Waiting for Distress

Singapore-listed Eagle Hospitality Trust is holding a stalking-horse auction in May for a portfolio of 15 US hotels with a floor price of $470 million. Madison Phoenix LLC, an affiliate of Monarch Alternative Capital LP will purchase the portfolio if a better offer is not received in the auction.

Stalking-horse auctions are a routine part of many Chapter 11 bankruptcies, but for investors that have been waiting for distressed assets to come to market, this news was extraordinary.

Namely, the portfolio was one of the largest collection of distressed assets to come to market since the start of the pandemic. In fact, to date opportunities in distress investing have been sparse.

Not surprisingly, the auction is attracting significant attention, according to Alan Tantleff, leader of FTI’s Lodging Gaming and Leisure industry practice. Tantleff was appointed to the interim role of chief restructuring officer to assist the REIT as it navigates the complexities of restructuring and bankruptcy. “Many investors are confident in hospitality’s recovery and they are looking for distressed assets in this space,” he says.

This is not how opportunistic and distressed investors imagined things would go one year ago. With the pandemic laying waste to whole asset classes, such as retail and hotels, it was expected that many opportunities would be had for investors with deep pockets. And indeed, billions of dollars have been raised to target distress.

But so far the pace of distressed assets coming to market has been agonizingly slow for funds that accumulated capital with this goal in mind. There is one school of thought that distressed investors may have missed their moment now that vaccines are rolling out, the US economy is poised for super-sized growth, and lenders continue, for the most part, to show patience with borrowers.

Delayed, But En Route

Another school of thought says that distressed opportunities have just been delayed, but they are coming.

CoStar Group, for instance, expects a large scale of distressed sales to hit mid-2021. The company modeled 16 different scenarios to determine how bad the carnage would be from this recession. In those exercises, the amount of distress landed between $92 billion to $370 billion, though it will likely be $126 billion.

“It’s a pretty wide range,” says Xiaojing Li, managing director at CoStar Group. “We think it [the amount of distress] could be a blended scenario that is somewhere in the middle.”

In 2010 and 2011, distress sales were $95 billion in 2010 and 2011. Part of the increase can be traced to the additional amount of commercial real estate in the market.

“From The Great Recession to now, there has definitely been a lot of new construction added to the market, as well as the inflation of CRE values,” Li says.

Even with the smaller amount of distressed assets in the Great Recession, it took almost 10 years to settle all the troubled loans and distressed properties. CoStar believes the distressed sales process will again be prolonged, with $321 billion being sold by 2025. From 2010 to 2014, $192 billion was sold.

“The distress process is a long process,” Li says. “It takes some time for the loan to go from default to the foreclosure and REO process. For the loans going through that, it takes about two years.”

Many other entities expect to see more distress enter the market as well. The Urban Land Institute, for example, believes that distressed debt will increase when government support packages run out. So does Federal Reserve President Esther George who recently sounded a warning about underestimating the support stimulus has given the commercial real estate industry.

Her main concern for the industry? When the support ends, many renters and businesses could find themselves unable to meet their obligations. This in turn would force banks to realize losses on existing loans which would then weigh down credit growth and broader economic activity.

“While it is important to acknowledge the role of policy in supporting the real estate market, it is also important to be aware of the forthcoming challenges when this support is withdrawn, especially against the backdrop of longer-term structural changes to the outlook,” she said in a speech.

Opportunities Emerge 

As of mid April, there are signs that more distress is creeping into the CRE community.

JLL’s loan sales and hotels and hospitality teams were retained by a CMBS special servicer to market the sale of an $80 million, non-performing loan portfolio collateralized by full limited-service hotels totaling 1,022 keys across five states.

“Given the pent-up demand and lack of hospitality product, we expect to see a strong turnout for this offering,” says JLL Managing Director Tom Hall.

Also in mid April, Bloomberg reported that Hospitality Investors Trust is negotiating with Brookfield, its largest investor, about a potential Chapter 11 filing as part of a pre-packaged bankruptcy. HIT owns about 100 hotels across the US.

It should not be surprising that these examples are focused on the hotel asset class. Eight percent of hotel sales involved a distressed asset between March of 2020 and February of 2021, according to Real Capital Analytics. This percentage takes on greater significance as there were very few hotel transactions in that timeframe, with only $10.6 billion traded, RCA says. By comparison, $36.6 billion traded in the prior 12-month period.

In other sectors, the distressed sales have been scant. In industrial and apartments, only 1% of sales in each sector “was tied to an asset purchased out of distress,” according to RCA. The two sectors together represented 60% of deal volume across the five core asset classes since the pandemic began.

Distressed sales in office and retail have risen but still haven’t come close to the levels seen in the Global Financial Crisis, according to RCA. Distressed office assets only constituted 1.3% of office deals over the last 12 months. In 2011 distressed office sales were 16.0% of the sector’s transaction activity. In retail, distressed accounted for 2.4% of activity. During the GFC, they were 12.8% of sales.

Reading the Tea Leaves

Comparisons to the GFC, though, may not be entirely on point.

The Global Financial Crisis came about because of poor underwriting and unnecessary risk.

“The credit quality gradually deteriorated, and that contributed to the last downturn,” says CoStar’s Li. “It was also more of an across-the-board across asset types where the collateral performance went down. You didn’t see too much of a difference across the property types.”

Ten or so years later, the pandemic-led recession has been different. After the 2007 and 2008 experience, institutions adopted better underwriting and stress testing and stronger cash positions, according to Li.

“There is a big variation across property type because this is not a recession with the underlying capital issues,” Li says. “It is more of an internal shock because of this health crisis. People were locked down. There was no travel, vacations, office use or people going to the store to make purchases. So that is part of the reason different sectors were influenced or impacted differently.”

With balance sheets in better shape, this recession has exposed variation among different CRE sectors. “Definitely hotel and retail were hit very hard this time,” Li says. “Office is in the middle because there is uncertainty about the future of office space.”

In fact, the ultimate fate of the office asset class appears to improve with each passing month. Last November, cracks had emerged in many asset classes’ fundamentals, including office. Outside of industrial, vacancies rose in all major property types and rent declines accelerated at both the national level and across most metropolitan areas.

It would have been natural to expect things to worsen in 2021 since CRE distress usually trails an economic downturn. But overall, the damage has been minimal. “It is likely too soon to pronounce a systematic, definitive recovery across property types and geographic areas, but in general first quarter data reflected relatively benign results,” according to Moody’s REIS.

In most cases, the expected acceleration of stress from the fourth quarter of 2020 never materialized, Moody’s said in a report. Not that the industry has bottomed out, at least not retail and office. Both of these categories are going through structural change which will likely pressure rents and vacancy rates into 2022. Multifamily, by contrast, is closer to its pre-pandemic performance, facing only persistent long-term unemployment and a glut of supply coming online later this year.

These pressures, though, do not appear likely to yield significant distress, or even major price discounts. In fact, any pricing reductions from the pandemic and economic dislocation will probably be short-lived. A survey from CBRE finds that 70% of respondents plan to increase investment by at least 20% this year compared to 2020, but only 30% of investors on the sale-side made the same claim. This disconnect between buyers and sellers will likely drive buying competition and pricing, creating a seller’s market.

Most investors are anticipating an active acquisitions year. While 70% plan to increase acquisition activity this year, another 23% plan to maintain acquisitions activity. Overall, only 7% of investors are reducing buying capacity or exiting the market altogether.

The CBRE report estimates that the low interest rate environment and economic recovery is driving buying demand in the Americas. However, property owners typically hold properties through economic dislocation and times of uncertainty, which is exacerbating a price expectation gap between buyers and sellers. CBRE expects buyer demand will help to convince more owners to sell, ultimately estimating that investment volume will increase 25% year-over-year in 2021.

The trend already began late last year. Investors ramped up buying in the fourth quarter, bringing a 60% decrease in investment volumes to only 34% or just shy of $300 billion.

Another challenge for distressed inventors is the reluctance of many lenders to push properties into foreclosure, coupled with a wave of opportunistic capital targeting troubled borrowers.

“The only asset sales that we’ve made for lenders to date have been deed in lieu, where the borrower has essentially handed back the keys and released it from their ownership,” Bob Webster, vice chairman and president, CBRE Hotels Institutional Group, said on CBRE’s “The Weekly Take” podcast. “But in a forced liquidity trade, which is a trade where the lender has to fight for the keys, that hasn’t happened yet.”

A primary reason there hasn’t been more fallout during the pandemic is that there are companies out there providing lifelines, in the form of capital infusions, to owners who are in a difficult liquidity position. “I’ve been very surprised at the magnitude of the liquidity in the space, looking to acquire hotels and looking to help with the liquidity distress in the ownership side of our business,” Webster says.

Looking forward, Webster says there is a tremendous amount of liquidity in the system for new debt and acquisitions. There might not be as much liquidity for refinancings, but he thinks the cost of that capital will continue to come down.

With so much capital out there, hotel values are holding up with prices within 20% of 2019 values, according to Webster. He says top-tier hotels that were doing well in 2019 and had little distress in the capital structure are durable assets.

Of course, vulnerable hotels are burning a significant amount every month.

D.J. Rama, president and CEO of Auro Hotels, says his full-service hotels are running 20% occupancies. The company is treating its full-service hotels like leisure hotels and giving a rate discount to attract customers.

“All our select-service hotels are running anywhere in the ranges of 55% to 60%,” Rama, who also participated in the podcast, says.

In Florida, where Auro has 21 locations and restrictions are being lifted, occupancies have crept into the low-80% range. Other markets aren’t performing as well.

“What you’re finding is that each market is behaving differently,” Rama says. “Our Minneapolis and Chicago assets are running in the 14% occupancy range. Washington, DC is running 16%.”

Smart Money

This is how distressed investors are likely going to succeed—by cherry picking the troubled assets on a market by market basis with the occasional portfolio, such as Eagle Hospitality’s, thrown in.

Consider the approach of Ares Management Corp.’s newly-closed third opportunity fund, which was oversubscribed by $1.7 billion of commitments. It will target distressed, repositioning, and selective development opportunities.

Opportunity funds may be better positioned to succeed than funds focused just on distress, which generally have specific mandates and must deploy capital within a certain period of time, in some cases forcing them to pay too much for assets that meet their mandates.

David Roth, head of US Real Estate Private Equity for Ares, made a nod to this situation with his description of the new fund’s “flexible mandate.”  Looking ahead, he said, “The unprecedented change in space utilization has potentially widened the opportunity set for both attractive undercapitalized assets and assets within sectors experiencing accelerated demand.”

On the other hand, some very smart money is circling for distressed opportunities and their positions are well worth considering.

In April, a unit of Blackstone Group acquired a stake in Mavik Capital Management, which, according to Bloomberg, is seeking to capitalize on “significant stress” brought on by the Covid-19 pandemic. The stake is described as a “small, passive” one through its secondaries business, people familiar with the transaction told Bloomberg.

Separately, a Securities and Exchange filing shows that MAVIK Capital Management, an entity controlled by Vikram S. Uppal, the CEO of Terra Property Trust, acquired the outstanding interests in Terra Capital Partners. As part of the recapitalization, “a private fund managed by a division of a publicly-traded alternative asset manager with more than $500 billion in assets under management, acquired a passive interest consisting of ‘non-voting securities,’….in MAVIK.”

Mavik has about $800 million under management, Bloomberg says and expects “unprecedented distress that will take many years to resolve,” according to an investor presentation viewed by the publication.