Distressed Debt, Transaction Structures, and Opportunities: Real Estate Trends in 2024

Michael Wachs:

Ralph. It's a pleasure and looking forward to our conversation.

Ralph Estel:

Alright, Michael, obviously you have a extensive experience here. You've probably seen a couple downturns and with your experience in the stress day, you probably had a unique viewpoint there. So I'm curious, what do you see for the Philadelphia marketplace in 24?

Michael Wachs:

Well, I would say yes, I have lived through several downturns and I think it is all really dependent on how the banks treat or how the regulators treat the banks as to how the banks are going to treat their clients as to what opportunities open up with regard to the capital markets. And I don't think Philadelphia is really much different than the country in general.

Ralph Estel:

We've had a number of clients who have wanted to make investments in Philadelphia and unfortunately haven't been able to find any opportunities over the past couple of years. And mostly because the sellers are kind of holding onto that high watermark valuation that they had pre pandemic and are unwilling to discount prices. Do you think the prices will start to come down?

Michael Wachs:

That's again dependent on how the capital markets treat the investors because investors are looking at their investments as a risk adjusted return and real estate is an alternative investment vehicle. So it really depends if there's going to be capital available to them or they have to use more capital as a result. If they want the same return on their equity, it's going to go up unless they can leverage things higher, I just would drop back. When you talked about Philadelphia, I mean there's a whole bunch of other factors besides the capital markets and I didn't really say that. Well, Philadelphia is different and I talked about capital markets. I'd also say that Philadelphia has a significant supply of multifamily coming online this year, which will impact that. We've also got a very high vacancy rate in the office sector, which we have across the country, but I think there's a number of other structural factors outside the capital markets that will impact where the opportunities are and who gets to benefit and who loses from those opportunities.

Ralph Estel:

With the amount of multifamily coming online, do you think we're kind of getting to the point where we're oversaturated, especially since if office buildings are empty, jobs really aren't here anymore? Is there a reason to be in Philadelphia?

Michael Wachs:

Well, I think the question is what does oversaturated mean? I mean if we just talk about housing. No, I mean this country is short supply of housing and while it has been easier to get entitlements and approvals to build housing in Philadelphia, it's been very difficult in the suburbs. So when you look at it by a submarket, you might say, well, there's too much product in that submarket. But with multifamily it's very simple. The leases are a year, but they're really in a sense almost like month to month. So as the market demand increases, rents go up as market demand drops or supply increases. Okay, rent drop. So what's going to happen is they'll fill, it's just they're going to fill at a different price point than what some of the initial investors underwrote as to what their and which will impact their returns.

Ralph Estel:

Your firm has invested in assets to be a mezzanine financing rescue capital and other distressed debt transactions. What recent trends in both opportunities and transactions have you seen?

Michael Wachs:

You're talking about recent trends or just over time?

Ralph Estel:

Maybe over time, but especially in the past years.

Michael Wachs:

Okay, well put it in context. We have always been a value add, value creation shock going over the expanse of my entire career. We moved into distress debt investing at one point because we saw that was the opportunity to create value. Similarly, back about seven or so years ago, we moved in providing preferred equity and mezzanine financing because as a risk adjusted return as opposed to buying the fee interest in the property, we came in with equity below us and we were still getting very good solid returns, but there was a downside protection that there's someone else's equity underneath us to protect us. The market has changed in the last six months to a year. Again, the runup in interest rates both on a short-term basis and on the long-term basis has impacted that financing area that is providing Mez or prep equity because it was typically underwritten by us and others who do it as a short term that is one to three year timeline at which point you were going to be refinanced by a permanent loan. And with the runup of interest rates, the permanent loans proceeds aren't sufficient to the underwriting that was done originally to take out that measure pre and sometimes today to even take out the original construction loan. So I don't think the same business model that was applied over the last five years can be applied going forward.

Ralph Estel:

So that's for mezzanine funding and risk capital. But what about the stress debt? Do you see any assets coming onto the market where it's just they can't refinance and there's an opportunity to maybe take a free interest in it at a bargain price? Do you see any of that?

Michael Wachs:

Well, no one knows what a bargain price is until it's aate point. Years later when you go, they look back and they go, wow, we got a bargain. Things traded a market price. No one is stealing anything. And that said, my opening comment about what the regulators do to the banks is how the banks will treat the borrowers. In the first recession I went through in, it was a banking crisis back in the early nineties, the regulators put a lot of pressure on the banks to get these assets off their books and they sold them at deep discounts. Now at the time, no one realized what deep discount was until years later. Looking back they did the last time around it was in the mid two thousands it was they used to call pretend and extend. And so the banks didn't have the same type of regulatory pressure.

As a result, they kept lending or kept their loans on the books. As long as the borrowers could service the debt, they would restructure them and rewrite. We're just at the beginning now of this cycle in terms of how are the banks going to deal with it? And there are a significant number of folks who have done repositioning or ground up construction loans. Let's just take multifamily for instance, since there seems to be more of that than anything else in our market. And they've gotten to the point now where they underwrote an interest rate on a takeout that is now 300, 400 basis points higher. As a result, the loan on the takeout doesn't repay the lender, the constructional lender. And the real question, will the constructional lender, how will they deal with that? Or how will the borrowers deal with that in terms of are they going to have to come up with capital, which is where we go with where's the opportunity?

And that it could be that all these people that raise distressed debt funds and the other platforms that are providing financing capital to the real estate industry, they may be now stepping in and there's a good side amount of liquidity on the sidelines and that liquidity may go into those kinds of, whatever you want to call 'em, bridge financing, be in between the new loan and the equity with the hope on their repayment that the values will increase over time or interest rates will drop again, allowing the sponsor to refinance or they simply step into the equity position and the sponsor ultimately loses more money down the road, but maybe not this week.

Ralph Estel:

Kicking the can down the road there for a little bit. Alright, so you just completed project in Cal Hill Street and I think you just said you started another one. How are those projects going?

Michael Wachs:

Well, our first project's 181 units and we were just finishing that up. It's coming along well. Although slowly we had some issues with equipment getting delivered and some other issues that have pushed us a little further down the road. But at the same time, we feel confident enough in the neighborhood and that particular sub-market, despite all of the product coming online across the city of Philadelphia that we started another project a block away at 12th and Calla Hill, that's 144 units. And so that actually just started construction last week.

Ralph Estel:

Were there any issues that you ran into that were kind of unique to Philadelphia?

Michael Wachs:

I don't know if they're unique to Philadelphia, but in terms of where as a city in developing the city, but I think that Philadelphia has had, it's a difficult process to get through. The suburbs are difficult too, but in a different way. In the city there are rules laid out. You're supposed to step on first base, then second base. If you do all that, you go around the bases. The problem is getting around the bases can take you significantly longer than you would originally think they should. So I would say the approval process here can be difficult, different than the suburbs and the suburbs. There's no clear path depending on the municipality and whatever. And those projects can get held up as well. The city just has, look, there's a new administration and they just got sworn in. Cheryl Parker. We're really looking forward to her taking over and to her administration and we like to see them start to correct some of those internal issues to make doing business in Philadelphia easier.

Ralph Estel:

What opportunities are you seeing in the future for multifamily or office space and the city?

Michael Wachs:

Let's start with office first. I think that, as we said, I think today in the Wall Street Journal, there's an article that across the board, like one fifth of all commercial office space is vacant across the country. Philadelphia is no exception. And then the region, Philadelphia with the after covid, et cetera, people coming back to the office has been tough. But we've just seen in Philadelphia, Parkway has done a phenomenal job during Covid, actually before Covid after, sorry. They started after Covid building a new office building for Morgan Lewis, and then they just started a second office building for Chu. That's brand new office space designed. It's new, it's exciting, it's great. So that is the future of office that is, I think maybe it's a little bit under demolished as opposed to overdeveloped, but I think you're going to see more specialty buildings. I mean that give the amenities and the things people want to enjoy working there because companies are going to pay more for rent to lure their people back so that it doesn't impact their corporate culture.

That's a whole other discussion of the time. The multi-side. There's a lot of product coming along this year. I don't think that there's a lot of opportunities for other people who have not broken ground to build new this year. But I do think that there will be a lot of opportunity for value add investors to take over projects from other sponsors who, like I said, underwrote to a different world and there's been a paradigm shift and they now will have to get out. And so there'll be some winners and some losers on that. And I think the question is how big will those winners and losers be with all the capital that's sitting on the sideline that's going to come in here. So that may be the savior for a lot of these sponsors that now have projects that they either started that they bill and now are trying to fill or that they bought and they repositioned with the idea to pay off the bridge loan and put permanent financing on. So I don't think it's been written yet.

Ralph Estel:

I guess the big question's going to be, what is that bargain price? Right? And no one knows. Alright, thank you Michael for taking the time to share with our audience. And thank you for our listeners for and thank you to our listeners for joining us on this episode of Breaking Ground. Subscribe to stay notified of new releases and listen to past episodes for more insights to the real estate industry.

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