CMBS workout complexity could slash 20% IRRs to 8%

With a wave of commercial real estate debt restructurings building, real estate veterans warn first time investors to be prepared for a steep learning curve and the impact of massive fees on returns.

The complexity of many distressed real estate debt deals – and the expenses involved in closing transactions – could severely dilute returns to the point where a 20 percent IRR could turn into an 8 percent IRR, a distressed debt forum heard last week.

Head of CMBS capital markets at Jeffries & Company, Mark Green, speaking at the Debtwire Distressed Debt Forum in New York, said that investors were often unprepared for the realities of buying a distressed note, not least the “massive fees” associated with acquiring the debt. Green stated that a 20 percent return could ultimately end up being severely diluted to as little as an 8 percent return once expenses have been accounted for, adding first time buyers of CMBS are often unfamiliar with documentation, structures, and waterfalls of CMBS deals, and the time commitments required to understand the nature of such transactions.

“There are great opportunities,” he said. “What’s probably a little challenging is to actually find the securities, to understand the real estate behind it, to underwrite that actual securitisation … unfortunately it’s a lot more complicated than just buying equity in the real estate world.”

CWCapital’s president David Iannarone, speaking on the same panel, stressed the importance of having attorneys to explain language regarding investor rights. “You really need to hire counsel,” he said. “One mistake in those documents could cost you a lot of money.”

Conflicts of interest between co-owners in a CMBS workout deal was an issue facing investors, according to Green. While one holder may own a significant amount of paper within the capital stack, others might own just one certificate. “To get people to come together to agree on one strategy is very challenging,” he said. “That in itself has taken roughly eight to nine months.” Even after a strategy has been agreed upon, disagreements over which advisors to employ can cause further complications.

Regarding loan modifications, the good news, Iannarone said, was that modifications were once again being worked out, as opposed to resorting immediately to foreclosures. “It wasn’t too long ago that the loan would come in and the borrower would just be throwing you the keys,” he said. Borrowers now, according to Iannarone, are both more optimistic about value ultimately returning to their properties as well as the availability of capital to support them in the meantime.

“One of our number one rules is, if you want a modification, you need to be bringing something to the table other than just your hope,” Iannarone said. “You need to come with cash and believe in your property by putting your wallet where your property is.”