Commercial Real Estate Finance

It seems that everywhere you turn today, another real estate company is raising a “distressed debt” fund.  The logic of course is simple.  People are trying to reduce their illiquid investments, and property is illiquid. Why buy new property, which carries with it all sorts of unknowns (including value) when there is seasoned, mature and rated product available in the form of distressed debt? Many property operators seek “loan-to-own” scenarios, in which they buy debt with the hope that the current borrower will default, thus triggering their ability to foreclose on the property, as a potential way of acquiring desirable product super cheap.  If they never have to foreclose on the asset, then at least they are making a known return.

Even operators with a historical penchant for development are forced to investigate the world of distressed debt.  After all, with property values having plunged over the last 18 months, its not as if the cost of building new product will look attractive anytime soon when you can buy existing product vastly below replacement cost. Thus, even developers must get involved as their traditional model has been rendered ineffective, at least in the short term.

So where does this lead us?  Clearly, there are many lenders willing to shed troubled assets from their books at a considerable discount.  Thus, there is a supply.  And clearly, there is demand, as evidenced by the sheer volume of distressed debt funds that seem to be multiplying overnight. Yet, the market for this product is a ways away, in my opinion.

This is because in order for there to be a market, the supply and demand curves have to intersect, and right now, they simply are not.  The bid-ask gap that existed in the property market has extended itself to the distressed debt market as well.  Banks know there are buyers, but the buyers are vultures and are always looking for a better deal, and thus are hesitant to pull the trigger.  Without a mechanism in place that essentially forces the banks to make the first move, as we had with the RTC, I am not certain that bankers will be inclined to shed their troubled assets at bargain basement prices.

Part of this issue lies in the very definition of “distress.”  People have widely varying definitions for what ‘distress” actually is.   After all, 18 months ago, anything that traded around 90 cents on the dollar was considered distress. 12 months ago, anything trading in the 70 cents on the dollar range was considered distress. Some simply believe that distress is a seller who “has to” or is highly motivated to sell, therefore selling in an inopportune fashion as compared to a traditional market sale. Others argue that essentially ALL debt is potentially distressed, depending on the maturity date of the loan!

I argue that all debt is distressed because there is no fluid trading market for it.  At least not yet.

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