debt for growth: "no surge, but you can eat again"

Right now, conventional wisdom declares that debt can only be found from insurance companies and some banks in a tight range of 50% to 65% loan-to-value (“LTV”), and can only be had for the most “perfect” assets. CMBS is just starting to happen, but forget about value-add, or distressed asset acquisitions - the only action right now is in stabilized institutional quality properties. As such, there is fierce competition and fast sinking cap rates for those few deals. Everywhere else, the market sleeps.

But conventional wisdom may be an incomplete view of the market. Structured debt does exist, select opportunistic investments are happening, and operators can begin to build a portfolio of value-add investments ripe for harvesting as the market recovers, but don’t expect it to be obvious or easy. There isn’t yet a consistent flow of opportunities or debt, but the landscape is changing quickly.

“Very few even realize that 65% to 80% LTV debt exists – but it does.” Bob Dennis , a debt fund manager at Wrightwood Capital told me recently. There are a small number of players, including NXT Capital, Mesa West Capital and Wrightwood Capital that are providing structured debt to real estate investors willing to take advantage of select new opportunities beginning to trickle into the market. Even though the market for oppportunistic asset sales is nowhere near the level industry players expected 12 months ago, there is a growing number of owners and lenders that are finally willing to unload their more troubled assets. According to Bob, “Sellers are fatigued and feeling pressure, values have improved from the lowest of lows a year ago and some are starting to sell assets at a discount.

The economics of acquiring these assets are starting to make sense, especially with an appropriate amount of leverage to help the parties narrow the bid-ask gap and produce an attractive leveraged return to the new equity.”

From a lender's perspective, Bob likes the way this market is starting to move, and contrasts it starkly with the market of 12 to 18 months ago: ”Last year, not only was there a significant bid-ask gap that brought transaction flow to a virtual standstill, but, sponsors and equity partners were reluctant to take on the default risk of senior debt. In an environment of falling values and continued uncertainty regarding the timing of an eventual recovery, it’s difficult to justify taking on a significant debt load. After all, it’s hard to default if you don’t have any debt.” The only problem is, without leverage, the bid-ask gap will persist and most value-add business plans are not economically feasible. Investors won't default if they go the all-equity route, but it is very difficult to make attractive returns without leverage at a price that sellers are willing to accept.

But in the last six months, even though markets have not returned to robust growth, there is more stability and it is possible to to be more confident that property fundamentals are nearing the bottom amid the modest economic recovery now underway. Some are starting to believe that future rent growth will take place, and are actually projecting rent increases in the years to come. As of yet, there is no landslide of opportunities, but there are a select few. According to Bob, “We’re starting to see transactions with sensible economics more frequently – but it’s still much like finding a needle in a haystack. There’s no growth surge, but you can eat again.”

Essential to this kind of needle-in-a-haystack market is a developer/operator's ability to find the assets, understand them thoroughly and build a solid business plan. According to Bob, “This isn’t about placing bets in a few markets, instead it’s about building opportunistic business plans around each acquisition that will produce attractive risk adjusted returns.” There is no easy way to do this, but it can be done. “Anyone who is providing high leverage debt has to underwrite the real estate, the business plan and the sponsor - not just count on capital flows to move in their direction. There is a real discipline required in this kind of market – to find and appropriately structure the deals that are somewhere between straight debt and equity and possess a degree of complexity and execution risk that defy mainstream trends, including financing non-performing loan acquisitions that require a successful work out with the existing property owner in addition to the implementation of a property level improvement plan.” Essentially, this is entrepreneurial capital, and it requires a disciplined but entrepreneurial lender to provide it.

Whenever I reflect on the last couple of years of post-crash, recessionary times, it is difficult not to compare this market with the real estate market of the early 1990’s. After the S&L’s collapsed, taking their real estate portfolios down with them, it was at least two years before the RTC was able to ignite the opportunistic frenzy of discounted real estate sales where out-sized returns were achieved through the RTC's singular goal to liquidate assets coupled with the absence of a developed equity market. If there is any kind of wholesale distressed asset bonanza to come, it will most likely unfold differently than it did then – but it’s a pretty safe bet that it will last longer, due to the significant scope of today’s over leveraging, but generate lower returns, given the amount of idle equity targeting this sector. Until real growth happens, it is encouraging to see some leverage return to the market as well as select value creation transactions.