Distressed debt deals are still the exception rather than the norm

Earlier this week, Oaktree Capital Management announced the $4.7 billion final close for its largest-ever property fund, Oaktree Real Estate Opportunities Fund VIII, far exceeding its original $3.5 billion target.

One of the most notable aspects of the fundraising announcement was that the Los Angeles-based alternative investment manager had already invested or committed approximately 40 percent of the fund’s capital at the final close. That 40 percent has been designated for what Oaktree head of real estate John Brady called “a compelling set of credit-focused investment opportunities.” Although the ROF series of funds is invested in both equity and debt, a document from the Nebraska Investment Council identified ROF VIII as “an opportunistic credit distress fund,” targeting distressed debt acquisitions, equity recapitalizations, rescue financings, and discounted securities purchases.

The quick deployment of the fund, which Oaktree began investing in earnest at the start of the pandemic, is not indicative of general real estate debt distress overall, however. In a debt-focused roundtable this week, PERE heard four managers speak at length about the potential opportunity in distressed real estate debt. But while some of the managers expected to see distressed dealflow pick up in the coming year, particularly from the hospitality sector, the four participants agreed that very few opportunities had materialized to date.

As one UK-based firm commented, “We’re still in furlough, and most distress has been kicked down the road.” Meanwhile, a US manager noted there had been very little enforcement by lenders on borrowers in default so far, and consequently he was not seeing any actionable opportunities.

Distressed assets have been trading during the pandemic. But they represented just $1.4 billion, or about 1 percent, of sales in Q4 2020, according to data provider Real Capital Analytics. Moreover, distress as a percentage of total asset sales has remained below 5 percent of total sales since 2016 – a far cry from the more than 20 percent of total sales during the last peak year of distressed asset sales in 2010, RCA data showed.

What explains the robust flow of actionable opportunities on which Oaktree says it is capitalizing, then? One US-based debt roundtable participant told PERE he had been discussing the Oaktree fundraise with his colleagues this week and believed the manager’s track record has played a significant role in its ability to access deals – its 2015-vintage ROF VII was generating a 39.6 net return and a 1.3x net multiple as of December 2018, according to a document from the Plymouth County Retirement Association. So has its reputation for being “a little more creative and specialized” than its competitors.

Among fellow mega-managers such as Blackstone and The Carlyle Group, Oaktree has consequently carved a niche for itself, the US manager noted. Such attributes have given Oaktree a competitive advantage in a space where there has so far been a lot of talk, but relatively little action.

Indeed, the firm is applying that competitive advantage to a small window of opportunity. The PCRA document noted the fund’s investment strategy “is positioned to transition away from distress towards growth-oriented opportunities” as the economy recovers.

RCA reported outstanding distress – meaning troubled loans currently in special servicing – of $55.6 billion and potential distress of $90.5 billion as of year-end 2020. Many distressed real estate debt players are still waiting for that outstanding and potential distress to turn into buying opportunities. By then, Oaktree will have likely already pivoted to the next stage of the cycle.