COMMENT: The GP who cried distress

Once upon a time, in the wake of the global financial crisis, there were many GPs and numerous research reports predicting a wave of distressed opportunities forthcoming in the US.

The rationale was that many properties were overleveraged and would need to refinance in an environment of limited liquidity and much more conservative underwriting standards. As a result, a number of such properties would go into default or seek a restructuring with a discreet source of fresh equity.

While opportunity fund managers did get to partake in some distressed situations in the US, for the most part, the predicted bounty did not arrive. Instead, a low interest rate environment and the policy of ‘extend and pretend’ helped to keep most troubled assets afloat until liquidity returned and the recovery took hold.

Now, just as the industry has become accustomed to America’s slow but steady recovery, there comes another GP prediction of a new wave of impending distress. In a recent note to investors, entitled Is It 2007 All Over Again?, Los Angeles-based investment manager PCCP predicted that the large volume of debt scheduled to mature between 2015 and 2017 will create new opportunities for investors in distressed property.

According to PCCP, the largest wave of maturities in the current cycle is now upon us, with roughly $1.7 trillion in real estate loans coming due in the next three years. With banks – estimated to hold about half of the real estate debt that is maturing – unlikely to extend more credit and an equal amount of debt that cannot be refinanced without more capital, PCCP predicts that some borrowers will turn to alternative sources to refinance or recapitalize before rising interest rates constrict funding. That presents distressed investors with a major opportunity.

Another big area of concern for banks involves the impact of the Dodd-Frank Act on construction lending. The regulation restricts ‘high volatility commercial real estate’ (HVCRE) loans, with banks ultimately required to hold 12 percent instead of 8 percent in capital reserves for each loan they issue. The regulation also will require mortgage originators to retain 5 percent of any loans they repackage and sell off through the CMBS market. Such restrictions would certainly change banks’ approaches to lending and effectively could knock them out of the resurgent CMBS game as well.

The latest version of Basel III also addresses HVCRE loans, which applies to certain acquisition, development and construction loans. Each HVCRE loan in a bank’s portfolio that meets the definition would be assigned a 150 percent risk weighting under the proposed rule, as opposed to a 100 percent risk weighting under current rules. This increased risk weighting goes into effect next January.

Much like in the wake of the global financial crisis, the rationale for distress seems sound. A significant volume of loans are coming due; regulations that could restrict real estate lending by making it make costly for banks are set to take effect; and there is the specter of rising interest rates. All these factors indicate that distress may indeed be on the horizon.

Of course, the market has heard this all before. More importantly, there are more alternative sources of real estate loans than ever before, including real estate debt funds and private lending programs, and the once-dormant CMBS market has been roaring back to life. Call us skeptics, but we’ll believe the cries of distress when we see it.

PS: Some of you may already have seen that PERE has a new sister publication: our owners have bought Real Estate Capital magazine. We now cover the entire spectrum of real estate investment and financing, engaging with all parts of the industry – investors and funds, financiers and projects. PERE will continue giving you the world of real estate equity and REC will give you the world of real estate debt. We'll tell you more soon.