Meadow Partners’ Jeffrey Kaplan on Rescue Capital in Real Estate
“We’re serving as a friendly ‘white knight’ capital source,” says Meadow Partners’ Jeffrey Kaplan
How does Meadow Partners define rescue capital?
We define rescue capital as helping a borrower with a debt problem –such as a maturity or repayment issue – solve that problem with its existing or new lender. Usually, to solve such a problem Meadow Partners makes a structured debt or equity investment, typically mezzanine or preferred equity, alongside the borrower. We’re serving as a friendly “white knight” capital source, most frequently providing rescue capital in a transaction that’s right sizing its existing senior loan by paying it down and/or increasing the rate. We also refer to rescue capital as “gap capital” because the capital fills the gap between what was previously financed and what can no longer be financed by the senior financing provider. From a pure risk/reward perspective, we are finding that we can execute rescue capital transactions today that can provide equity-like returns while only taking on debt-level risk.
How does Meadow Partners define distressed investment opportunities, how does that definition differ from rescue capital opportunities, and between the two, where are there more opportunities to invest presently?
We view rescue capital and distressed opportunities as separate and distinct: they are different investment themes with different return profiles. While our roots are in distressed investing (albeit if both an asset and its balance sheet are distressed, the opportunity may be too distressed for us), we have not seen pure financial distress since immediately following the Global Financial Crisis (“GFC”). At that time, we were buying non-performing loans on a loan-to-own basis as well as failed condos, which we bought cheap enough that we could operate them as rental apartments. While we are starting to see an uptick in pure financial distress today - we recently acquired a London apartment property that was built as a for-sale condo that we purchased from a forced seller - and expect there to be an increased opportunity set moving forward, it is still early days. Today, however, we are finding more rescue capital opportunities and see that opportunity set growing at a faster pace. The best part about engaging in a rescue capital transaction is that we can invest in well leased properties that are fundamentally sound. While the balance sheets of the properties are distressed, the properties themselves are established and operating well. As such, we see a big difference between a “distressed property” and a “distressed balance sheet.” To be clear, when we are providing rescue capital, we are not doing so for “distressed properties.” Rather, we are looking at properties that, in most cases, the borrowers were recently planning cash-out refinancings, but today can’t access cash-neutral refinancing. So, we are filling that gap, which is the piece of the puzzle that we believe is most attractive. Throughout our firm’s history, we have always executed these types of recapitalizations and restructurings – rescue capital deals so to speak – the difference is that now the properties aren’t really broken (or as broken as they once were), only their balance sheets are.
How does Meadow Partners differentiate its rescue capital strategy from that of a traditional lender?
We don’t think of ourselves as a lender because while we make debt investments, we do so with an equity investing mindset. As experienced real estate owners, we bring our ownership mindset to every investment we make, whether it be a debt investment or an equity investment. We strive to be good, true, constructive partners to our borrowers -- not just by providing capital, but by adding value at the property level – because we understand firsthand that real estate transactions never go exactly to plan. In our experience, borrowers view having a flexible partner who recognizes a deal process can evolve, as a net positive. Unlike many traditional lenders, we are very specific about the types of properties or borrowers with which we transact, consistent with the way we operate Meadow Partners’ business overall. The rescue capital deals we are engaging in are not loan-to-own; we are not trying to take over a property. Furthermore, we are never just transacting for volume. Often, we’re already familiar with the properties and areas where we are evaluating an investment. Finally, when structuring the loan itself, we take a more equity-focused approach than a traditional lender. We do not have a standard set of loan documents like a lender would, which we find once again gives us more flexibility, and we spend more time working on the fine print of the intercreditor agreement. That intercreditor piece is the most important to us because we need to protect our downside risk while also ensuring we have built in flexibility with the senior lender to fix a problem if one arises.
Can you provide an example of your rescue capital strategy at play?
When evaluating rescue capital deals, we typically look for cash-flowing, fully leased properties. However, there are also times when we will invest in a property that needs to be leased-up if we have enough conviction. A perfect example of such a property where we put our rescue capital investment strategy to work is Kingmaker House, an office-to-residential conversion project currently under construction in New Barnet, London. We had originally looked at the property from an equity investment perspective, but it was trading above the level at which we valued it, so we passed. We continued to follow the asset and eventually its existing lender was unable to manage its loan. The sponsor needed a capital provider and came to us to see if we would be interested in acquiring the lender’s mezzanine loan. Since we were familiar with the property from the diligence we had done when considering an equity transaction, and are very active in the London residential market, we were highly interested in engagement, acquiring the mezzanine loan, and open to more risk from a lease-up perspective. Following the Kingmaker House transaction, the same sponsor came to us for an additional mezzanine loan on another property.
How does Meadow Partners source rescue capital opportunities and how do you evaluate your borrowers?
We primarily source rescue capital opportunities similarly to how we source any other investment opportunity. We are typically evaluating the same types of properties and operators we would evaluate investing in and partnering with on an equity investment. The biggest difference in sourcing, however, is that we are getting a significant amount of direct inbound calls from senior lenders asking us to serve in that “white knight” role –it’s a proof of concept for what we’ve been doing. Of course, we are also seeing consistent deal flow directly from brokers, developers, and other market participants.
Have you seen lenders change their approach as the U.S. Federal Reserve and other banks continue to raise interest rates?
Absolutely. Our thesis behind the rescue capital opportunity today is based on what has happened in the lending market. Lenders are almost numb to how far and how fast interest rates have risen. Six months ago, the Secured Overnight Financing Rate (SOFR) was close to zero and now it’s at four and change. Rates are increasing at an insane clip. The other factor is that spreads have widened over the same period. Historically, when interest rates had gone up, spreads had narrowed, helping to partially offset the increase in the base rate. That’s not the case today and that’s just the backdrop for the real issue however, which is that the Fed and all regulators are essentially telling banks “risk-off.” While regulators may not be stating that explicitly, they are creating penalties that are ultimately deterring banks from making these types of real estate loans. The environment today, however, is very different to that of the GFC, when the issue was a general economic problem leaving institutions unable to afford to take the necessary write-downs. This time around, while bank scan afford to take a hit, regulators are encouraging banks to avoid that situation completely. We are seeing banks rejecting loans or giving very strict deadlines for paying-down and re-margining for borrowers with whom they’ve had longstanding relationships. The other important piece is that following the GFC, a lot of traditional debt funds stepped in to bridge the gap the banks couldn’t fill. Whether its interconnectivity in the financial system or simply the fact that the funds are levered themselves, debt funds aren’t really a competitor today for rescue capital deals today.
How long do you expect the current opportunity set to persist and across what property types?
There’s a lot of capital on the sidelines that can be put to work today, but we are trying to be patient and prudent because we think it’s very early innings of a downturn. Looking at the big picture, we think this opportunity set will last for another couple of years, so we don’t want to catch the falling knife or rush into the opportunities available today because we think the market for our strategy is going to get even better. Having said that, we’re actively evaluating a dozen deals in New York City and London right now. We like some properties but are waiting for pricing of our rescue capital to become more favorable, which we expect it will. Certain other properties are too distressed at the asset level. With respect to property types, office buildings have had the hardest time securing cash-neutral refinancings. We are evaluating several opportunities to finance trophy office buildings that have long enough lease terms and cash-flowing credit tenants to become safe, smart investments for us. We look at lease-up risk in apartments much differently—especially if it’s a new build. For example, some of the rescue capital opportunities we are evaluating involve rolling a construction loan on an apartment building into a permanent loan. That level of risk – one where we are bridging a financial gap while a stable property is leasing-up is tolerable.