Over the next two years, there will be 3,600 distressed bargains to pick from.
In order to achieve high returns on money in the real estate sector in 2023 and 2024, one must invest in distressed CRE assets. This distressed cycle differs from previous ones in that most lenders aren’t repossessing the CRE assets. Instead leneders are managing and leasing them for a while, then selling the properties. Rather than foreclosing on the property, they are more likely to sell the note or mortgage.
Lenders prefer to be “asset-light” when it comes to huge and complicated CRE assets, like many other industries like hotel management, technology manufacturing, food delivery, and ride-sharing. For intelligent distressed investors who have acquired mortgage notes secured by commercial property and are familiar with the onerous foreclosure and bankruptcy procedure that may follow, this gives a special and intriguing opportunity to gain a clean title to the property. In order to benefit from the influx of incoming CRE loans that will go into default, distressed investors should start acquiring funds right away.
These problems will lead to CRE distress and defaults in this cycle:
- Increased interest rates and the borrower’s inability to refinance at these rates
- A decline in occupancy, revenue, and NOI, as well as the borrower’s inability to pay the property’s current debt service
- Covenant violations and mortgage loans
- Inability to pay the escrows and payments due under the mortgage and note
- In some circumstances, it will be more expensive and prohibitive to use an interest rate swap or collar to minimize the interest rate risk associated with floating rate loans.
- A substantial drop in the property’s value
- A drop in occupancy, the departure or bankruptcy of important tenants, and
There is a fantastic chance for distressed investors to get in touch with the various CRE lenders and try to purchase the note and mortgage on the property at a sizable discount given that all the aforementioned problems presently affect around 2.0%, or $90 billion, of the total CRE loans outstanding, which total $4.5 trillion.
There will be 3,600 distressed deals available over the next two years if the average defaulted loan is $25 million. The discount on the loan paper must be 10%–15% higher than if the property had been sold by the lender as a foreclosed asset because distressed investors today are taking on more risk by purchasing the note/mortgage and then going through the foreclosure process, which is typically handled by the original lender.
For instance, a $100 million office property that had $70 million in debt at 5.0% interest alone and was 95% leased in 2019 is now 70% leased and is only worth $70 million. The NOI at the time of acquisition was at a 4.5% cap rate, or $4.5 million, but it is now just $3.2 million, which is less than the $3.5 million a year in debt payment. In spite of efforts to restructure the loan with a lower interest rate, postponed payments, or a debt paydown, the borrower has defaulted on the loan by failing to make the last three months’ worth of payments.
The lender engages a CRE brokerage company to sell the note and mortgage since it does not want to foreclose on the property. likely distressed investors will require an extra discount on the note of at least 10%-15% or a price of $59.5 million to $63 million for the $70 million loan since they must go through the foreclosure and likely bankruptcy process, which in certain places might take years.
This is a reduction of 37% to 59.5% and 85% to 90% from the original loan amount and property value, respectively. The investor will foreclose or accept a deed in lieu of foreclosure if the borrower does not tie him or her up in bankruptcy. The investor has now acquired the office building at the above significantly reduced price and will benefit from any occupancy and rent increases when the local office market improves and the building’s valuation rises as a result of falling interest rates.