Warren Buffett, the legendary value investor, once said, “Only when the tide goes out do you discover who’s been swimming naked.”
For commercial real estate, the tide has indeed receded during the past 18 months as short-term interest rates have risen by over 500 basis points to a 20-year high, while the industry grappled with higher inflation and low unemployment. Now, we’re discovering who among us has been swimming naked and it’s not pretty.
Among the hardest hit real estate market participants are syndicators of over-leveraged investments with debt at floating rates. They’re facing a reckoning. If—and it’s a big if—they can refinance their current debt, it’s at a substantially higher rate. More likely, they will have to make capital calls to their current investors to raise funds to right-size their leverage.
Capital calls are reasonable, to be sure, but depending on how they go, some may be forced to sell into an uncertain market. No one wants to do that.
Even to owners, investors, and developers who have lived through multiple real estate cycles, it’s a stressful time as most assets face downward price pressure. How unpleasant your reality is as a syndicator depends on how prepared you are for the current environment.
The challenge is even more acute for the small to middle market in commercial real estate because institutional capital is largely out of reach. For this segment of the market, today’s climate can be devastating. The keys may have to be handed over to the bank.
There have to be other answers. Fortunately, there are.
A new generation of capital providers is serving the small to middle market with joint venture and preferred equity, mezzanine financing, specialty financing for green energy improvements, private capital raised by non-traded REITs, and debt funds more willing to invest in smaller properties and in secondary and tertiary markets. Here’s a look at some of the capital providers that have emerged in recent years:
- New sources of joint venture equity. A number of firms have risen out of the Covid crisis, including ours, which opened shortly before the lockdowns. Midloch Investment Partners was born specifically to address the need for joint venture equity in the underserved middle market. In our case, the focus is on the Midwest, but we’re doing deals with local sponsors in other markets as well. Our capital can be patient, which is a big advantage in a distressed market with high uncertainty.
- New sources of preferred equity and mezzanine financing. New streams of capital are flowing from owner/operators who have created new buckets for investing as their proprietary deal flow has become thinner or is not achieving satisfactory risk-adjusted returns, says Cody Kirkpatrick of Berkadia. Other private equity investors looking to minimize their risk are also now providing preferred equity and mezzanine financing for new development, acquisitions and refinancings.
- New sources of financing for green energy improvements. A relatively new entrant in the capital stack has been Commercial Property Assessed Clean Energy (C-PACE), which is a form of off-balance sheet financing repaid as an assessment on property tax bills. Depending on your point of view and inclination, PACE can be either a debt or equity replacement. The financing can be used for new construction or renovation to fund energy efficiency and renewable energy improvements ranging from the building envelope to the roof to the HVAC system and more. Notably, PACE financing can even be secured retroactively.
- New non-traded REITs. Notwithstanding news reports of investors seeking “early withdrawals” of their investments in some non-traded real estate investment trusts, the sector including a new wave of players has continued to raise massive amounts of money in 2023 for investment in multifamily and commercial real estate, according to Robert A. Stanger & Co. Expect non-traded REITs to be circling the wagons for distressed deals in the current market as more weakness is exposed.
- New debt funds. As highly regulated national and regional banks have pulled back (though certainly not halted) their commercial real estate lending, investment funds including debt funds have proliferated, with about 30% more fund managers in the market today than in 2018, reports Preqin. These funds are sitting on billions of dollars of capital to potentially be deployed in real estate. Of course, some funds may struggle to meet their target return rates in the current environment, but the point is debt financing from alternative sources is available for many borrowers.
All that said it’s important to note that at times like this in the real estate cycle, it’s not just money that’s important … friends are too. The relationships you have in the industry are worth their weight in gold: broker relationships, lender relationships, investor relationships, and more. People who are familiar with your track record and trust your judgment are much more likely to be supportive of plans for your properties that are practicable.
It’s a trying time for commercial real estate, especially syndicators in the small to middle market, but there’s sufficient equity and debt available to save the deals worth saving and support investments that may be on the margin. Certainly, based on the industry’s track record of surviving past recessions and even higher interest rates, we know this too shall pass.
Tim Donovan serves as managing director of investments with Midloch Investment Partners, a Chicago-based real estate investment firm and fund manager that focuses on joint venture equity investments. Midloch invests in multifamily, industrial, retail, and office properties, partnering with local developers and operators using a value-add strategy.
