As I was saying in my last commentary, it’s time to stay calm and carry on in a market that is flashing green, red and yellow signals simultaneously. These are market conditions in which nimbleness will be rewarded. Whether the economy is going to continue to grow, albeit in a very low gear, or whether we’re going to have a recession of one species or another, things are not soon going to return to the BEFORE.
It is now virtually certain that we will have a wave of distressed debt between now and the return of robust growth. I know, I know. I’ve written about the risk of leaning into a distressed debt wave before. One raises money, beefs up workout and restructuring resources and then…waits. And your delicious distressed debt wave fails to arrive and Godots you. To slightly repurpose what some wag said (Lord Keynes perhaps?) markets can stay confounding longer than investors can stay patient. But this time (Hah!) is different. No, I’m serious.
The base case for the distressed opportunity I’m building here is coincident with the base macro case deemed most likely by the majority of the commentariat right now (even they can be right once in a while). We’ll have slow or no growth for some period of time and probably a modest or shallow recession sometime soonish, if we’re not already in it. Throughout, we will see stubborn inflation, which will not abate in any meaningful way. The price of risk will stay elevated and debt coupons high. I know there are voices in the market that the Fed is bluffing and the put is still in. While I am on the record (in this commentary) that I suspect the Fed’s current inflation fighting ardor may abate temporarily with the election coming and a whiff of recession news in the air, post-election with persistent inflation being anything but transitory, the inflation fighters will re-emerge, and if we have not already begun to enjoy it, we’ll have ourselves a nice little recession. Look, to be clear, a wave of distressed debt is not now dependent on future events. This wave of distressed debt is now fully baked into the cake. No probable or even wildly possible path forward for the economy over the next year or two, not a bit of growth, not a dodged recession, not a more rapid than expected decrease in inflation, will prevent it from occurring.
In these market conditions, there are and will continue to be increased premia for all species of risk. Cap rates will go out, valuations on everything, and certainly commercial real estate, will come down. Coupons remain elevated and more likely than not, continue to grind up for at least a while. After a decade or more of stable cap rates and stable coupons at very low levels, it is an absolute certainty that many, many assets will be over levered and fundamentally not re-financeable. This is true for commercial real estate and no less true for the leveraged loan marketplace (the land without covenants…boy, will that butcher’s bill come due now!).
In the real estate market, the MBA expects something north of $250 billion of commercial mortgage loans to require repayment or refinancing before the end of 2023, with another $250 billion in 2024, both because of hard maturities and extension criteria that can’t be met because of deteriorating financial conditions. Moreover, the MBA data does not capture bank balance sheet lending which will certainly follow the same pattern. Much of this will be a challenge to refinance. Eventually, that will drive this market, but finding cooperative borrowers and getting these deals done will be a grind. As this new market reality is likely to last for multiple quarters (not months) something’s gotta give, but reconciliation to this new normal will creep in on cat’s feet over many months.
LIBOR and now SOFR, which persistently stayed in the single digits for years, have now popped up to almost 250 bps and will certainly continue on this upward trend as Fed funds continue to go out. The market is discounting a virtual certainty that will see at least 50 and perhaps 75 bps in September and the Open Market Committee minutes of the last meeting suggested (as opposed to the pacific tone of prior meetings) a tub-thumping Rambo-like commitment to do what it takes, for as long as it takes, to get interest rates back down somewhere close to the 2% Fed target, or at least to a level which is no longer obviously accommodative.
It’s not just the floating rate market. Hardly shocking that. The ten-year has stuck to a fairly narrow range but has once again crept back above 330 bps. That’s not an exit ramp for commercial real estate confronting increasingly high coupons in the floating rate market. The price of risk will be up across the board.
The consequence is that we’re going to see a lot of assets that will require significant new equity or material sub debt to refinance.
Will the equity be there? While there’s plenty of equity sloshing around the system looking for a place to play, I don’t see that money pouring into commercial real estate without demanding a significant premia for risk that will make it non-accretive to the “old” equity and with a demand for a level of control unamiable to the current ownership. Sagging valuations, an imminent recession, dodgy prospects at best for the next couple of years, and elevated coupons on all species of debt means that while investors might be there, they are going to extract a significant pound of flesh.
Sub debt will be the way forward for most deals. Expensive for sure and risky for legacy equity, but what can one do? Rescue equity will be even more expensive. As more and more loans reach maturity or fail extension conditions, the demand for this money will be enormous. The demand for anything that will fill the daunting gap in the capital stack that is accretive to the equity (or accretive to the equity in the wild imagining of a largely fabulist property ownership class) will mean a preference for sub debt over dilution by new equity.
There are two ways to play this environment for those with dry powder and…let’s call it, conviction. One could simply go to the ownership class and offer to step into the breach and fund the cap stack gap. But, how to get to these point-of-sale opportunities is the question. One must find and identify distressed borrowers, but also find borrowers who are ready to confront the new realities and be agreeable to deal honestly with the world of lower valuations, smaller first mortgage loans and more expensive sub debt. Right now, we’re not there as many levered property owners are pursuing a strategy (that’s a strategy?) of kicking the can down the road. Look, one can make fun of can-kicking, but it has worked where credit interregnum is brief. That’s not this time. The road will end soon, albeit not today. Capitulation is going to happen, but could be a slow burn. Those who remember the Great Recession remember the interregnum after the recession’s bottom before transactional activity really picked up. Even the proverbial chicken with its head cut off struts around the barnyard for a bit. So, for anyone looking to put money to work soon, trawling the country club bars looking for a willing property-owning counterparty might be frustrating.
The other way to play this market is to view the lending community as the customer base. Buy loans from portfolio lenders who want to shed risk or are not equipped to play in the cage-fighting matches of workout, foreclosure and bankruptcy. Lenders, not typically infected with the fabulist mindset of the borrower community, already clearly see lower valuations, higher prices for risk and recognize these are not ephemeral conditions. The lending community already can foresee the wave of maturities and frustrated extensions and bridges that are beginning to look more like piers than bridges.
Two very important things are happening now which may potentially transmogrify portfolio lenders into willing sellers. First, the non-bank portfolio lender’s business model is based upon reasonably priced liquidity and easy access to that liquidity. Liquidity has been relatively easy to acquire and relatively cheap for the past decade. We are now seeing a broad withdrawal of liquidity from the marketplace. While the liquidity is still there, it’s offered at considerably higher interest rates. Warehouse lenders have turned cautious (there’s some word on the Street that the regulators have put something of a spike in the warehouse lending wheel). Certainly, some new warehouses will be offered and some existing warehouses will be extended and renewed (but at much higher spreads). Days of easy and cheap leverage for the portfolio market are over will not return for quite a while. And not to beat the obvious to death here, the CRE CLO market is still largely closed and unlikely to return to robust growth in the next few months (and it may get considerably worse as QT expands, as some commentators have suggested that overenthusiastic QT will supercharge the arrival of the liquidity desert).
As portfolio lenders are confronting their Scylla and Charybdis of the need to lend, with a balance sheet depending on leverage and a compelling need to refresh their capital, more and more will become motivated sellers.
The other thing, thank you, Gnomes of Basel, is the broad adoption of the Current Expected Credit Loss (CECL) accounting protocols that all banks and largely all other GAAP-reporting lenders must fully adopt by 2023 (many of the larger banks have already adopted). CECL was designed by said Gnomes to prevent banks (and other lenders) from “hiding” losses when confronting early signs of enhanced credit risks or deteriorating market conditions.
Under the older loss recognition model, losses were only booked when the losses “were incurred.” Basel, FASB and the regulators, concluded that the old model could transform balance sheets into Potemkin Villages as clearly foreseeable losses were not reflected in the balance sheet until losses actually occurred, at which point is arguably too late and often happen at the very worst point in the business cycle. In an ebullient market where borrowing costs are going down and valuations are going up and everyone is having a great deal of fun, CECL was just a Debbie Downer. What? I’ve got to book a loss when I make a loan? That’s insane. However, in the market we’re confronting now with falling valuations, CECL is likely do what the regulators expected it to do; cause the banks to take significant reserves against their positions far earlier than was true at the outset of the Great Recession.
For those who remember, during the Great Recession, many institutions understood that selling assets was simply a bad idea because it would then cause the institution to mark the rest of the portfolio as actual realized losses (that couldn’t be ignored) taking losses in a discontinuous way and causing enormous volatility in balance sheets. Now with CECL in place, many of these losses may have already been booked month to month and quarter to quarter. This should cause the banking and portfolio lending part of the marketplace to be more willing to lighten the load, particularly given ongoing regulatory heat on excess concentrations in certain asset classes, notably commercial real estate.
Going back to where we started, though, building up material piles of dry powder in expectation of a distressed debt cycle is hard and takes an inordinately long amount of time. Raising a distressed debt fund now might not see a first closing until far into next year, resulting in managers watching the opportunity come and go before they are ready to deploy significant capital.
Consequently, what the distressed market needs to be nimble and get in when the getting is good, is leverage. To stretch what dollars are available and join the battle early. Obviously, traditional warehouses won’t be a likely source of this; most of the traditional warehouse lenders don’t like performing loans all that much, let alone non-performing loans.
What one needs to do is to build out a distressed debt securitization platform (or otherwise find leverage). Securitization structures became briefly popular in the years following the Great Recession before the markets returned to ruddy health, but worked reasonably well. In these transactions, underlying loans and REO assets were individually analyzed in order to assess how much cash could be harvested from aggressively managing these assets and how much time would be consumed until such assets were reduced to cash. A proceeds pipeline and consequently a waterfall was built on that basis. Some senior investment grade classes were possible, with the rest of the structure PIK-ing and with the manager, of course, holding first loss position. We have this technology and it needs to be dusted off and conversations begun with both investors and ratings agencies.
Distressed debt securitizations can be broadly syndicated or done privately. Perhaps structuring these transactions privately is the easiest path forward. On a private basis, investment grade securities can be bespoken for IG investors with the stomach for the distressed debt game and sponsors can hold the entrepreneurial risk of last dollar and the real benefits of collecting more and faster. If memory serves during the last period when these deals were modestly common, transactions outperformed and sponsors did extraordinarily well.
So, there we are, on the cusp of a significant…“opportunity” (for some, disaster for others) It’s time to get ready. It’s time to find some investors willing to step up. It’s time to find leverage, dust off old technology, start to building relationships in the market.
This is not going to be a great deal of fun and, if I remember correctly, there are no closing dinners in a distressed debt cycle. But valuations are going down. The price of risk is going up. The liquidity desert is real. Distressed debt will proliferate and need good, new homes.
It’s only charitable to provide them, isn’t it? Let’s have at it.
