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Stateside: Recaps take centre stage as lender forbearance runs dry

US real estate owners are addressing capital constraints by adding new debt.

As covid-19 vaccines are distributed at a rate of more than a million a day, there is growing optimism in the US about a return to normality. But for many real estate owners and sponsors, particularly in the hospitality sector, the countdown to herd immunity is measured against dwindling cash reserves and waning lender leniency.

A last-minute bill in late December extended until the end of 2021 a troubled debt restructuring relief programme that allows banks to offer forbearance to borrowers without triggering regulatory enforcement. However, not all lenders are willing to make use of it in perpetuity. Lisa Knee, head of the real estate private equity practice at the New York accounting firm EisnerAmper, says the more interest payments are required, the more borrowers will be forced to act.

“Real estate owners need to prepare for a new set of circumstances in 2021,” she says. “They need to pivot from short-term lender accommodations to more long-term debt strategies, given their best estimates of how their properties will perform. They cannot just go to their lender and ask for a pass.”

To the rescue

This harsh reality has created a window of opportunity for alternative lenders to step in and provide rescue capital with relatively little risk involved.

“There are high-quality sponsors with high-quality assets who have unimaginable liquidity disasters unfolding,” says Boyd Fellows, managing partner of California-based debt firm ACORE Capital. “But that is a perfect situation for us to provide a financial solution.”

Unlike previous crises driven by bad practices or underlying market fundamentals, Fellows says the current disruption is completely external and therefore comes with fewer uncertainties about the state of the financial sector and the overall economy. Once the virus has been contained, he expects certain owners and operators, in hospitality specifically, to return to pre-pandemic levels of performance.

Yet, while hotels, shopping centres and development projects are the prime targets for recapitalisations, other sectors – such as offices, which is racked by uncertainty about future usage rates, and even certain multifamily properties – will face liquidity issues. “In general, a lot of older money is going to get subordinated and new money is going to have to come in,” says Josh Zegen, managing principal of New York-based manager Madison Realty Capital. “That is a function of when you see markets where the bid-ask spread is very wide. This is a way to narrow that gap.”

Despite inoculation efforts, covid continues to proliferate throughout the US, keeping consumer spending muted. It was down 0.2 percent in December, the second straight month of decline according to the Department of Commerce.

Hospitality has borne the brunt of this downturn. The hotel delinquency rate has been the highest in the commercial mortgage-backed securities world throughout the crisis, peaking at 24 percent in June before stabilising at around 19 percent in the last three months of 2020. In late January, a unit of Singapore-based Eagle Hospitality REIT, which owns more than $1 billion of leisure, business and airport hotels in the US, filed for bankruptcy protection. According to Bloomberg, two hotel owners with combined liabilities of $50 million or more also filed for bankruptcy in 2020 – the highest figure in a single year since 2012. More filings are expected in the months ahead.

Research firm Trepp has identified 127 commercial real estate loans totalling $4.5 billion that have deeds-in-lieu of foreclosures pending, meaning borrowers are close to handing over the keys. Notable securitised loans that fall into the category include a $36 million facility for the Sheraton Suites Houston. On the retail front, a $126 million note on Westfield Citrus Park, a mall in Tampa, Florida, is also deed-in-lieu.

Distressed asset sales made up just 1 percent of transactions across the US market by the end of last year, according to data provider Real Capital Analytics. That was the same rate as during the first quarter of 2008, two years before distressed sales peaked at 20 percent of the total market.

History repeating itself

Madison’s Zegen expects this crisis to follow a similar trajectory. “This year will be most like a 2010 vintage, whereas 2020 was like 2009, when the bid-ask spread was super wide, and values and cap rates were all over the place,” he says. “In 2021, the gap will start to narrow a bit as things stabilise more.”

Last year, Madison, as an equity investor, recapitalised an industrial-to-office conversion in Brooklyn, New York in a deal in which the existing debt was kept in place. The recapitalisation became necessary after its initial equity partner walked away from the project, citing covid distress. Zegen says that had Madison looked to sell the property, the debt markets would have limited how much the new buyer could have paid, which would have resulted in a loss. Instead, Madison brought in a new partner and used its equity to pay down a large amount of the existing debt and lower the interest on the remainder to a more manageable rate.

On a larger scale, Highgate Hotels’ acquisition of $2.8 billion of hospitality assets from Colony Capital in September was an example of a new participant coming into a deal in which existing debt was retained. Highgate paid less than $100 million for 197 properties but assumed $2.7 billion of debt in the process. One debt fund manager told us a traditional acquisition would have required a larger equity cheque from Highgate, and Colony would probably have had to sell at a loss rather walk away with a modest proceed of $67.5 million.

On the equity side of the US market, managers have recapitalised and restructured funds to ensure well-performing assets remain liquid. Lori Campana, a partner at Boston-based capital advisory firm Monument Group, says many investors have been willing to sign off on changes to capital structures in the interest of maintaining value. “There are some very strong assets in a lot of portfolios,” she says. “But they have been in mothballs for a year, so general partners have to look for ways to preserve the upside and they will need more time. Limited partners understand that, and if they believe in the manager, they will allow that to happen.”

Across all private assets last year, direct secondaries, of which fund restructurings are a part, accounted for a greater share of purchases than fund secondaries – a first since
Toronto-based secondaries firm Setter Capital began issuing annual reports about the secondaries market in 2013. In real estate, funds still accounted for 62 percent of activity, but the margin was the slimmest on record, with $1.04 billion of direct deals and $1.7 billion of fund deals.

Zegen nevertheless believes that this type of recap is only viable when a fund’s underlying properties have a clear performance outlook: “Other than industrial or a couple of hotter asset classes, the primary recap you’re going to see moving forward is more of a distressed recap.”

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