US creditors are wary of calling in commercial real estate loans because many do not want to be saddled with undesirable assets.
When the wolves came to Ziel Feldman's door, it was a triplex penthouse on the Upper East Side of Manhattan. Feldman, chief executive of HFZ Capital, one of the city's swankiest developers, was forced in December to put his own house up for sale — asking price: US$39 million ($53 million) — after creditors sued to foreclose on several of his faltering condominium projects.
To many in the real estate world, that event looked like a harbinger of doom. By then, lenders had granted months of forbearance after the Covid-19 pandemic paralysed New York City last March. The expectation in the industry was that many would call time on delinquent borrowers in the new year, touching off a great reckoning after a decade-long rally that has bequeathed plenty of questionable projects.
"The non-performing loans are coming!" Laurie Golub of Square Mile Capital warned in November at the annual conference hosted by New York University's Schack Institute of Real Estate, claiming that lenders had been "coddling" borrowers. "Don't expect creditors to extend forbearance much longer," another panellist agreed. One analyst likened the situation to a storm cloud on the horizon poised to burst at the first crack of lightning.
But a strange thing has happened since then: creditors have broadly held fast, creating a period of leniency that is approaching a full year for some borrowers, and has persisted longer than any seasoned professionals can recall.
"Maybe a single asset or borrower has gotten relief like this. But never on this scale," says Norman Radow, who made his name in distressed real estate by cleaning up Lehman Brothers' real estate portfolio after the 2008 crisis. His company, Radco, now owns thousands of apartment units across the country.
The can is being kicked down the proverbial road on an unprecedented scale, according to Radow. "What happens when it stops rolling?" he asks. "That is the answer we all want to know."
Real Capital Analytics, a research firm, classified US$146 billion in commercial real estate assets as being in distress — or soon to be — by the fourth quarter last year. Two-thirds of that was accounted for by retail and hotels. The distressed debt pile bulged in the second quarter last year, but has since accumulated more gradually.
Distressed sales have so far been few. The far more common approach has been for creditors to show further patience for assets they believe will have value on the other side of the pandemic. Often that means pushing for recapitalisations or refinancings in order to buy time.
Deal by deal
In late December, Ashford Hospitality Trust, which owns a portfolio of upscale hotels, warned investors it was teetering on the edge of bankruptcy. It ended up signing forbearance agreements on US$1 billion in loans, and secured a loan of up to US$350 million from Oaktree Capital that management believes will see it through to recovery.
"For now, as a lender, it's really on a deal-by-deal basis," says Billy Meyer, of Columbia Pacific Advisors, which recently launched the Columbia Recovery Fund to provide bridge financing for Covid-stricken borrowers. "If there's a good probability that the property recovers then lenders will try to work with borrowers."
Meyer and other real estate investors are now debating whether the great reckoning that many foresaw is still just another quarter away — or perhaps may not come at all. If so, then a property crisis that began unlike any other — precipitated by a once-in-a-century pandemic — may also have a unique aftermath.
Jordan Roeschlaub, vice-chair of capital markets at Newmark Knight Frank, a commercial real estate broker, is among those who have reassessed their view of the market.
"Everyone sort of anticipated towards the middle end of last year that in the beginning of Q1 there's going to be this floodgate of credit positions sold in the secondary marketplace, and there's going to be a lot of distress. Quite frankly, it hasn't come," he says. "I don't know if it will."
Part of the reason, Roeschlaub and others agree, is the enormous amount of capital chasing real estate investments at a time when bond yields are so low. By some estimates, there is more than US$300 billion in "dry powder" waiting to be deployed. Those funds are helping to create a floor under property values.
The speedy rollout of effective vaccines has created a sense that there is, at last, light at the end of the tunnel if borrowers can endure just a bit longer until health restrictions are lifted and full economic activity resumes.
In the meantime, the Federal Reserve's extraordinarily loose monetary policy has made it easier for many to do so, according to Fred Harmeyer, who manages the debt portfolio at Rubenstein Partners, a real estate investment firm. At the outset of the crisis, in late March, mortgage lenders sponsored by TPG and Angelo Gordon wobbled as their portfolios sank in value, forcing them to raise collateral. It appeared to be the crack of lightning.
But the market has stabilised since then. "I think people expected when Covid first occurred — just as they expected during the great financial crisis — to suddenly see a disgorgement of assets, and there would be great distressed buying opportunities. With the Fed stepping in, you haven't seen that level of instant distress," says Harmeyer. Still, there have been some notable cases, including regional shopping malls taken over by lenders, and Harmeyer has seen assets quietly put on the market in recent months. "I think it's likely we'll see more of that," he predicts.
One reason that lenders are extending "forbearance upon their forbearance," as one put it, is that they have no choice. Governments have placed restrictions on evictions and foreclosures during the pandemic. Many courts are either closed or backed up. It has also helped that banks have entered the crisis with far less leverage than they did in 2008.
Pierre Debbas, a real estate lawyer in New York at Romer Debbas, says Manhattan landlords, by and large, were also in better financial shape, allowing many to muddle by with reduced cash flows from tenants. "I would project that banks will lean towards restructuring debt simultaneously with landlords restructuring a significant amount of their leases and that the city will not experience a major spike in foreclosure actions," he adds.
Beds, sheds and meds
A less salutary reason for lenders to extend leniency is that they do not want to be saddled with undesirable assets — particularly hotels and brick-and-mortar retail. Both faced questionable prospects even before the crisis — whether because of oversupply or the rise of ecommerce. Their problems have only deepened as Covid-19 has accelerated changes in consumer behaviour. It is difficult, for example, to say when — if ever — business travel will return to pre-pandemic levels, and therefore, what the value is of a business hotel.
Developers trying to sell a glut of luxury condominiums in New York are also likely to suffer. One investor predicts "a musical chairs of capital partners and lenders slowly wiping each other out".
On the flipside, real estate categories such as industrial warehouses, which are vital nodes for ecommerce businesses, have thrived in the pandemic. So have life sciences developments, which house biotechnology companies and pharmaceutical laboratories. Housing, outside New York City and San Francisco, has also held up.
"The bottom line is, you've got buckets of in-favour, and buckets of out-of-favour," says Doug Harmon, chair of capital markets at Cushman & Wakefield. In the real estate services firm's new strategy report, it is recommending "beds, sheds and meds" to investors.
Somewhere in between those buckets are office buildings, the biggest chunk of the property market and one whose future has become a matter of intense debate. Even with the rise of flexible working, some see them retaining their value after the pandemic eases — albeit with capital investments to enhance their public health features and make them cherished meeting places for collaborating workers.
Others, such as Michael Silver, chairman of Vestian, which advises tenants on commercial real estate, believe that is fanciful. Silver is convinced that working from home is a revolution in its early stages, and that office properties will eventually see their values shredded by 30 per cent or more.
"If you listened to developers in March, they were pounding their chest and saying, 'This is an aberration. Everything is going to come back to the way it was.' It's not," Silver says.
Patience wearing thin
One lender who has concluded that the time for patience has passed is Richard Mack, chairman of Mack Real Estate Group and a third-generation New York developer. "Unless there are extraordinary circumstances, we just can't give people any more forbearance at this moment," he says.
In December, his firm initiated foreclosure proceedings against the developers of a condominium project in Brooklyn who had fallen behind on payments. The matter is now being fought in court.
The arrival of a Covid-19 vaccine has not persuaded Mack to shift his stance. "Just to say: 'we have a vaccine, everything returns to normal.' No, I don't think that happens," he explains. "Even with a vaccine, business travel is not coming back right away. Even with a vaccine, people are going to work from home more, which is going to impact office. Even with a vaccine, people are going to continue to expand their online shopping. All of this was true pre-Covid and it's accelerated post-Covid."
Two reference points for real estate veterans trying to make sense of the current crisis and how its aftermath might play out are the crashes the industry suffered in the early 1990s and then following the 2008 financial crisis.
In the first case, the wider economy was generally healthy but real estate was troubled, thanks to tax laws that encouraged too much building. The result was tremendous amounts of distressed properties that allowed savvy investors like Sam Zell, the self-proclaimed "grave dancer", to amass great fortunes.
In 2008, real estate was dragged down by a financial crisis. Commercial properties were again battered. But quality ones ended up bouncing back sooner than many investors expected.
Mack sees features of both crises in the current one: for troubled assets — particularly retail and hotels — he predicts a more painful and prolonged early 1990s-style experience while others could rebound quickly, more akin to 2008. Rising sunbelt cities are in favour; New York City and San Francisco are out.
'People capitulate'
One thing that has changed since 2008, and will probably influence how the next phase of this crisis plays out, is the composition of lenders. Like Mack, many developers have launched debt funds to take over the riskier forms of real estate lending that banks retreated from after the 2008 crisis. Such funds, which tend to seek higher yields to compensate their investors, only accounted for 7 per cent of the real estate lending market in 2015, according to RCA. By 2019, their share had grown to 22 per cent.
"A lot of the banks ended up just kind of focusing on the most institutional clients and really holding back on leverage, de-risking their portfolios. And I think that's what really opened the door for a lot of these private lenders to step in," says Scott Modelski, a managing director at Blackbear Capital Partners, a commercial real estate brokerage.
How those lenders will behave in their first big crisis is uncertain. One view is that they will be more nimble than banks because they are less encumbered by regulation, and therefore better able to negotiate solutions with borrowers short of foreclosure.
But some of these firms — although they do not advertise it — are in the business of "loan to own", and will look to foreclose. (Among the lenders to foreclose on Feldman and HFZ was the lending arm of another developer, CIM Group.) Still others may themselves be reeling as the riskier loans they made late in the cycle are now souring.
"Some of the opportunity funds that went up the scale of risk, they are going to get hurt. No question about it," Gary Barnett, founder of Extell Development, which pioneered the supertall luxury condominiums that overlook Central Park — and is now struggling to sell them, predicted late last year. "Most of the banks will not get hurt. The banks did not, generally, go too far up. They'll get their money back, one way or another."
In February, Barnett sold a stake in two Manhattan apartment buildings for more than US$300 million, helping to tide him over while his new US$3 billion luxury tower languishes. The buyer was Scott Rechler, the head of RXR Realty, and another New York property scion. It was the type of opportunity that Rechler believes will increasingly be on offer for developers with access to capital as others come under strain.
He still anticipates properties and loans falling into outright distress — but it will take time. That is because many assets will have to be repurposed — say, converting a middling office building to apartments, or a shopping mall to an industrial warehouse. For those deals to be viable, prices will have to fall further. "You need to wait to get to the point that the lender takes over and that the lender is written off, and then it clears at a price that makes sense," he says. "Eventually people capitulate."
How long that might take is unclear. When the real estate market began to collapse in 1990 it was not until 1993 or 1994 that Rechler's previous firm, Reckson, began to see opportunities to buy. Rechler sold Reckson in January 2007, then raised US$9 billion in private equity funding and did not return to the market until August 2009.
"We're probably right now still in 2008," he says, by way of comparison. Then again, even longtime real estate investors are hesitant to draw parallels with a crisis like no other.
"With Covid, because no one's ever lived through a downturn that was self-inflicted by turning off the economy, no one really knows when you turn on the economy how fast it's going to come back," Rechler says. "So people are holding out hope."
Written by: Joshua Chaffin
© Financial Times