Publications

- December 1, 2018: Vol. 5, Number 11

When the levee breaks: Is your debt fund sponsor prepared to take back the keys?

by Jay Hart

Investment dollars are flowing into privately managed debt funds at historic levels, seeking both yield and stability at a time when many believe we are in the later stages of a very long upward trend in the commercial real estate cycle.

Numerous factors are piquing interest in the commercial real estate debt sector: the enormous $4.1 trillion commercial and multifamily mortgage marketplace; the history of lower loss and higher recovery rates than comparable corporate bonds; the opportunity for portfolio diversification (e.g., property type, geography) coupled with short duration instruments that facilitate risk rebalancing; and the presence of subordinated capital as a margin of safety to late-cycle value disruption and volatility. In addition, research shows a high level of negative covariance between commercial real estate debt and most other financial assets, thereby allowing a portfolio manager to construct a more “efficient frontier” if real estate mortgages are added to the mix.

As a result, it’s not surprising 94 debt funds currently are active globally, with $33.1 billion of aggregate capital raised as of January 2018, compared with the 61 debt funds with $24.8 billion of capital in January 2015.

Unlike high-yield distressed-debt investments, the commercial real estate debt funds described above are organized to construct a balanced portfolio of “performing” loans that generate a steady and predictable core-like quarterly dividend for their investors. Nonetheless, even the best portfolios with the most disciplined underwriting will experience both technical (e.g., covenant) and monetary defaults within the loan book. When these circumstances present themselves, it is paramount the debt fund sponsor has a tested team of workout specialists to optimize resolution. Without such a team, the likelihood increases that loan recovery rates will be lower along with corresponding fund investment returns. So, where are investors likely to find “performing” debt-fund sponsors with a significant workout or turnaround pedigree?

GUIDED BY HISTORY

To begin such an evaluation, the background of any debt fund manager and its team members must be placed against the historical context of past real estate cycles and disruptions. World War I Supreme Allied Commander Ferdinand Foch once said it takes 15,000 casualties to train a major general. In the commercial real estate loan-workout equivalent, the past 35 years have witnessed only two severe downward cycles in the United States and arguably during only one of these was it possible to gain the level of experience that Foch describes.

The global financial crisis of 2007–2010 was a period of extreme stress in the world financial markets and banking systems. Although prices across commercial real estate declined almost 40 percent, the sector never quite crashed like the housing market. Yes, there were foreclosures and defaults — bank loan delinquency rates exceeded 5.0 percent, peaking at 8.8 percent in 2010 — but not to the scale of the housing market, which was the primary focus and concern at the time. Rather than precipitating a wave of aggressive commercial real estate loan workouts and litigation, banks frequently renegotiated and extended the terms of the loans, a process commonly referred to as “kicking the can down the road.” This less-aggressive strategy was largely adopted in the interest of self-preservation, as most institutions did not have the balance-sheet strength to fund costly litigation and absorb mark-to-market adjustments that would have been unavoidable in the workout process. Accordingly, little workout-related trench warfare occurred and, therefore, few new workout specialists were minted.

On the other hand, a far worse cycle (from a workout perspective) started in the mid-1980s, when commercial real estate loan-delinquency rates stayed above 10 percent for several years — peaking at more than 12 percent — and remained greater than 5 percent until the mid-1990s. This dislocation caused the failure of virtually every savings and loan association in the Southwest, as well as many of the bank holding companies in the Northeast. During this period, unlike the era of the global financial crisis, boards of directors and regulators aggressively mandated the full workout of subperforming and nonperforming commercial real estate loans. This is perhaps best remembered by the creation of the Resolution Trust Corp., a U.S. government–owned entity charged with liquidating real estate–related assets inherited from insolvent savings and loan associations. The RTC, along with other financial institutions, bundled billions of dollars of nonperforming loans for sale, providing the catalyst for the creation of a class of deeply experienced workout professionals, folks who are today in their early 50s.

As the distressed-debt markets of this period began to recover, many of these workout professionals became founders and senior team members of the early 1990s commercial real estate private-equity platforms, several of which continue to successfully manage high-yield value-add and opportunistic debt and equity investment strategies to this day. It is, therefore, the debt fund sponsors and team members with this type of long, established track record; credit culture; and background that may offer the most relevant and valuable loan-workout skills and perspectives necessary for maximizing recovery rates and minimizing losses.

TECHNICAL SKILLS

If your existing or prospective debt-fund sponsor is not as battle-tested as those noted above, several technical areas are worthy of further evaluation and discussion with them. In particular, assess their views and experience with the various machinations of (a) the “legal workout” process, (b) the “bricks-and-mortar workout” process and (c) their fund’s organizational structure.

A key consideration in any distressed-debt resolution is accurately identifying the cause of distress and building estimated cash-recovery models that correctly account for collection expenses and related timelines. Once this is completed, a prudent “legal workout” can be implemented. There are numerous legal strategies and tactics that can come into play, including debt-for-equity swaps, loan restructurings and modifications, as well as deed-in-lieu, judicial and non-judicial foreclosures.

The foreclosure process is largely dependent upon the law of the state in which the collateral is domiciled. These laws have a direct impact on the estimated cash recoveries. When states mandate a judicial foreclosure process, it often involves longer timelines and greater costs, given the protection and defense rights typically afforded borrowers, as well as the bottlenecks that often occur at the courts. Non-judicial foreclosure states, on the other hand, can have a more streamlined and cost-efficient process.

The existence of cross collateral or other liabilities and creditors can further delay and complicate the legal resolution of troubled loans. Some areas of complexity include the existence of mezzanine debt, secured and unsecured trade claims, mechanic’s liens, delinquent property taxes, and the like. Of course, if voluntary or involuntary bankruptcy is added to the mix, there are endless considerations to be made that are far too voluminous to outline here. Nonetheless, does your debt fund sponsor have internal knowledge, experience and viewpoints on these matters?

If the debt fund sponsor is successful in navigating the complexities of the “legal workout” and ultimately achieves ownership of the collateral, do they have the skill set and core competency to operate the property and maximize residual value (i.e., the “bricks-and-mortar workout”)? To optimize success, a firm should have meaningful, direct commercial real estate ownership experience, without the assistance of joint-venture operating partners, and should demonstrate this experience across multiple property types and geographies. Hospitality, retail, office, industrial, apartment and senior housing properties each have unique capital requirements, expense and profit margins, branding and marketing strategies, and operating nuances. The debt fund sponsor’s prior ownership experience should, therefore, match the diversity of the collateral in the loan portfolio.

In addition, given the circumstances here typically involve some level of underperformance at the collateral level, one may further argue a successful track record of owning and operating value-add, opportunistic and other complex turnaround properties is of greater significance and benefit than the ownership of less-volatile core, stabilized properties.

Finally, it’s not only the workout personnel who help optimize distressed-loan resolutions, but also having the appropriate fund structure to do so. When problem loans arise late in a closed-end fund’s life, as they so often do, lacking sufficient remaining term can severely compromise a fund’s ability to resolve litigation or implement collateral-level improvements. In these circumstances, loan sales and property sales at a discount to the unpaid obligor balance are frequently used because they generate liquidity within the timeframe of the fund’s life. With this common strategy, however, capital basis and value are often forfeited for the benefit of the distressed-loan buyer. In contrast, an open-end fund has enough runway available for the fund’s sponsor to enlist more-comprehensive strategies to maximize recoveries and, therefore, preserve investors’ capital. Open-end funds are ideally suited for a commercial real estate debt product, given the loan book’s scheduled maturities and cash availability for redemptions.

SCIENCE AND ART

In conclusion, successful loan workout is as much an art as it is a science. Heavy-handed or misdirected legal strategies can have a destructive effect on collateral value, real estate–owned/foreclosed assets without proper operational oversight can suffer waste and further decline, and laissez-faire distressed loan sales as a quick portfolio fix can leave significant loss-recovery dollars on the table. The legal and operational complexities of loan workouts are numerous, and nothing substitutes for proven experience. Is your debt fund sponsor prepared to take back the keys?

Jay Hart is managing partner and COO of CrossHarbor Capital Partners.

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