Distressed debt’s appeal surges amid market uncertainty

Fresh from raising its first real estate fund, Bain Capital formed a half-billion-dollar venture to acquire distressed real estate debt last month. Joining forces with a local New York lender, the private equity firm sees opportunity in the loan-to-own space.

The Boston-based group is allocating capital to the partnership from its credit platform’s distressed and special situations strategy. But Bain is far from the only firm interested in non-performing loans, with some managers finding fundraising success in the strategy.

Through the first two quarters of 2019, real estate funds that include distressed debt as part of their mandate closed on $18.75 billion, according to PERE data, making it the most popular debt strategy so far this year. Funds focused on senior loans have closed on $4.6 billion while subordinate or mezzanine debt gathered less than $1.1 billion.

For distressed debt, the first-half equity haul is the largest half-year volume for such vehicles over the past five years. Since the start of 2016, an aggregate of just $23.65 billion has been closed on by similar funds.

Much of the capital entering this space has gone into diversified real estate funds targeting an array of equity and debt strategies. Lone Star raised the largest amounts, raking in $8.2 billion and $4.7 billion for Lone Star Fund XI and Real Estate Fund VI , respectively. The next three-largest closings, however, involved debt or credit specific funds. Cerberus Global NPL and Cheyne European Strategic Value Credit attracted $4.1 billion and $1 billion, respectively, while Lone Star‘s $750 million second North America-focused residential mortgage fund rounded out the top five biggest funds targeting distressed debt.

A common thesis is that mature pricing has driven cap rates down, making certain equity acquisitions less appealing. Taken in tandem with other market trends, some managers see this pricing environment leading to a rising demand for refinancing and, ultimately, more defaults.

David DesPrez, Bain Capital Credit’s vice-president of distressed and special situations, sees opportunities arising in three areas in particular: luxury condos, subsidized multifamily and retail.

“By almost every key metric – transaction volumes, average condo price, land prices – the New York City market peaked in the 2015-16 timeframe and we’re seeing it come down, albeit slowly, from that peak”

David DesPrez, Bain Capital

Underwriting is an issue in all three property types, he told PERE, with developers and landlords assuming certain prices that now seem unattainable because of changing market dynamics or new regulations. Bain Capital Credit sees these trends playing out at large scale in New York, DesPrez said, and has made SKW Funding, a private lender and distressed debt platform based in the city, its local partner.

“By almost every key metric – transaction volumes, average condo price, land prices – the New York City market peaked in the 2015-16 timeframe and we’re seeing it come down, albeit slowly, from that peak,” he said. “We are also seeing pullback from lenders, so it’s become incrementally more difficult for borrowers to refinance or to get any outside the box debt.”

Carol Faber, co-chair of the distressed property practice at Akerman, a Miami-based law firm, credits an uptick in interest to widespread uncertainty in the real estate market. While there are few signs of distress in the market presently, she said many investors are wary of the long-running growth cycle.

“People are starting to think a downturn is coming sooner than later,” she told PERE. “They want to be well positioned to take advantage, so they’re talking about it and trying to raise money for it, but they aren’t necessarily deploying it just yet.”

While fund managers have been more disciplined with their use of leverage since the global financial crisis, Faber said the real estate debt space also has become more complex in that time. “They sliced and diced the capital stack in a number of different ways, so to the extent that there is distress, the workouts will be a lot more complicated than they were last time,” she added. “But where there are challenges, there are also opportunities.”