RSM: Major Distress Unlikely to Materialize  

Conditions are not ideal for the distressed debt market to take off like investors have been hoping, according to Lauren Gerdes, real estate senior analyst with RSM US LLP.

Data reported by the Federal Reserve shows defaults on commercial real estate loans remained below 1% through Q3 2022, with rental rates tracking at elevated levels across all sectors maintaining cash flow.

“With a recession on the horizon, we will likely see a slight increase in defaults in 2023 as interest rates rise further in Q1 and are expected to hold through the end of the year coupled with a slowdown in rent growth,” she tells GlobeSt.com.

“However, it will be nowhere near the 9% default rate experienced following the Global Financial Crisis.”

Instead, lenders are working with borrowers to modify and recapitalize their positions on upcoming maturities and defaults rather than forcing distressed sales, Gerdes said.

“Lenders remain cautious issuing loans at loan-to-value ratios between 50% to 60%, compared to 65% to 75%, seen over the recent years,” she said.

“This is requiring additional equity funding to bridge the gap. Investors and private debt funds with flexibility in capital deployment are in a position to take advantage of investment opportunities in various positions in the capital stack achieving higher-yield preferred returns.”

Risk is Hard to Price Right Now

She said RSM has seen an increase in mezzanine debt and preferred equity investment, especially in assets with upcoming loan maturities and riskier developments where traditional financing has disappeared.

“Investors are focused on opportunistic investment with strong cash flow duration, such as geographies with insufficient supply, vacant mixed-use industrial space, or multifamily assets where market rents and demand will outweigh inflationary pressures,” according to Gerdes.

“However, the risk is hard to price right now and lenders will be focused on debt service coverage ratios requiring longer due diligence over future cash flows adding to the slowdown in transaction volume.”

Liquidity Will Continue to be a Challenge

She said that buyers and sellers will need to come to an agreement on valuations in this market to increase deal volume.

“Liquidity will continue to be a challenge with tighter financial conditions in 2023; however, low delinquency rates and sustained cash flows maintained at higher interest rates, especially in the multifamily and industrial sectors, will ease some uncertainty in lending, allowing for an increase in transactions expected in the second half of 2023.”

Dry powder aimed at real estate investment in the U.S. remains above $250 billion, however, fundraising momentum has weakened, Gerdes said.

Data reported by Preqin through the end of 2022 reflects a 26% decrease in capital raised year over year.