What was novel four decades ago suddenly looks relevant again for the reeling U.S. commercial-real-estate industry.
Regional banks and their exposure to commercial real estate were thrust back into the spotlight in February after New York Community Bancorp Inc.
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reported a surprise loss from its large book of property loans.
The lender, like others, has been considering loan sales to fortify its balance sheet.
As banks work to minimize fallout from underwater loans and teetering borrowers, other investors have been dusting off real-estate mogul Sam Zell’s “Grave Dancer” playbook from the 1980s, a road map to opportunities that, in his words, “arise from the distress of others.”
Zell died last year at 81, after amassing a fortune by picking through the graveyard of busted commercial-real-estate deals. The billionaire’s legacy also includes bankrupting newspapers and making foul remarks about women in commercial real estate.
Still, Zell’s 1980s distressed-debt investing manifesto has become eerily relevant again, namely in the way that excess speculation, a surge in inflation and oversupply, including in the office sector, creates opportunities for others.
A notable difference from Zell’s earliest grave-dancing days, however, is the sheer amount of money at stake. U.S. commercial mortgage debt has mushroomed to an estimated $4.6 trillion in 2023 from about $2.2 trillion in early 2007, according to the Mortgage Bankers Association.
A bet on hotels
“The first thing I would say is that right now, financing for office is as stressed as it ever has been,” said Marcello Cricco-Lizza, a portfolio manager and managing director at Balbec Capital. Cricco-Lizza, whose firm oversees $6 billion, acknowledged that the pandemic was a unique moment when lending froze up, but he said that was a relatively short-lived crunch compared with what he is expecting now for commercial real estate.
A former bond trader at Goldman Sachs
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Cricco-Lizza said he anticipates a “slow bleed” to occur in all but top-tier office space as landlords see old leases expire, get downsized or be renewed at lower rent levels. “That’s not going to happen just this year,” he said. “It is happening every year for the next three or four years.”
Against that backdrop, Balbec has been focused on originating short-term loans, most on multifamily and hotel properties, but it is also looking to buy distressed debt from lenders, including real-estate investment trusts and debt funds.
“Our thesis is that hospitality is a winner from some of the headwinds,” Cricco-Lizza said. “If you are not going to the office as much, you need to travel more, go to conferences, for face time with colleagues.”
Rate-cut delays
A mantra gaining traction in the U.S. property market has been “stay alive until 2025,” in hopes that the Federal Reserve will have pivoted to rate cuts by then, reducing its policy rate from the current 22-year high.
“I wouldn’t lose track of the fact that the Fed has hiked interest rates massively,” said Leo Huang, a portfolio manager and head of commercial real-estate debt at Ellington Management Group.
Even if the Fed starts slowly cutting rates this year, borrowers with existing floating-rate loans have already been growing weary from costlier interest payments and lower property values since the central bank’s rate hikes began in 2022, he said.
Huang also sees echoes of the 1990s savings and loan crisis, which he witnessed early in his career. That resulted from the prior decade’s property boom and took nearly a decade to resolve as groups of distressed-debt buyers took over underwater commercial-real-estate loans from failed lenders.
In multifamily real estate, where demand has remained robust, Huang sees opportunity in properties that have good business plans but whose landlords “borrowed too much money, and don’t have the wherewithal to continue supporting their loans.”
He added: “I think there are hundreds of billions of dollars of debt that will change hands, a lot in office, but not all of it.”
Running out of gas
For now, regional banks looking to shed commercial real-estate mostly have been offering one-off deals in which they selectively move assets off their balance sheet, said Pat Jackson, chief investment officer at Sabal Investment Holdings.
“At some point they will say, let’s make big, bold moves,” said Jackson, who bought billions of dollars worth of loans from banks in past downturns.
A catalyst for more concentrated selling of assets looks likely, especially as lenders and borrowers come to terms with property values, which have reset lower.
While overall values were down 21% in January from peak 2022 levels, according to Green Street’s Commercial Property Price Index, values in the hard-hit office sector were 35% lower, and multifamily was off by 28%.
“With a lot of the debt on bank balance sheets, much of it is floating-rate, which went up over the past 18 months,” Jackson said. “It’s like being in a car that’s out of gas. With no cash, you can’t afford to buy the gas to put in the tank.”
‘Yields we haven’t seen in a while’
Another place distressed-debt buyers have been looking for big rewards in downtrodden commercial real estate has been in bonds used to finance hotels, office buildings, shopping centers and other types of property.
Zachary Liebmann, a portfolio manager at Waterfall Asset Management, said signs of distress have been quick to manifest in the commercial-mortgage-backed securities market, where bonds backed by pools of property loans trade daily.
Despite a rally over roughly the past two months, he still is seeing opportunities in the sector, including as investors turn to Wall Street dealers to quietly unload larger blocks of bonds. “They are offering yields we haven’t seen for awhile,” Liebmann said.
“I think it’s hard to tell if we’ve bottomed,” he said. But where bond prices are now, he sees a good risk-reward tradeoff, making it a little hard to wait for potentially even bigger discounts.
