- April 1, 2021: Vol. 8, Number 4

The distress around distressed debt funds

by Steve Bergsman

The COVID-19 pandemic has introduced dislocation within real estate markets, and lending markets have experienced some shake-ups. That has meant potential debt-investment opportunities.

“The current commercial real estate lending market is favorable and offers attractive risk-adjusted returns for investors who are well capitalized and able to respond nimbly to what we expect will be an evolving opportunity set,” says Matt Salem, partner and head of KKR’s real estate credit business.

In mid-autumn 2020, the Federal Open Market Committee warned small- and medium-size banks could face stress from defaults on loans to commercial real estate if consumers continued to avoid traveling and shopping. That was also a concern for the real estate debt–fund industry; in the aftermath of the great financial crisis, more stringent banking regulations were put in place, and since then, banks have been underwriting the most secure property loans. In short, the banks had the best pricing and the best transactions. So, if the banks were stressed, where does that leave other types of lenders?

“If the banks are suffering, the private lenders have to be suffering multiples of that,” avers Stuart Boesky, CEO and founder of Pembrook Capital Management.

The economic recovery after the most recent recession was the longest in recent history, and as any upward cycle nears an end, real estate lenders tend to do two things that often result in doom. The longer the cycle goes on, the harder it becomes to get a market-rate return, so lenders start making loans to riskier asset classes and do so with riskier terms. A lender that worked multifamily may slide over to hotels, for example, and loans that were done at 65 percent loan-to-value push up to 80 percent to 90 percent LTV. Second, to get that market-rate return, the loans are overleveraged — the lender turns to a bank, collateralized loan obligations or repurchase agreements, basically borrowing against those assets to bring down the cost of capital.

“My gut tells me more than half the private debt industry has done horribly in 2020,” Boesky observes. “Ultimately, this will all come out.”

By definition, most debt funds toward the end of the previous cycle drifted to the aggressive side of the lending spectrum, doing mezzanine, or lending on hospitality or other riskier product types. “Those debt funds are getting hit really hard,” notes Ryan Krauch, principal at Mesa West Capital.


Still, deciphering the overall health of the real estate debt–fund platform is complex due to underlying valuation peril versus a certain sanguinity about the industry in general. There has not been an inordinate amount of distress, and that has been due, in part, to a very active government response to the economic consequences of the pandemic and, since the most recent recession, most market participants are better prepared for the downturn.

“We did see the market heat up, and groups certainly were stretching for return or moving into riskier sectors; however, generally speaking, the lending market doesn’t feel nearly as aggressive as it did in 2007 to 2008,” says K.C. Kriegel, a senior vice president with PCCP. “Risk tolerance is more balanced than it was a decade ago.”

Or, perhaps, the worst is yet to come. “I don’t think the shakeout has occurred yet,” notes Sean Dobson, chairman and CEO of Amherst. “We are not convinced people have taken their marks on loans that were originated in the last two or three years.”

The reckoning will come in one of two ways. The first will be in pricing because advance rates had vaulted quite high in favorite asset classes — leverage shot high while pricing dropped low. Second, we will see a larger correction in office and hospitality, although no one knows if the changes caused by the pandemic will be large or small, permanent or temporary, fixable or unrepairable.

“Loans are maturing, and there is only so much you can do to modifications before the lender realizes the underlying borrower has been wiped out,” says Dobson. “When this correction occurs, we expect to see opportunities in originating loans secured by transitional real estate.”

This is not an outlier assumption. From the start of the pandemic, investors realized real estate would be meaningfully impacted, and early in 2020, there was a mad rush to distressed-debt instruments. Kayne Anderson Capital Advisors raised $1.3 billion to invest in distressed debt in only two weeks and had to turn away investors. In May, Business Insider reported more than $10 billion was about to flow into the real estate sector through distressed-debt investment vehicles. And for a moment in time, these investors appeared to be perspicacious — for two weeks in the spring, several holders of debt were forced to sell quickly to repair balance sheets, with the debt being off-loaded at steep discounts. Owners of a hotel in Brooklyn, for example, reportedly sold $80 million of distressed debt.

Then the market quickly righted itself.

At the start of 2021, the real estate debt market is either half full or half empty. This interlude is either the calm before the storm or lenders will be able to hang on until the market improves.

“We are seeing a pickup in transaction activity while the competition is still limited from the impact of COVID-19,” says KKR’s Salem. “Going forward, we expect the investment opportunity to increase as the execution of business plans are extended, creating the need for recapitalization and bridge lending.”

Distressed-debt funds have been disappointed. Limited partnership, or LP, investment funds are desperately looking for distressed-debt sale or investment opportunities, but for the most part have found limited selection. This is because lenders are working with borrowers, even on the hotel and retail situations where the sponsors didn’t have ample reserves to withstand the impact of pandemic closures. Lenders don’t blame sponsors for their current situations, and often are agreeing to accrue interest or advance additional money on a shared basis to help sponsors get through the pandemic.

While hotel, retail and, to some extent, office have been brutalized by the pandemic, other sectors have done well. A great many debt funds were focused solely on multifamily, for example, where business has been stable, if not improving. While there have been concerns about people moving away from trendy urban cores, such as New York City or Boston, many funds invest across the Sun Belt states or in the suburbs, which is where the population movements have been long term. In addition, agency financing is a big part of apartment financing, whereas riskier mezzanine is rarely used.

“Distressed!” exclaims Eric Draeger, CIO and head of investment management for Berkshire Residential Investments in Boston. “There has been a lot of talk about distressed, but in multifamily there hasn’t been a lot of opportunity in that part of the market. This asset class holds up a little better. It doesn’t exhibit major market swings because it is not dependent on just one big tenant, as in some asset classes.”


Generally, for real estate debt–fund investors, the lure has always been income and stability of the investment. With the market entering a corrective environment, however, suddenly there is another investment stream — for upside growth — and this is where distressed strategies come into play. Kriegel calls this the “barbelling” of risk appetite. For many, performing debt feels like a good segment of the market to park capital and generate current income. For those looking for more-opportunistic returns, distressed-debt and value-add opportunities are in demand, as well.

“There are two camps,” notes Krauch. “One says, ‘Let’s go opportunistic because there is going to be a ton of distressed,’ while another camp says, ‘I want to put my money to work, but I don’t know how this will play out. I’ll be more conservative.’ Institutional investors just trying to meet actuarial yields would much prefer the cash flow certainty of real estate credit.”

This has led to market aberrations. Pembrook plays in the multifamily playground, which, even though it is quite stable, has also seen a lot of capital raised for investment in distressed assets. This has pulled monies from the “flow” business, or run-of-the-mill bridge lending. With the commercial REIT industry down almost 20 percent in 2020, a lot of damaged balance sheets were left behind for real estate funds. Pembrook, which historically averaged about $400 million in business on a weekly basis, was doing closer to $1 billion at the start of 2021. “We are generally a lender for acquisitions and rehab,” says Boesky. “Those transactions are down 50 percent nationally, but our pipeline has doubled, so what is going on?”

It can be only one thing, he surmised. Any capital raising has been for distressed, and not a lot of capital has been raised for multifamily “flow’’ business. The LPs still raising money are getting what business there is.

Today, LP investors are underwriting the future value of an asset solely based on income and cap rates returning to pre-pandemic levels. “In most areas, income is not expected to exceed pre-pandemic levels after the pandemic ends, and cap rates can’t go any lower than they are now, or were pre-pandemic,” explains Steve Bram, principal and co-founder at George Smith Partners. “So, the only added value is buying today at a discount to pre-pandemic pricing, and waiting for the cash flow and values to go back to pre-pandemic values.”

Bram adds, “Everyone has a short memory when trying to put out cash,” and he predicts most of the investing will be in LP or GP equity for deals that need help.

If the temperament and aim of investing in real estate debt funds is changing, then that messes with the strategies of the big institutional investors, which like things neatly and cleanly branded; real estate is one thing and fixed income another. Going back a short two years, real estate debt–fund investing was mostly low risk and had the same characteristics as other types of fixed-income strategies; hence, it was parked in the credit bucket. With the rise of distressed funds, the risk profile increased, requiring more fundamental real estate skills to analyze investments, suggesting these should be put in the real estate bucket. As Draeger comments, “The higher the risk, the more it becomes real estate.”

Think of it this way: If one is doing investment-grade debt, a standard investment in, perhaps, first mortgages on apartments, that is fixed income, but if the investors are now relying on future appreciation and a change in real estate quality, the investment carries a higher risk-return, so it becomes a real estate play.

Real estate debt–fund investing rests on a slalom run, which is why some institutional investors are creating an alternative or strategic credit bucket, which allows them to ski on all types of terrain.

Says Dobson, “You might start out in credit, but you could end up somewhere else.”

It remains to be seen how the debt investment market will evolve as we move into a post-pandemic environment.


Steve Bergsman is a freelance writer based in Mesa, Ariz.

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