Is there Enough Rescue Capital to Stave Off Distress?

Last week I penned a piece discussing how and when transactional velocity will return to the market. There is so much we still don’t know about the current macro-economic environment and of course the real estate investment market, but one thing we do know is that the market will come back. One of the points I made: “That as transactions increase in number the first wave will be dominated by recapitalizations and structured transactions where the equity feels like debt and is somewhat insulated” bears further discussion. From a technical standpoint, what I am really referring to is what has commonly become known as “Rescue Capital”. Much has been made about the vast amount of rescue capital that has been raised and is still accumulating on the sidelines and is becoming poised to jump into the market when the time is right. 

First, let’s discuss precisely what the term “rescue capital” refers to: Generally, when the term is used it refers to an investment that is structured as preferred equity that is intended to be true equity for investment and tax purposes, but has more debt-like features than traditional equity. Without getting too technical, an infusion of rescue capital typically comes along with a reconfiguration of the existing asset level capital structure. The new capital will likely relegate the existing investors to the bottom of the stack and will have voting rights and control provisions that exceed that of a typical preferred equity position. In some cases, the lender will also need to make concessions that could include loan resizing, but a foreclosure is avoided and the owner retains control. It can be a way more efficient and cost-effective way to recapitalize an asset this way as opposed to having it run through a process where there is a foreclosure or bankruptcy which in many jurisdictions can add as much as 7% in various taxes before new equity is even applied to the property. Of course if the deal performs well over time the owner can even make some of their equity back and in some cases get a return. Each situation is different, but these types of deals can be incredibly valuable for a property that has positive cash flow but cannot be refinanced in the current environment, requires capital for improvements, or simply is in need of an expensive rate cap.

How much of this capital is out there? Since the pandemic, fundraising has been heavily skewed to the value-add and opportunistic end of the spectrum. Not all of this capital can be deployed as rescue capital, but many of the funds that can do both equity and debt will allocate as much as 25% of their opportunistic capital to these types of positions. Truthfully, there is some guesswork to how much of the approximately $247 billion of dry powder that these funds control can be used for rescue capital but given their fund construct it is easy to imagine as much as $50B could be deployed.  Of course, there are funds that have been raised and are being raised to specifically target distressed situations. I am tracking an additional $25 billion in this sector in about a dozen funds and am certain there is more coming. Some of that money will be used for direct purchases of distressed properties, some will be used to purchase loans and certainly some will be used as rescue capital. Given some of the unique technical aspects of rescue capital, there are also funds being raised specifically for this purpose with the idea that a specialized fund can better navigate the intricacies. It’s a little harder to give a precise number there, as the evolution is still in process and the fundraising market is difficult at this exact moment,  but I can name at least six of these funds which because of their specificity tend to be on the smaller side and average about $150 million.

The bottom line is though it is difficult to truly estimate the amount of rescue capital that has been raised, I don’t believe there will be an issue finding equity for situations that require it. The big challenge will be finding deals where the asset plans are still intact, the existing capital structure can handle another participant and the long term value prospects are such that the rescue investor can make a clear-eyed risk assessment. With over $80 billion of loans on office buildings maturing in 2023 and many of those ending up as maturity defaults, there will be growing distress in the office sector, but the vast majority of those deals will not work for rescue capital. Right now, rescue capital is most appropriate in deals where floating rate loans have gotten dramatically more expensive and the project still requires capital but lacks liquidity. Included in this category are developments underway, multi-family assets in the midst of a value-add program, and a very few stabilized office assets that need to fund improvements. Each situation will be different and it will be vitally important for property owners to be realistic about where the market is and what their best outcome could be.

John Kevill is managing principal of the boutique brokerage and investment firm Solitude Cove Capital and a senior advisor to consulting firm Arcturus.