Bridging the gap

A growing number of equity investors are looking at short-term credit opportunities to fill a widespread funding gap between what sponsors are seeking and borrowers are willing to lend on properties.

There are a number of factors that created and are exacerbating this problem, including rising interest rates and a lack of certainty around valuations, says Bruce Stachenfeld, chair of the New York-based real estate law firm Duval & Stachenfeld.

Stachenfeld believes there will be substantial opportunities to recapitalize existing projects and fill the gap on new ones – likely via preferred equity or mezzanine debt. “There is almost a feeding frenzy for parties that are going to need this capital and parties which want to provide this capital,” he says.

Stachenfeld gives an example of a sponsor that owned property valued at $100 million with a $70 million mortgage coming up for a refinancing.

“When interest rates go up, the sponsor can no longer borrow at 2.9 percent – pricing is more like 5 percent or more and when the maturity hits, the sponsor also finds out the property is no longer worth $100 million – it’s now worth more like $80 million,” Stachenfeld says.

“The sponsor then finds out the lender will no longer provide a $70 million mortgage on that property, instead offering around $60 million and the question becomes where that $10 million is coming from. That is the funding gap we are seeing.”

Stepping in

Boston-based Taurus Investment Holdings is one of the managers that believes there will be strong opportunities to make structured credit investments over the next 12-24 months as higher interest rates, rising inflation and the broader economic and geopolitical turmoil continue to disrupt the commercial real estate markets.

A key problem for many sponsors looking to exit or refinance debt on a property is that interest rates are significantly higher than anticipated and are expected to move even higher as the Federal Reserve and other central banks target inflation, says Peter Merrigan, chief executive officer and managing partner of Taurus.

“A year ago, these sponsors would have been able to get bank loans, but today it’s a different story”

Michael Corridan
Kawa Capital Management

Additionally, loan maturities and interest hedge expirations triggering covenant breaches will force the mark-to-market action in the next 12-18 months.
“Interest rates likely will stay higher for a while, which means there will be some distress relative to financing – exits just won’t pencil out the way people were expecting,” Merrigan says.

“This will trigger more distress and more structure credit opportunities for refinancings and other types of deleveraging.” Merrigan adds that the commercial real estate market is operating without a playbook, explaining there are an unusually high number of unknowns in the market right now. “We will be watching what the Federal Reserve does and watching how inflation responds as we try to figure out how this will all play out,” he says.

The bigger picture  

Taurus is not the only firm to have identified this opportunity. New York-based apartment manager Canvas Property Group expects to see these opportunities start to arise as soon as the next three to six months, with the window going out as long as two or three years.

Rob Morgenstern, founder and managing principal of Canvas, says: “We are in a unique moment for deals that were structured over the past four to six years and are finding that many sponsors are seeing that a key component of their business plans changed, be it because of changes in rent laws or the pandemic. Whatever the change, the debt markets are not as liquid as they were and there may be situations where sponsors need some cash to help support their deals.”

These opportunities are not traditional distressed situations. Rather, market participants describe them more as what happens when a good operator with a reasonable business plan has been affected by changing laws, the pandemic or other factors beyond their control.

“We don’t think this will be a blood in the water event, but we think that through our relationships with lenders, sponsors and capital markets brokers, we can create a meaningful difference,” Morgenstern says. “We could buy a building, we could form a joint venture, or we could help fund an equity gap between what a sponsor wants and what the lender is willing to lend, and we believe this could be a meaningful focus over the next year or two.”

Miami-based Kawa Capital Management also sees opportunities on the debt side of the equation. It is planning to deploy between $75 million and $150 million on high-quality lending opportunities in major markets as traditional lenders take a step back.
“We are looking at first lien positions within gateway or top 20 MSAs,” says Michael Corridan, managing director at Kawa. “A year ago, these sponsors would have been able to get bank loans, but today it’s a different story. We see room to get equity-like returns at do-no-harm leverage levels.”

Waiting for the storm

While there has yet to be substantial distress, the warning signs are flashing. While October data from MSCI found less than 1 percent of all transactions were driven by distress, market participants say this number is quietly growing.

Paul Lloyd, co-founder and CEO of London-based advisory Mount Street, says the firm is starting to see some of these opportunities crop up with its clients. Through its servicing business, the firm has insight into some of the early warning signs for when a deal might be hitting speedbumps. The industry has come a long way since the Global Financial Crisis, he adds.

“During the GFC, lenders stuck their heads in the sand and hoped their problems would go away,” says Lloyd. “But we are seeing a few more lenders being proactive and, as a party that knows the sponsors, lenders and underlying assets, we find we are better placed to deal with the problems. The first step is always having a consensual conversation so that the sponsor feels like they won’t have the rug pulled out from beneath them.”

The expected increase in this kind of activity has not yet been widely reported, with market participants noting buyers and sellers need to be on the same page about valuations before transaction volume starts to pick up again. There is a similar disconnect between sponsors and lenders.

“There are not enough data points, and you don’t know how high the base rates will go. Until the yield curve stabilizes, it will be hard to price assets,” Merrigan says. “There are lenders who are starting to lend again, and we have secured several loans in the past few weeks. Spreads are about the same or a little wider, but base rates are much higher and that is affecting the all-in cost of capital.”

Finding a party to plug this gap is possible, but it will be costly. And it likely will be limited to the best-capitalized sponsors, Stachenfeld cautions.

“It is expensive money, depending on the circumstances, it could be 10 or even 15 percent,” he says. “This is the fulcrum of what will be happening all over – it will be in mezzanine debt or preferred equity, which is easier for the lender allowing the capital to come in to get comfortable with it. It is not exactly leverage but does the same thing.”