Many struggling real estate owners hoped that the first half of this year would be when interest rates finally came down. That doesn’t appear to be the case anymore. March’s consumer price index report showed inflation rose 3.5 percent year-over-year, and economists are prolonging predictions for when rates will fall. The number of cuts this year likely won’t be as much as expected. Some, like JP Morgan Chase CEO Jamie Dimon, even think another rate hike may be in our future.
Interest rates remaining higher for longer will undoubtedly cause more pain for real estate owners. Those in the industry holding out for cuts could soon consider selling assets, handing the keys back to the lenders, or halting projects altogether. This period of high interest rates began with the first increase in March 2022. Since then, there have been ten more hikes. After years of high times and low rates, the hangover is lasting longer than the industry wants it to, and people are looking for relief to weather the adverse effects.
The amount of commercial real estate debt maturing this year makes the situation trickier. Newmark estimates that $929 billion of commercial real estate loans will come due in 2024. The market’s distress is unwelcome news for most, but it’s leading to opportunities for some investors to go on the offensive. Peebles Corporation is one of those investors. The firm recently launched a new Miami-based private credit arm called Willowbrook Partners to provide rescue capital to struggling real estate owners. Willowbrook Partners will provide bespoke credit solutions for distressed commercial real estate projects in the $5 million to $50 million range. The loans will target multifamily, for-sale residential, retail, industrial, and self-storage assets in major cities in states traversed by I-95.
There’s a surge of interest in the market from investors like Willowbrook Partners, who are looking to take advantage of rescue capital transactions. Investment data firm Prequin estimates global real estate funds operated by private equity firms had a record $544 billion in cash as of the second quarter of 2023, up from $457 billion at the end of 2022. As property distress spreads, other debt-workout scenarios like bankruptcies and foreclosures will still be in play. However, the uptick in rescue capital deals is evident and reminiscent of a trend made famous during stagflation in the 1980s.
Capital to the rescue
Rescue capital is a phrase that describes loans to commercial real estate owners facing financial hardships. Most rescue capital is tailored to situations where traditional financing channels have been cut off because of heightened risk. It serves as a strategic solution to prevent project failures and foreclosures. A rescue capital infusion can be delivered through debt or equity financing from specialized lenders, equity sources, private financiers, or financial institutions that offer this type of financing. Rescue capital often provides a better alternative than handing the keys back to the lender.
These capital infusions are a more cost-effective way to recapitalize assets rather than bringing new equity in through foreclosure or bankruptcy. With the right partner, rescue capital deals drive value and provide the financial flexibility required to weather challenging market conditions. The need for this capital source will increase if interest rates remain high, compelling more property owners to seek financing that can quickly provide short-term solutions.
An infusion of rescue capital for a struggling property owner helps, but it comes with strings attached. A significant restructuring of the existing capital stack is usually required, which may result in new terms for all investors involved and new participants. Possible consequences include dilution of voting rights and economic interests. Current investors could be pushed to the back of the line and made ‘hope note’ stakeholders in extreme circumstances.
Achieving a successful outcome in these deals for property owners requires skillful negotiations. Not every distressed property owner will qualify for the criteria set for rescue capital, either. “It’s intended for properties on the fringe, but not true wipe-out deals,” said Terri Adler, Managing Partner at Adler & Stachenfield, a real estate law practice based in New York City. “For true wipe-out deals, there are other remedies.”
Many institutions are opening distressed asset funds, but the amount of capital being infused will not significantly impact the widespread distress in the real estate market. The capital may rescue quite a few properties, but the finance strategy doesn’t have superpowers. Financiers aren’t doing the rescuing for altruistic reasons, of course, but because they present an opportunity to seize on the market’s dislocation. Like any form of financing, these deals carry inherent risks. For lenders, there’s the potential of borrower default and declining property values. The potential benefits for lenders include superior equity returns compared to traditional lending and shared profits in joint ventures.
The ‘falling knife’ office
One opportunistic investor is New York-based Lightstone Group, which recently launched a $500 million rescue capital platform. Lightstone is seeking investments between $20 million and $100 million in multifamily, hospitality, and industrial assets across the U.S. Notably, the company won’t consider office assets. Lightstone expects to deploy the capital over the next two years, targeting the nation’s top 50 metropolitan areas and helping to restart stalled developments or properties that need additional capital expenditures.
Lightstone launched its lending arm in 2018, called Lightstone Capital, and the pandemic allowed the company to step into deals where traditional lenders backed out. “As a private firm, Lightstone can move quickly and be extremely flexible on structuring and investment terms,” said Mitchell Hochberg, President of Lightstone Group. The firm’s capital platform has originated approximately $1.3 billion since its inception, with over $400 million in its pipeline. Lightstone develops, manages, and invests in $9 billion worth of assets across 26 states, with its largest portfolio share in New York City, Los Angeles, and Miami.
While the firm’s portfolio leans toward those three cities, Hochberg said they have spread their investments across the country to maximize geographic diversity and avoid concentration risk. “In our multifamily platform, we deliberately avoided chasing low cap rate deals across the Sunbelt and instead built a sizable portfolio across the Midwest, which has proven to be a resilient investment thesis,” Hochberg said. In industrial, Lightstone has a considerable presence in the Southeast and Midwest, where they target high-growth infill areas within 25 miles of a central business district.
Lightstone will entertain opportunities in all asset classes for its new rescue capital platform, but it is specifically focused on its core investment expertise in multifamily, hospitality, and industrial. “While there are clearly many distressed office opportunities, Lightstone has historically and will continue to avoid the ‘falling knife’ facing this asset class that renders it impossible to assess valuations,” Hochberg said.
Green Street Advisors reports that office values have decreased by about 35 percent since March 2020, but they’ve yet to bottom out. The Great Financial Crisis was the last time office values fell this far, but they recovered roughly 80 percent of their pre-crisis peak value in a faster timeframe. Fitch projects the U.S. CMBS office delinquency rate to more than double from 3.6 percent as of February 2024 to 9.9 percent next year. The shift to remote work and challenging refinancing conditions will drive a protracted recovery timeline for the office sector, and Fitch says it could lead to permanent property valuation impairments. This is the ‘falling knife’ that Lightstone’s Hochberg referred to, and it’s one of the reasons some distressed asset funds aren’t targeting office assets.
Not every investment firm is shying away from office distress. Artemis Real Estate Partners recently closed its largest-ever real estate vehicle, Artemis Fund IV, with $2.2 billion in commitments. Artemis will spread the investments across various markets and asset classes but has signaled interest in distressed office properties and assets in struggling markets like New York and San Francisco.
Artemis previously focused on hot asset classes like industrial and multifamily in rapidly growing markets in the Sunbelt. Offices may be on its radar now because of massive pricing drops, though their view is that pricing needs to continue to adjust. “We’re in a period where it’s great to have dry powder,” said Rich Banjo, co-president of Artemis Real Estate Partners.
Office property values may not have bottomed out yet, but the pricing discounts may offer once-in-a-generation buying opportunities for some to get ‘alpha’ returns in the next five years. Distressed trading activity is still in the early stages. Distressed office sales accounted for only 2.6 percent of total transactions over the past 12 months. This is mainly due to being still early in the price discovery period. Distressed trading activity unfolded over seven years following the Great Financial Crisis, so a similar pattern will likely hold in this distress cycle.
The turmoil in the commercial real estate market is causing migraines for some and advantages for others. As distress piles up, opportunistic investors are stepping in. Every rescue capital deal is unique, and each institution’s investment thesis for these funds differs. It will take a good chunk of capital for many distressed properties to get to the other side. Some commercial property owners with debt maturing in the next few years may negotiate new terms with their lenders. For the ones who can’t, there will be no shortage of rescue funds that could provide a needed boost. Along the way, some opportunistic investors will make good or maybe even contrarian bets that could prove to be wise moves. The market’s turmoil is a gathering storm for some in the industry but a window of opportunity for many others.