The Daily Capitalist wishes to welcome Douglas McKnight as a new constributor. Doug will mostly discuss commercial real estate within the context of Austrian economic theory. Doug has been a commercial real estate appraiser for 23 years. He previously served as a director for the national appraisal firm Marshall & Stevens. He has published two articles in “The Appraisal Journal“, one of which won the Armstrong Khan award for the most outstanding article of the year. He is currently the managing director of CapStruc Advisors and is working on a book on the value of assets. — JH
In the Christian tradition, Jesus died on Good Friday and rose again on Easter. A similar phenomenon is underway in commercial real estate.
In 2011, Blackstone Group LP paid $1.1 billion for a portfolio of suburban office buildings and $9.4 billion for nearly 600 shopping centers. In January, Colony Capital, LLC acquired 103 budget hotels and Korman purchased the 88-unit Crescent luxury apartment complex in Beverly Hills. In February, a joint venture of Mack-Cali Realty Corp. and Winthrop Realty Trust paid $40 million in order to acquire junior debt in a portfolio of seven office complexes in Stamford, Connecticut in anticipation of taking them over this August. None of these transactions resembled what most people imagine when they envision commercial real estate sales. A large segment of the commercial real estate industry has been effectively re-defined as a subdivision of the distressed debt industry.
Historically, someone interested in selling their real estate would engage a commercial real estate brokerage that would list the property, meaning that the brokerage would promote it to potential buyers and other brokerages. If the brokerage found a qualified buyer, the property would be placed under agreement so that additional marketing efforts would cease. While the property was under agreement, the potential buyer would typically apply for a loan from a financial institution for 70% to 90% of the purchase price and engage attorneys and engineers to perform due diligence on the property and the terms of the transaction. The financial institution would perform its own due diligence, engaging credit analysts, a title company, and an appraiser to ensure that its interests were protected. If everything worked out, the buyer would take ownership of the property within a couple of months.
Now the game has changed.
These days, many commercial real estate transactions do not involve brokers, borrower loans, or even willing sellers. Instead, federal judges often play a role. Potential buyers are as interested in the debt structure of the entity that owns the real estate as they are in the real estate itself.
The real estate is typically owned by a legal sub-entity that was created, and is wholly owned, by a principal entity specifically for the purpose of holding the real estate. This sub-entity typically has several layers of debt with various levels of seniority. When the sub-entity encounters distress and ends up in reorganization (chapter 11) bankruptcy, the most senior creditors stand to recover their investment, while the most junior levels stand to lose their entire investment. Between these extremes there is one level of debt that stands to recover some, but not all, of its investment. In reorganization, it is this level that will most often be given control of the property. Distressed property investors refer to this level of debt as the fulcrum asset.
By gaining control of the fulcrum asset, distressed real estate investors can effectively gain control of an entire asset at a fraction of its market value. The trick is to first identify and then purchase this fulcrum asset. If the investor overestimates the potential of the target to reimburse creditors, they can end up purchasing a level of debt that is too junior to recover any money. If they underestimate this potential, they will be paid back on the debt that they own but fail to take control of the asset and the opportunity for high returns.
The identification of this fulcrum asset can be quite complex. There are, not two, but three competing parties in bankruptcy litigation: secured creditors, unsecured creditors, and the bankrupt entity. It is in the interest of the senior creditors for the value of the entity to be as low as possible while it is in the interest of the unsecured creditors and the bankrupt entity for the value to be as high as possible. The court decides what valuation will be used. The investor targeting the fulcrum asset must evaluate the likelihood of the decisions of these court proceedings.
Assuming that the distressed investor is successful in gaining control of the asset, it can then unlock the real estate investment that has been misdirected from its most productive uses and reposition the assets to better uses. This is the natural process through which markets recover from crisis. Access to these markets is predominately through private equity funds. Blackstone, the largest fund in this market, expects an 8% direct capitalization rate (one-year net operating income divided by price) on its investments but several other funds buy at a 9% direct cap and sometimes sell to Blackstone at an 8% cap.
If you have the funds and sophistication to invest in these private equity funds, you have a great opportunity. If not, I’d suggest that you stay on the sidelines or in the bleachers as far as commercial real estate investment is concerned for the time being. The potential down side of real estate private equity funds is limited to further degradation of their investments, while the potential up-side is very high. A property with an 8% direct cap rate now could yield a much higher return in the years to come if the real estate market recovers even moderately.
Just as there can’t be an Easter without a Good Friday, the recovery of real estate requires this re-organization of assets. As it stands, only the most well-funded investors can engage in this activity. Individuals and small businesses and private equity funds are effectively excluded from this market because of the difficulty of obtaining bank financing. Consequently, much of the commercial, industrial and residential real estate in the U.S. is still trapped in less than maximally productive uses.