightstone Capital in 2018, which has allowed it to step into deals where traditional lenders have shied away from the pandemic. “As a private company, Lightstone can move quickly and be extremely flexible with structuring and investment terms,” said Mitchell Hochberg, president of Lightstone Group. The company's capital platform has generated approximately $1.3 billion since inception, with more than $400 million in the pipeline. Lightstone develops, manages and invests in assets worth $9 billion across 26 states, with New York City, Los Angeles and Miami accounting for the largest shares of its portfolio.
While the firm's portfolio is biased toward those three cities, Hochberg said it spreads its investments across the country to maximize geographic diversity and avoid concentration risk. “For our multifamily platform, we have purposefully avoided low cap rate transactions in the Sunbelt and instead built a large portfolio across the Midwest, which has proven to be a resilient investment theme,” Hochberg said. In industrial, Lightstone has a significant presence in the Southeast and Midwest, targeting fast-growing infill areas within 25 miles of central business districts.
Lightstone will consider opportunities across all asset classes for its new rescue capital platform but is particularly focused on its core investment expertise in multifamily, hospitality and industrial. “There are clearly many distressed office opportunities, but Lightstone has thus far avoided, and will continue to avoid, the valuation-destroying 'falling knives' facing this asset class,” Hochberg said.
According to a report by Green Street Advisors, office values have fallen about 35% since March 2020, but have not yet bottomed out. The last time office values fell this far was during the financial crisis, but they recovered about 80% of their pre-crisis peak in a shorter time. Fitch expects U.S. CMBS office delinquency rates to more than double from 3.6% as of February 2024 to 9.9% next year. The shift to remote work and tougher refinancing terms mean the office sector is expected to take a long time to recover, which Fitch said could lead to permanent property valuation writedowns. This is the “falling knife” Lightstone’s Hochberg referred to, and one of the reasons some distressed funds are not targeting office assets.
Not all investment firms are shying away from the office downturn. Artemis Real Estate Partners recently closed Artemis Fund IV, its largest real estate fund to date, with $2.2 billion in investments. Artemis diversifies its investments across a variety of markets and asset classes, but has shown interest in distressed office properties and assets in struggling markets like New York and San Francisco.
Artemis has so far focused on popular asset classes like industrial and multifamily in fast-growing markets in the Sun Belt. Office properties may be hot right now because they've fallen so much in value, but the firm believes they need to continue to adjust prices. “This is a good time to have ample capital,” said Rich Banjo, co-president of Artemis Real Estate Partners.
While office property values may not have bottomed yet, price discounts could present a once-in-a-generation buying opportunity to capture “alpha” returns over the next five years. Distressed property deal activity is still in its early stages. Distressed office sales accounted for just 2.6% of total transactions over the past 12 months, primarily because the price discovery period is still in its early stages. Distressed property deal activity unfolded over a seven-year period following the Great Financial Crisis, so a similar pattern is likely to continue in this distressed property cycle.
The commercial real estate market turmoil has been a headache for some and an upside for others. As the problems mount, opportunistic investors are stepping in. Every rescue capital deal is different, as are the investment thesis of each institution for these funds. Many troubled properties will require significant capital to be rescued. Some commercial real estate owners with debt maturing in the next few years will be able to negotiate new terms with their lenders. For those who can’t, there will be no shortage of rescue capital to give them the boost they need. Along the way, some opportunistic investors are making good bets, or even contrarian bets, that could be smart moves. The market turmoil is a storm building for some in the industry, but an opportunity for many others.