Distressed Real Estate Debt – An Investment Opportunity

As a way for a lender to address ongoing challenges stemming from fluctuating interest rates and uncertain market conditions, many lenders are using a “blend and extend” strategy. This involves refinancing an existing loan by blending the current interest rate with a new, often lower rate, and extending the loan term.

While the “blend and extend” strategy is providing some level of breathing room for sponsors and keeping lenders from having to take back keys (which many lenders have no desire to do), it means these existing lenders are receiving fewer loan repayments—let alone prepayments—leading to less capital for deployment into new loans. Thereby, the new supply of credit from traditional lenders in the real estate market has decreased meaningfully.

In this backdrop of above-average demand and limited supply, alternative real estate debt providers are experiencing a plethora of opportunities to fill the void left by traditional lenders in a “lender’s market,” with strong pricing power and access to high-quality assets with favorable risk profiles. Consequently, private funds and other specialty lenders are taking an increasing market share of CRE debt capital commitments.

For savvy investors, distressed real estate debt presents a compelling opportunity. Distressed debt refers to bonds or loans that are trading at a significant discount due to the borrower’s financial difficulties. In the current high interest rate environment, several factors contribute to the rise of distressed real estate debt:

1. Value Opportunities: Investors can purchase distressed debt at a discount, potentially leading to high returns if the underlying properties stabilize or recover in value. This can be particularly attractive in markets where long-term fundamentals remain strong despite short-term financial distress.
2. Control Over Assets: By acquiring distressed debt, investors can gain control over the underlying assets, often at a lower cost than direct property acquisition. This can provide strategic advantages, such as the ability to restructure debt terms or take ownership through foreclosure.
3. Diversification and Risk Management: Investing in distressed debt allows for diversification within a real estate portfolio. It can also serve as a hedge against market volatility, as distressed assets often have lower correlations with broader market trends.

The Shifting Landscape

The Mortgage Bankers Association reports, that over the next three years, nearly $2 trillion of the $4.7 trillionⁱ in commercial real estate loans nationwide will mature. While it’s reasonable to expect that most of these loans will be extended, some borrowers may default or lenders may lose patience, resulting in some forced sales.

The leading contributors to non-agency loan closings as of Q2 2024 were alternative lenders, such as mortgage REITs and debt funds. This has been driven primarily by bridge lending, which doubled its prominence from a year earlier. Collateralized loan obligations (CLO) also increased in Q2 2024 from the previous quarter.

The next largest lending group was banks, which hold about 38 percent of total commercial real estate debtⁱⁱ and saw a decrease in activity in Q2 2024 compared to a year earlier. With greater regulatory scrutiny, banks will focus on maintaining their current loan portfolio and managing exposure to the sector during the next few years. As banks are expected to remain cautious, new opportunities will continue to open up for private lenders.

Challenges

Navigating the complexities of investing in real estate debt comes with many challenges, such as credit risk, market risk, limited liquidity, complex exit strategies and sensitive debt instruments. The private lending lifecycle has various processes that can benefit from the use of technology to help manage increasing operational complexity and accounting challenges.

• Structuring and Documentation
  • Complex Deal Structuring: Real estate debt transactions often involve complex structures, including senior loans, mezzanine financing, and other bespoke solutions. Ensuring that these structures are well-documented and legally sound is critical to protecting the lender's interests.
  • Legal and Regulatory Compliance: Debt investments must comply with various legal and regulatory requirements, which can vary significantly across different jurisdictions. This adds a layer of complexity in managing cross-border investments.

• Asset Management

• Monitoring and Servicing Loans: Unlike direct ownership, where the investor directly manages the property, debt investors must rely on effective loan servicing and asset management to ensure timely payments and manage defaults. This requires robust systems and processes to track loan performance and handle distressed situations.
• Collateral Management: Ensuring the value of the collateral (the real estate asset) and property cash flows remain sufficient to cover the loan in case of default is crucial. This involves regular appraisal and market analysis.

• Operational and Organizational Challenges

• Team Expertise: Managing a real estate debt portfolio requires specialized knowledge in finance, real estate, and legal matters. Building and maintaining a team with the necessary expertise can be challenging but is essential for effective management.
• Technology and Analytics: Leveraging advanced analytical tools and technology is crucial for effective risk management and decision-making. This includes systems for tracking loan performance, market trends, and borrower financial health.

Choose a Provider with Technology and Expertise

By partnering with the right provider, fund managers can access the technology and expertise that will help them navigate the challenges of distressed real estate investing. Next-generation technologies like artificial intelligence (AI), optical character recognition (OCR), natural language processing (NLP) and robotic process automation (RPA) to digitize non-standard data, automate manual processes and reduce risk. Whether choosing a SaaS, outsourcing or co-sourcing model, the right provider can help you scale your operations to accommodate growing loan volume and complexity while delivering on investor demands and expectations.

To learn more about how to choose a solution that helps you achieve success in the distressed real estate investing space, download our "Top 8 Strategies For Achieving Economies of Scale in Private Credit" whitepaper and join us for the "Finding Opportunities with Distressed CRE in 2024" webinar we’re hosting in conjunction with the Mortgage Bankers Association.

ⁱ https://www.mba.org/news-and-research/newsroom/blog-post/chart-of-the-week-2024-commercial-mortgage-maturities-pushed-up-by-2023-extensions

ⁱⁱ https://irei.com/news/some-distress-will-emerge-amid-wall-of-loan-maturities/