Silicon Valley Bank, Signature Bank and First Republic Bank all collapsed this year, due in large part to their decisions to concentrate investments on fixed–rate loans. About $1.1 trillion in commercial real estate loans are maturing by the end of 2024, with some analysts estimating loan write-downs—and therefore losses—totaling billions of dollars. In response to these events and market sentiment, billions of dollars are being raised by opportunistic investors, primarily institutional, looking to capitalize on the market dislocation affected stressed and distressed assets.
Capital Raised for Investment, by Year
But not every deal is a good deal, and this environment will require that potential deals are carefully analyzed to sort assets into two general categories: those that are merely stressed and those that are more deeply distressed.
What’s the difference between stressed and distressed assets? A stressed asset is one in which the cause of the stress is relatively obvious, and the risks are contained and quantifiable. You come home from vacation to find the kitchen faucet dripping. The solution is either to tighten loose parts or to replace the faucet. In either event, you can identify the cause of the problem and solve it with a high degree of confidence. In a distress scenario, the cause may be less obvious and the potential repercussions much more challenging—or impossible—to identify and quantify. Rather than a leaking faucet, you find a ruptured pipe and a flooded kitchen. The cause of the rupture is unknown and so is the extent of the damage, which may take substantial time and money to fix.
In a real estate investment, examples of both stressed and distressed assets abound. For instance, we recently were presented with an opportunity that fits neatly within the stressed category: A well-known and reputable developer had completed and leased up a new construction project. The sponsor had not used excessive leverage, and by all accounts the property was performing as expected. However, because of the rapid change in the capital markets environment, the developer needed to execute a cash-in refinance, requiring an infusion of $15 million. Even the best multifamily developers rarely keep this level of liquidity on hand, and they needed an investment to complete the refinance.
In this case, the cause of the stress and the solution were easily identified and quantified. This type of stress is common—generally healthy and well-managed projects adapting to the current financial climate, employing needed capital and continuing on their path to completion. These types of investments are at the center of our current investment thesis.
However, extended periods of higher interest rates, such as we are seeing now, may create distress. I believe that the market will see more distress among multifamily assets of 1970s and ’80s vintages that were purchased in the past couple of years—for more than it would have cost to build new—with leverage of 80% to 90%. Refinancing those loans may require the lender to take a loss.
Office buildings in the Chicago Loop fall firmly within the distressed investment category. Office occupancy in Chicago has steadily declined for years and accelerated at the start of the COVID-19 pandemic, with very little rebound in the past 12 months. It’s easy to define the cause of lower occupancy as lower demand, but it’s much more challenging to determine why demand has fallen. Is it corporate relocations out of state or the work-from-home movement? Maybe the cause is functional obsolescence of the properties or increased crime. In any event, investors are holding multimillion-dollar loans on empty office buildings. What should they do when there is no clear sight on demand, and where will they get the money to pay the loans? This distress is playing out in real time.
Over time, opportunities tend to move from distress to stress. The cause of distress will eventually be more clearly identified, and the solution can be quantified. Eventually, the homeowner will know the extent of the damage from the ruptured pipe, and the cost to repair the damage. Chicago office investors will more accurately know the cause of the limited demand; they will find alternative uses for the buildings and determine how much it will cost to convert them. Until that time, the risk to a distressed investment is substantially higher than a stressed investment, and investors need to wade in very carefully, or avoid them entirely.