In the early days of the covid-19 pandemic, the conventional wisdom was that a large-scale lockdown would lead to significant distressed opportunities across the commercial real estate market.

Eighteen months later, that story has yet to play out. There have been pockets of distress in the retail, office and hotel sectors, but other parts of the market, like the industrial and multifamily sectors, have seen their fortunes boom.

“There’s really not a whole lot of distress in the system, period,” says Ian Ross, founder and principal of New York-based investment manager SomeraRoad. “Besides one-off, weird, funky deals that were already doomed, there’s not a whole lot out there that’s actually in trouble.”

Distress, as measured by classic metrics from the commercial mortgage-backed securities market, is actually trending downward. The share of CMBS loans in special servicing reached 5.1 percent in July, marking a steady decline from a pandemic-era peak of 6.2 in October 2020, according to a Fitch Ratings review of Fitch-rated US CMBS deals.

“You’re not seeing a lot of borrowers come back for debt relief 2.0,” says Adam Fox, a senior director in Fitch’s US CMBS group, adding that most borrowers that initially sought relief are successfully meeting loan obligations.

“There was an expectation there would be some opportunities to purchase distressed debt,” Fox says. “Those really haven’t come to fruition in any large way. You see very few note sales, very few [discounted payoffs].”

Data from Real Capital Analytics tells a similar story, with the analytics firm tracking outstanding distress of about $52 billion spread over 2,237 properties through the end of the second quarter. RCA estimates there is much greater potential for distress than actual distress, reporting that about 9,261 properties totaling roughly $133 billion could see some pain.

During the same period, RCA found that hotel and retail properties made up more than 80 percent of the outstanding distress in the market. And at the same time, the levels of potentially distressed assets fell in the second quarter and distressed sales made up about 1.3 percent of all sales.

“A lot of smart people have put a lot of money in a box to feed on a tsunami of distressed debt across commercial real estate… The only problem with that theory is that it hasn’t happened”

Rick Jones

That is unwelcome news to a host of opportunistic players that raised capital in the wake of the pandemic. Since the beginning of last year, investors ranging from Blackstone to Principal Global Investors and Cerberus Capital Management raised at least $16.1 billion in US dollar-denominated funds to focus on a mix of mezzanine loans, other debt and opportunistic strategies, according to data from Real Estate Capital USA affiliate PERE.

“There are opportunities out there. But the problem is a lot of lenders are well-capitalized,” says Daniel Lisser, a New York-based senior director with Calabasas-based broker Marcus & Millichap. “Banks are selectively selling loans, but very selectively. With CMBS, it’s the dregs that are out there: the regional malls and the really bad hotels.”

The relatively strong, well-capitalized banking system, along with record-low interest rates and, of course, massive amounts of federal stimulus, have all helped keep distress at bay.

“It’s like Waiting for Godot, right?” says Rick Jones, a partner at law firm Dechert. “A lot of smart people have put a lot of money in a box to feed on a tsunami of distressed debt across commercial real estate… The only problem with that theory is that it hasn’t happened.”

He notes there is an “amorphous notion” among borrowers and lenders that the government will eventually bail out the system, causing them to kick the can down the road on troubled assets.

There are also, naturally, optics to consider, too. “You won’t get invited to the best cocktail parties on the Upper East Side if you are considered someone who horribly evicted people from their houses,” Jones says. “There’s a lot of sensitivity about not being the rapacious capitalist out there right now; rapacious capitalism is not the best odeur, as we say.”

Veto the vultures

Amid all these various factors, a different kind of playbook is emerging for opportunistic investors.

The typical debt plays, ranging from loan-to-own to discounted payoffs to uniform commercial code, or UCC, foreclosures, have receded. Instead, the market has seen the rise of white knight capital, or rescue capital, with investors bridging gaps on troubled assets via equity, preferred equity and mezzanine debt financings.

“With all the liquidity out there, I think that’s shifted the structure of how these deals get resolved,” says Matt Hershey, a Denver-based partner at New York-based fund advisory firm Hodes Weill & Associates. “You don’t have as much leverage, your capital isn’t that precious, that you can really take full control over these deals.”


Outstanding distress spread over 2,237 properties through the end of the second quarter, according to RCA


Potential distress across 9,261 properties, per RCA

Instead, the capital injections are serving as “a lifeline to try and get their asset out the other end, as opposed to a full loss of control and transfer to the new investor,” he says.
One of the more prominent examples of this strategy was executed in May, when AJ Capital Partners’ Graduate Hotels portfolio secured a $225 million preferred equity investment from ACORE Capital, as reported by real estate trade publication Commercial Observer. The firm’s hotels are centered near major universities and target campus visitors, a segment hit hard by the pandemic.

The preferred equity investment helped pay down loans in exchange for maturity extensions, added liquidity to cover operating shortfalls, and helped fund ongoing development projects, Commercial Observer reported. It was structured so AJ Capital would not need to relinquish equity ownership. Executives at Nashville-based AJ Capital did not return a request for comment.

Fresh faces

ACORE’s investment came on the heels of the launch of its ACORE Hospitality Partners investment vehicle. With capital of $1 billion, the vehicle is intended for an investment strategy focused on originating and acquiring structured hotel debt investments including senior and mezz loans, B-notes and preferred equity. The firm is targeting returns in the mid-to-high teens, according to a source familiar with the strategy.

“You look at their portfolio and [see if] they came from a debt platform or did they come from a loan-to-own platform [to determine] what’s their MO on the transaction”

Laurie Grasso
Hunton Andrews Kurth 

“We call it ‘recovery capital’ because, for us, it’s not a credit problem per se. It’s a liquidity problem; there’s just no cash in the checking account,” says Warren de Haan, a Los Angeles-based managing partner and co-chief executive of ACORE, adding the firm is currently underwriting two to three more opportunities in the sector.

“There have been pools of capital that were formed to take advantage of distress. Our vehicle is positioned differently… we are very well known as a trusted lender,” de Haan says. “We’re not trying to get to their properties – like buying up a bunch of distressed properties and foreclosing on them – that’s never the intent. The intent was to help bridge the borrowers to the other side, to a better day.”

That type of positioning can help seal the deal in what has become a crowded field for providing rescue capital, says Laurie Grasso, a partner and co-chair of global real estate at Hunton Andrews Kurth. There are new players that run that gamut from funds to institutions to life insurance companies to family offices, all of which have different portfolio requirements.

Grasso says: “You look at their portfolio and [see if] they came from a debt platform or did they come from a loan-to-own platform [to determine] what’s their MO on the transaction.”
Rescue capital is also being seen across sectors, including the residually popular multifamily, where developers are looking for funding to bridge the gap while they finish leasing up units.

“We’ve definitely seen a pickup in our pipeline,” says Doug Lyons, a managing principal at Chicago-based Pearlmark, whose team structures mezzanine loans and preferred equity investments. The firm targets returns in the “low double digits” on the former and a slightly higher figure on the latter, he says. It has been particularly active in multifamily construction, where the firm will finance up to 80-85 percent of cost on development deals.

The pandemic has driven demand for funding among some urban multifamily projects, which saw their business plans derailed by construction delays, cost over-runs due to supply chain issues and weaker-than-expected leasing demand.

“There are a number of projects that have been completed and are in lease-up and there’s a strong desire to take out the maturing construction loan,” Lyons says.

The wildcard sector

As the pandemic has progressed, clear winners and losers have emerged. Sectors like industrial, self-storage, data centers, life sciences and, for the most part, multifamily have gone through the roof, while hotel and retail have led the pack in distress.

“When cycles like this happen, often everything goes down,” Hershey says. “You don’t often have this broad bifurcation in performance… That is pretty unique to this cycle.”

He adds the strength of markets like industrial and multifamily has dampened interest in the distressed trade, as investors pivoted toward a confidence play in growing markets.
On the retail side, the pandemic has exacerbated downward performance trends already in motion, particularly for low-performing, class B and C regional malls, says Melissa Che, a senior director in rating agency Fitch’s US CMBS group.

REC USA Oct21 Cover_ThemeLoans on those types of properties should have trouble refinancing in the coming year, Che adds. “Sponsorship commitment is going to be a huge part of, ultimately, whether these loans will successfully refi,” she says. “You’re likely going to have to put in some equity.”
Firms like Washington Prime, CBL and PREIT, even sponsors like Simon Properties Group and Brookfield Properties, are tiering their portfolios and handing back keys to some of their weaker assets, she notes.

Broadly speaking, Fitch sees about $18 billion in Fitch-rated US CMBS debt maturing next year, and that refinancing load appears “relatively manageable” given loans are refinancing into a much lower rate environment, Che says. Hotel and retail will continue to be the weak spots on a case-by-case basis, she adds.


Outstanding distress in the market in the market made up by hotel and retail properties, according to RCA

On the hotel side, the ongoing recovery has been strong but uneven. Gains racked up in select pockets, executives note. Coastal, drive-to leisure hotels in places like South Carolina and Maryland have seen a strong rebound. Large business-centered hotels in places like Dallas and New York that have been dependent on corporate travel and conferences are still struggling.

De Haan says business travel has even surpassed group travel as the weakest segment in the hotel industry. “What’s worrying people is we can sit here and have a Zoom and we can accomplish 95 percent of what we need to. It would be better in person. But we are accomplishing quite a lot,” he says. “So, maintenance-related business travel, we believe, is going to lag badly, particularly in big urban centers. Those properties are going to have real issues.”

Amid the rebound, de Haan sees opportunity for further investment in two key areas: funding capital expenditures for things like maintenance and improvements, and to service what he calls “capital structures in motion,” which could arise, say, when an equity partner is looking to exit or when the property’s loan matures.

Hotels drew heightened interest from distressed investors partly because of their potential for a strong rebound, Hershey of Hodes Weill says. “People felt more confident in the hospitality distressed play because hospitality just generally snaps back that much faster,” he says. “Whereas, with the retail distressed play, people really didn’t know where you could even go with some of that stuff – like, what do you do with a B mall?”

While investors are generally united in their views on the winners and losers, the office market sticks out as the wildcard sector.

“Changes in behavior are still fluid. It’s still in motion. A lot of people were going to come back to the office in September. Now that’s been pushed to the end of the year or next year,” ACORE’s de Haan says. “What impact is that really going to have on the psyche of the tenants? I don’t know, it remains to be seen how this plays through.”

Executives note how the office market has benefited from the stability of long-term leases, which has halted a stampede of tenants heading for the exits. But that dynamic has also transformed the office play into a game of wait-and-see. “Office is just so tough to tell because most tenants are honoring their leases, but when leases roll, everybody is taking less space,” says Lisser of Marcus & Millichap. “Hybrid work is here to stay, at least for the near-term.”

The shift to hybrid work has office lenders scrutinizing near-term lease maturities, as well as any potential for tenant downsizing, Pearlmark’s Lyons says.

“We’re starting to see an interest in gap financing to close the gap in some office recaps,” he says. “There’s a lot of uncertainty and so the senior lenders that are willing to lend are pretty low in advance, relative to often the maturing senior [loans]. So that’s where I believe there’s a real need for white knight capital.”

Given the changes in office fundamentals, the firm is adjusting its underwriting as well. “We would be fairly conservative and be looking for longer-term with credit leases in place, to have a comfort level and a basis that makes sense,” he says. “Our capital would be more oriented towards, call it a mark at about 80 percent of our look at valuation, and so we might provide some of the gap. But sometimes the sponsor might also need to come up with a little fresh equity, an additional commitment to the business plan over a three- to five-year period.”

Regardless of the ongoing changes, executives express faith in a continued need for office space, particularly for class A buildings, in major markets.

“I think almost all real estate professionals are naturally urbanists and believe in people coming together,” Hershey says. “There was a much more initial negative view on traditional urban office, and I think there’s been a swinging back of that pendulum.”
Of course, the future of the office market is not the only thing up for debate in the coming months.

Executives point to a host of other factors that could influence the future direction of the market. Items ranging from the course of the Delta variant to inflation and continued labor shortages are weighing on the country’s broader recovery. One of the biggest uncertainties centers around government intervention – whether in relation to federal stimulus, eviction
moratoriums or interest rates – and how and when that bubble of support may burst. An end of forbearance will bring a critical hurdle for the real estate sector to clear.

“The story might be that there may be a distressed debt cycle in front of us,” Dechert’s Jones says. “We may be the old cartoon, with the coyote chasing the roadrunner. We’ve fallen off the top of the cliff, but it’s not so bad yet because we haven’t hit the ground.”