In any investing environment, there are winners and losers. During crisis environments, the winners are often big winners while the losers are often big losers. Who is poised to come out ahead during the COVID-19 crisis, and who is poised to fall behind?
Where The Money in Distressed Debt Is Flowing Today
In recent years, several prominent real estate funds have emerged that allow investors to pool their money into mutual fund-like securities offered by public real estate companies. Unlike REITs, they typically do not pay ongoing dividends. Instead, investors seek to gain returns through the appreciating value of the underlying assets. COVID-19 is proving to be a unique opportunity for some distressed real estate fund investors, but it could prove to be a pitfall for others.
According to Business Insider, more than $10 billion is about to pour into the real estate sector through distressed debt instruments.
One of the properties responsible for this new opportunity is the Williamsburg Hotel in Brooklyn. Benefit Street Partners is seeking to sell $80 million of distressed debt tied to the hotel. This is not surprising since COVID-19 essentially killed the hospitality industry overnight. That means debt tied to hotels across the country could hit the market in the next few months simply because hoteliers and other industry service providers are seeing a major drop in business due to fewer people traveling. Even with local economies beginning to open up across the nation, the hotel industry is going to struggle to return to its 2019 glory, and it could be a couple of years before it fully recovers. That spells opportunity for investors with cash to buy up the billions of dollars in debt that hotels, as well as food and beverage, restaurant, and tourism companies, have floating around.
Kayne Anderson in Florida raised $1.3 billion in two weeks and ended up turning investors away.
There were 939 commercial real estate funds globally in early April. At that time, they were seeking to acquire almost $300 billion in debt. One estimate in early May concerning the rate of delinquent commercial mortgages was 11 percent. As the economy continues to struggle, this number could go up by the end of the year even if every state opens up its economy completely by the end of this month (which is unlikely). The commercial real estate sector will continue to struggle and we’ll see more distressed debt hit the market as lenders seek to reduce their dry powder inventory.
In essence, firms in industries where the debt-to-equity ratio is high and where COVID-19 has impacted market forces negatively are likely either looking for buyers now for their distressed debt or soon will be.
Who Is Buying Up Distressed Real Estate Debt?
Cash is king. Investors sitting on piles of it have the best opportunity to purchase distressed real estate fund debt in the short term. They not only have the cash to make purchases, but they also have the opportunity to get to that cash quickly and to close deals as struggling lenders seek to recapture liquidity.
Lenders in industries impacted negatively by COVID-19 face a high number of probable defaults. If they can’t sell loans at a discount and regain their financial strength, these lenders will likely fold. Many of these lenders are small or alternative lenders that rose up on the heels of the last financial crisis but which have not navigated through a difficult economy until now. COVID-19 is their stress test.
One industry that is seeing huge fallout from COVID-19 is the retail sector, which was struggling before the current crisis as technology firms like Amazon and Overstock ate into their market share. Neiman Marcus and J Crew are among several retailers that have already filed bankruptcy in 2020. JC Penney is preparing to file and could do so by next week. As brick-and-mortar retailers close store locations, commercial landlords and commercial new construction will suffer (one notable exception is multifamily). If store locations are tied to capital investment, much of that debt will likely find a new home by the end of the year.
It’s likely that large traditional investment firms like Blackstone and Starwood Capital Group are going to swipe up a lot of the debt (and not just in retail). According to Morningstar, they are sitting on billions of dollars in cash and cash equivalents.
Greystone & Co. set up a $400 million fund to buy distressed real estate debt, but, according to company CEO Stephen Rosenberg, the company is wary about buying up debt too soon due to prices going lower rapidly and little market liquidity. In March, Florida-based Directed Capital purchased $10 million in loans for $7.4 million. Some of the investors targeting distressed real estate debt began to look for the opportunities in December, attempting to get ahead of the game.
Preqin reported that private equity firms have been building up distressed debt funds and was holding $77 billion in dry powder in 2019.
There is no doubt that 2020 will be a year of huge capital shifts toward major investment firms, private equity companies, hedge fund managers, and financial institutions that have the cash to buy up distressed debt as smaller players crumble, fumble, and fall to the ground. This will likely trickle down to smaller firms, which will scoop up the deals the larger players take a pass on. Investors looking for a rich opportunity may begin shifting their portfolios to increase liquidity so they can grab the tail end of this opportunity at the end of the cycle.
Where Real Estate Debt is Struggling In 2020
Marriott International carries $12.2 billion in debt and saw a 92 percent decline in Q1 2020 earnings compared to Q1 2019. Struggling to manage liquidity, the hotel chain will continue to struggle as long as shut down orders and social distancing remain in place. The hospitality industry will likely be impacted by COVID-19 for a couple of years.
Related industries such as the airline and cruise industries, as well as entertainment, have been similarly impacted by COVID-19.
The events management industry has also been affected as people are not gathering in large crowds anymore. That includes business conferences, rock concerts, and venues people rent for family reunions, graduations, and weddings. The food beverage, restaurant, and retail sectors are also struggling. These industries tend to be heavily invested in real estate. Companies in these industries with low liquidity and high debt will have to fight to maintain financial health. Their lenders will likely sell at least a portion of the debt in order to manage their own financial health, and that translates into opportunity for debt investors.
Auto sales are down 47 percent in the last month.
What each of these industries has in common is a high dependency on real estate. By the same token, these seven industries with high unemployment due to COVID-19 all rely heavily on commercial real estate development. As companies in these industries restructure their debt load, some of that will likely end up in the hands of investors ready to seize upon the opportunity. You could be one of them.