Omega Poole
So, good morning everyone. I’m delighted to welcome you this morning to the FORA breakfast webinar on investment in distressed real estate assets. My name is Omega Poole. I’m a partner in the real estate group at Mishcon de Raya and I also head up our debt advisory practice. I am joined this morning by Alex Cuppage from Sherman Financial Group and my fellow Partner, Nick Strutt who heads up the real estate finance practice at Mishcon de Raya. In a minute I’ll ask Alex and Nick to briefly introduce themselves. But just to give you a sense of where we’re heading over the next 55 minutes, we are going to look and touch upon an overview of the market with a particular focus on distressed opportunities. I’ll briefly talk about what I’m seeing in the real estate debt space. We’ll also look at ways to potentially access distressed investment opportunities and some of the pitfalls that might arise. Please feel free to raise questions using chat. If you’re trying to get those in early on we’ll look to address those and we’ll try and get everything wrapped up by the end of the hour. So, let’s start with some introductions. Alex, perhaps you could go ahead, just briefly introduce yourself and Sherman to the group.
Alex Cuppage
Morning everybody, my name is Alex Cuppage. I lead the European Investment Team for Sherman Financial Group. We are a US-based family office. We… most of our income comes from financial services so, our real estate allocation is very much focused on distressed, opportunistic assets. We started investing in real estate in the last cycle just after 2008/9 predominantly focusing on distressed land acquisitions. Our typical cheque sizes range anywhere from 5 million to 200 million.
Omega Poole
Thanks very much Alex. Nick, perhaps you might like to introduce yourself and also our firm to the group.
Nick Strutt
Yeah morning everyone my name is Nick Strutt, I am one of Omega’s partners in the real estate team and I head up the finance division at Mishcon’s which has a full service property theme in all aspects of property. My day job is property finance, acting on both the sponsor and the lender’s side and after the previous downturn I did a lot of debt restructurings and distressed debt acquisitions and actually did some debt restructurings acting with Alex Cuppage in his previous life as a banker.
Omega Poole
Thanks so much Nick. So, perhaps let’s start by setting the scene. Alex, could you share with us your views on where the market is now, post-Covid. Perhaps some potential opportunities to acquire distressed assets and any structural changes that you’re seeing.
Alex Cuppage
Sure. I think a good starting point is really to kind of play back to the 2008 crisis. You know, we’ve been speaking to a lot of people in the industry and we see it kind of falling into two camps. There’s the groups that think this is, yeah, we can take out the 2008/9 play book again and there’s others that think there’s far more structural changes at bay. So, I think we compare 2008, you know, 2008 was very much a leveraged asset-driven crisis. Where you saw liquidity issues at both the lender level and the sponsor level asset. The private equity back in 2008 played a much smaller role and we were going to start the high-interest rate environments. You compare that to today. Over the last 10 years dry powders are at an all-time high, mainly driven by mega private equity. You know, as of Q4 2019 dry powder globally stood at over 550 billion and banks are in far better shape today than they were in 2008. You know tier one equity is at an historical all-time high. We’ve had 10 years of technology and behavioural change in assets and over the last I would say two to three years and primarily driven now by Covid you know, ESG has played and is going to continue to play a much bigger role in terms of institutional investments. So, with all that in play, we’ve really kind of spent the last three to four months taking a step back and looking at where we think potential distress could come from. We have tried to look at it from an occupier’s perspective. So, we have big investors in office. We have probably spent… we have talked to major institutional occupiers. We have spoken to the chief executives of some of the largest cloud computing firms and tried to understand well, what have they seen with Covid and what were they seeing pre-Covid. And I think where we’re kind of coming out on this is you know, Covid is really just accelerating trends that were already occurring and major structural change won’t be everywhere but we need to understand where that’s going to be. So, in terms of maybe just going through individual asset classes, we don’t think office is going to be completely replaced, but if we’re looking at an office building today we don’t know what the rental value of that office building is going to be in three to five years’ time. We don’t know what the Capex is going to be on that building in three to five years’ time. Retail, we felt that pre-crisis or pre-Covid you know, you were actually seeing some great innovation between online and offline particularly coming out of the US. Post-Covid you’ve seen a huge amount of change to online. Again, what’s going to be the impact on retail going forward?
Omega Poole
So, Alex, would you say it’s fair to say that all asset classes are going to come out of this in the same way or that all asset classes are not created equal in this current situation?
Alex Cuppage
Yeah. I just think in the short-term it’s going to be very difficult to really understand the kind of true impact. So, we’ve really been trying to look at well what’s the liquidity drivers in the market here in the short-term and how can we kind of position ourselves for potential distress? So, one way that we’ve kind of looked at it is you know well, who are the potential people that can invest into this market? So, you’ve got public listed real estate companies. We doubt that they are going to be able to have a longer-term focus versus their share price to the longer-term changes that are needed. We look at kind of private equity funds who are again quite short-term focus in terms of the returns they’re having to achieve and we would again question whether they have the in-house asset management capabilities and the longer-term focus to invest in assets gross of the change. Where we think the real opportunity is actually to partner invest with proven real-estate companies and asset managers that have a very strong track record of managing change through cycles and can take a medium to a long-term view. In terms of some kind of distress investment themes you know, we’re kind of… where we see potential distress coming and again this is evolving over the months, you know public market pressure you know, are there a number of REITS that can’t manage the kind of short-term share price versus the longer-term need for a change in their underlying real estate assets. So, looking at some kind of public to private initiatives. We’ve been focused and this is more in the US than in Europe but it would be interesting to hear from you, Omega whether this will play out in your… but whether there’s going to be some distress from the alternative lenders. As mentioned, the pillar banks, the core tier one equity is pretty strong. We don’t see a huge amount of distress coming from that sector. But you know, alternative lenders that have got aggressive on advanced rates have underlying wholesale funding in place and whether that could get pulled and fundamentally, don’t have the asset management skills at a platform level that they may need to kind of work with borrowers or where they take over the assets. Two of the key areas that we are really excited about are investing in kind of super-prime generational assets and repurposing them for the new world, whatever that may be. You know, we’re starting to see some opportunities now coming from vendors of these assets, where they haven’t traded in 20 to 100 years. In major cities like London and New York and we can get in at a pretty low basis relative to historical values. To do that though, you really need to take a 10 plus year view. We’re very excited about that. The other areas that we’re really kind of focused on is where we see a huge amount of Government support and stimulus coming in. So, to give you two examples, affordable housing, we just think is the number one play coming out of this crisis and also care homes. Albeit with the care homes it’s operational real estate so you need a very, very strong partner there. In terms of the kind of characteristics, we don’t really expect a huge amount of growth short to medium-term. I go back to the point about rental growths and what is the true underlying long-term rental value of an asset. I think short-term you probably won’t see a decrease in rents, but maybe in three to five years you know, we could see a massive fall in rents if you haven’t repositioned that underlying asset for the new norm. We think any kind of asset or whether it’s an operational real estate business like hotels, student accommodation, care homes, we want to see 24 months liquidity. We don’t see a vaccine coming any time soon with Covid so we’ve got to learn to live with this and manage it. So, bringing 24 months liquidity to an asset or an operator we think is a great way to enter. In everything we look at we’ve got to be prepared to spend capex and that capex number is often unknown because we just don’t know how we’re going have to reposition the asset. So, again focusing on again what’s your day one purchase price or how you enter that in a structured way is very important to us. Ultimately…
Omega Poole
Really Alex, we’re talking about moving back to the absolute fundamentals of real estate management in terms of all of those opportunities and areas of the market that you’ve outlined. Going back to working with those people who’ve got those real asset management skills seems to be the crux of unlocking a lot of those situations that you’re looking at. Would you say that’s fair?
Alex Cuppage
Yeah. I think look if we go back to 1900s. Like pandemics, improvements in technology and science have always changed cities and buildings. The one thing that’s kind of stayed certain is focusing on the fundamentals and that is not going to change here so location, buying well, having a unique asset that is flexible and adaptable over the near to longer-term, focusing on driving strong cash flows. That’s going to be as important as ever but really you know where I think people may fall down is trying to understand the changes versus structural changes – sorry, understand the short-term trends versus the structural changes. That’s going to be absolutely key and I think also managing expectations. So, one very strong investor that we know actually posted me two weeks ago that they don’t believe there’ll be any distress that kind of comes to the market. They think Government stimulus will prop up the market. The interest of institutions won’t let rents fall and assets values fall over the near term. So, under that scenario there won’t be a huge amount of distress. However, the way that we look at it we’ve got… we’re going to have low interest rates for the next five maybe 10 years. Certainly over the next cycle and that’s kind of following on 10 years of low interest rates. There’s a huge amount of dry powder so, I think it’s fair to assume that you know, at a broad level you have to manage expectations that returns are going to be lower than what have been expected in other distress cycles.
Omega Poole
Thanks very much. Perhaps then I should maybe briefly pick up on the point that you were making around the real estate finance side of life as I think you mentioned at the start banks and the market as a whole was holistically across the board in a much better position now than it was before the last financial crisis. Obviously, this latest crisis has been driven by the pandemic rather than the banking side of things and the CASS Commercial Real Estate Lending Report for example, showed that 40% of the leverage in the commercial real estate space was under 50% - 40% of the loans were under 50% leverage which shows that across the piece and obviously, this is not talking about individual positions, the market was in a better place. Also, just before Covid compared to before the global financial crisis, we certainly hadn’t seen the really high levels of leverage and very covenant like structures that we had seen characterising 2007 and 2008. And as you mentioned Alex, the capitalisation of the lenders is certainly much better now as a result of the regulatory changes that have been put in place than it was before the last crisis. So, the lending market for real estate is definitely not the same as it was when we hit the last crisis and the other big change has been that the banks no longer dominate the market completely. So, obviously as you were mentioning there has now been a proliferation of lots of alternative debt funds and also the pension and insurance institutions that have come into the market and now make up say 30% of all of the real estate finance lending. So, we’re not just reliant on the banks working out their positions or managing their positions we also have a much sort of broader breadth of liquidity from a finance perspective that hopefully should mean the market is more stable. With that as a sort of background we have actually seen a number of alternative debt funds pull out of the market so, although it’s the case in Europe that such lenders are not so reliant on wholesale finance lines that you were referring to that characterise US debt funds, there have been a number whose own finance lines have been withdrawn and so they’ve completely retrenched. We’ve also seen the clearing banks become much more conservative and effectively focus on their existing books managing those positions working with their current clients and customers and also, really, almost overwhelmed by the Government-backed schemes where they’ve had to devote a lot of resource to underwriting those as they’ve sort of evolved over time. But there is a huge volume of debt that will need to be refinanced this year and next year – about 43 billion according to CASS. So that in itself could trigger potential opportunities in the distress space and so alternative debt funds could well be a source of potential opportunities. The refinancing of this debt as clearing banks in particular focus on their existing clients and generally become more conservative could be another potential opportunity. And interestingly actually although I think the view was that or I think the view might be that banks might not be such a rich source of these sort of work-out opportunities as they were in 2010 say. Sharon Quinlan who heads up corporate real estate or corporate banking at HSBC made the comment the other day and I’m paraphrasing hugely but effectively the point was because of all the regulation and the new changes that have been brought into place, actually banks hands are tied to some degree in terms of the flexibility of the work out options they can go through. Obviously, they’d prefer to have, to be as flexible as possible when working out positions but actually a perverse impact of the new regulatory regime introduced after the crisis is that they may be more restricted than they otherwise would have been. Nick, perhaps we could come to you and talk about obviously, we’ve touched on a market overview that Alex kindly provided. I’ve briefly talked about some of the, the state of play in the finance from a finance perspective but what are the different routes into investing in distressed opportunities?
Nick Strutt
Yeah. Thanks Omega. I’m just going to do a very quick run-through of the different routes in. So, there are various points of entry legally when it comes to distressed acquisitions. Each have their own sort of merits and pitfalls and the weapon of choice is going to be very much driven by the dynamics of the particular deal. I think it’s fair to say that one of the most common points of entry in my experience is debt related. Secure creditors obviously hold a lot of cards so stepping into that position is most common. In terms of in the last downturn we did see a lot of debt acquisition and I think coming back to what you were saying Omega, in terms of the regulatory pressure that’s put on the banks and you know, what’s happened recently with the new Insolvency Act that came into play last Friday which actually hamstrings them a bit in terms of enforcement, I think they’re going to be squeezed in to selling off their loan book because the loans are more expensive than they were to hold previously and they are going to find it difficult to enforce. So, I can see a fair amount of opportunity coming in that regard. In terms of a debt acquisition strategy they sort of they follow two forms. You can either sort of acquire to loan to own so to speak. So, using security to take control of the asset. Or you can just wait on a redemption. So, lining the delta between the acquisition price of a loan and the redemption value of the loan. The forms of purchase themselves can take various different forms. It could be a wholesale purchase of a whole book albeit that tends to be the preserve of the large funds like Starwood and Cerberus whose MO is buying loan books. It could be the acquisition of a sort of wholesale funding alliance that are loan on loan acquisition where you take out the lender to the lender to take control of the lender and thereby take control of the underlying positions. It could be a bespoke acquisition of a single loan which is perhaps relevant for the audience here. Or it could be a secondary purchase of a loan coming out of a wholesale acquisition so, Cerberus buys a book and then sells off instead of individual positions to separate purchasers. As an alternative to buying a debt, as Omega mentioned, there is a lot of refinancing needed at the moment and as another way of entering people are, and we’re seeing this already, people are refinancing existing positions attracted by a higher yield with potential to potentially enforce at some point in the future. And actually what we’re starting to see already and we’ve written this in deals like this already whereby the lender has a hard bait conversion right whereby they can convert a loan into equity at some point in the future. So, you’ve got a sort of inbuilt sort of loan to own structure. A variant of becoming the lender yourself, as Alex mentioned, there is, especially in some of the new debt funds, a sort of paucity of asset management skills and what we saw in the last downturn was a lot of people making a turn in terms of JV-ing – entering a joint venture agreement with a lender – whereby the borrower lacks funds or lacks expertise and you enter into a joint venture agreement whereby you provide those funds and/or expertise and get a profit share at the end, shared up with the lender and the borrower will get some sort of sliver of equity to kind of keep them sort of interested. In terms of non-debt related forms of entry, they boil down into consensual and non-consensual so non-consensual being sort of buying direct from an administrator or a receiver and then a consensual just being consensual M&A. In terms of the sort of main legal considerations which sort of influence the way in which a deal is structured and will also affect the pricing of the risk, the principle issue is really diligence. If you’re buying the debt you can diligence the finance documents but you’re going to get a very limited warranty coverage from the seller so, from the existing lender. From experience that’s very much a game of cat and mouse and we’ve come across a couple of instances where underlying issues haven’t been covered by warranties and have come up after the event. So, it’s very much caveat emptor on loan acquisitions. And the diligence of the underlying asset is obviously difficult because the borrower won’t be involved and at most you’ll get sort of access to some historic diligence reports on a whole harms basis. You may get reliance but more often than not you don’t. If you’re re-financing or JV-ing that’s a different story because obviously the borrower’s involved and you can get a proper home-side sort of legal DD process done, and an evaluation process. In terms of other sort of relevant considerations, it’s important to note that sort of loan to own as a strategy by itself is not entirely straightforward. It’s a common misconception that you, as a secure creditor, can simply swap the asset for the debt. There is an ancient legal principle called foreclosure where you can do that but it’s never used. You have to get Court approval and it won’t be granted. So, what you have to do is effectively buy that asset through an enforcement process and the sale price will be net – you can net the loan amount from the sale price. Most likely it will be a receivership purchase if it’s a single asset. Again, that sort of raises a couple of points for considerations in terms of the receiver will need to get fair value for that asset on the sale so the best price reasonably attainable in the market and if the asset is sold to the lender itself then the burden to show that you’ve achieved that value or paid that value resides with the lender or receiver. And it’s also important to note that the borrower will retain the right to repay the loan right up until the point of sale. So, you could get all the way down the line, you could buy the loan, you could enforce the security and then at the last moment the borrower repays and you lose, obviously, you get your loan back but you lose the asset. And as a final point to note, the Insolvency Act which came in last Friday imposes some restrictions in terms of how you can enforce. Most relevantly there’s now a four week moratorium that the borrower can instigate before enforcement action can take place. So, it’s not… it used to be the case that you could effectively enforce within 24 hours of default of payment. That’s now not the case. So, it just needs to be borne in mind in times of sort of pricing of risk. That’s it from me, it includes rather a whistle-stop tour and I could have spoken a lot more about everything I’ve spoken about there. So, if anyone’s got any questions please do fire them my way.
Omega Poole
Thanks so much, Nick. So, I think that provides us with a really good overview of the different routes in and some of the pitfalls to look out for. Alex, perhaps we can come back to you? So, once an investor has done their analysis of the market and in particular tried to identify those trends which are structural versus short-term, and maybe is considering the different routes in that Nick was just outlining for us, are there any particular challenges that arise from the current Covid situation or maybe to turn that around, how would you guide people to go about trying to identify these opportunities and what should they do to sort of try and unlock them?
Alex Cuppage
Thanks Omega. Maybe I’ll try and kind of look at this from a family office perspective. So, it’s you know, I keep going back to kind of the dry powder points. For family offices to kind of come in direct and compete against larger private equity funds who you know, our biggest challenge is we’re targeting similar level returns to the opportunistic funds. In some cases we are able to compete with them in terms of the cheque size as well but we’re not under pressure to put money out the door you know, we’re not drawing management fees so, we’re never really going to be able to compete with them on day one price. And maybe kind of thinking back to the last crisis when I was working out a 5 billion debt book and when I look back to that crisis there were very few amazing deals that we got but the ones that were achieved were bilateral deals where you know, Propco’s and other family offices had built really strong relationships with us on the debt side and they focused very much on what they could bring to the table, what solutions they could achieve with us. I think that’s really as a family office you’ve got to have some sort of competitive advantage. You’ve got to identify a problem. You’ve got to bring a solution to the table and whether that is kind of as Nick talked about, going in via the debt or the lender or it’s actually going to the existing vendor today and solving their problem. Frankly, quite now, where there is distress it’s bringing liquidity, it’s bringing liquidity to the table. It’s giving someone 24 months runway to get through this current crisis and it’s backing the existing vendors to achieve their business plan and you know, it’s giving them some upside at the end of the day. I think sitting back and just waiting for distress to happen is not an option. You’ve got to be in the deal flow and the best deals I have no doubt are going to be bilateral deals as they were in the last crisis.
Nick Strutt
And just to add to that, I agree with everything you’ve said, Alex. I think the first door to be knocked upon would be the mez lenders out there. I think different to the previous, in 2008 there wasn’t much mez around because you know senior had the run of it because the LTVs were so high but in the last few years a lot of mez has been written and obviously they are high up the risk curve and the first people to feel the pain. A lot of the mez is written through new funds which don’t have, may not have, asset management experience and if they’re in leisure they’ll be concerned about as you say the 24 months of liquidity that’s required. We are speaking to mez funds already who are looking for potential JV partners who are going to come in and potentially add that liquidity and maybe add a different skillset in terms of asset management skills. So, I think that’s the first opportunity out there in terms of, if you’re proactively looking for property opportunities.
Omega Poole
And Nick, have you seen people access those kind of opportunities? Are they… because obviously at the moment it’s very difficult because we’re all constrained by many of us having to work from home. So, how are your clients looking to build up those relationships and access those opportunities?
Nick Strutt
I think it boils down to just leveraging your network, in terms of your professional network and other networks you may have. So, you can just make those connections. As I say, we’ve got… we act for various debt funds with different types of distress on their books. Some of it embryonic but some of it which will definitely come to play in the next couple of quarters and it’s just about making sort of requesting your professional networks to make those introductions effectively.
Omega Poole
I think it’s also – sorry, Alex, go ahead.
Alex Cuppage
I was just going to add you know, maybe not necessarily through the debt route, but in terms of focusing on solutions. You know, I don’t know if anyone saw that there was an article in Bloomberg yesterday talking about financial services firms and how much space they’ve been giving up pre-Covid and that’s only going to accelerate post-Covid. Most of that is technology driven, just getting rid of jobs and they don’t have the need for the same floor plate. But you know, bringing solutions to floor plates, in terms of occupation, I think is just a great way in. There’s something that we’re looking at, at the moment where traditionally it’s been a retail-led building, single occupier, great brands occupier, they need 50% less of the space and they could still trade phenomenally well at 50% less of the space. So, we’ve brought an occupation solution for the other 50% to change the dynamic of the building, change the experience of the building and when you run the numbers through it’s a win-win for them and it’s a win-win for us and the overall value of the building should increase. So, I think definitely I think of the solution as the whole long-term occupation of the building.
Omega Poole
So, we’re talking about potentially accessing opportunities by providing solutions, whether that’s potentially the runway or transitional capital Alex that you were referring to or more practical things like filling floorspace and helping to increase occupation of buildings as we see some structural trends play out. It’s interesting actually, I think Alex right at the start you referred to the dry powder on the equity side and it’s also the case that there’s significant dry powder on the debt side as well. So, real estate capital for example, they do a survey every year looking back over the previous five years and the five years up to 2018 there was about 42.7 billion. Five years up to 2019 there was 49 billion in the debt space and we’ve seen for example, 32:27 raise another 300 million for their whole loan solution. So, there’s also liquidity on the debt side but it’s not flowing as freely as it would be in a normal market. And one of the challenges I think for family offices in particular, but for everyone really, is trying to secure leverage for example, once they’ve acquired a position, whether that’s through a debt process or an equity process and trying to work out where that finance is going to come from. So, we found as I think I referred to at the start that clearing banks are really retrenched and so we even have some situations where we’re looking to buy assets for clients, the asset is already banked by a clearing bank. Our client is looking to acquire that asset and step into the shoes of that debt, but the clearing bank in the post-Covid regime is unable to consent to that just because they can’t take away any new to bank customers. So, it’s a challenge for family offices who don’t perhaps have very strong clearing bank relationships and so perhaps the opportunity for them is to work with their existing finance providers or to look to those alternative debt funds that remain strong in the market to provide the liquidity that they might need later down the line as they go through the asset management plans of the distressed opportunities that they’re looking to acquire. I suppose one burning question that I think we haven’t touched on yet is really around timing of opportunities in the distressed space. So, Alex you were saying you don’t you know, you would very strongly advocate people being proactive about looking to unlock opportunities and build up their relationships and see how they can effectively add value to new situations. But when do you think we’ll see sort of a flow of distressed if we do, come into the market in a form that family office investors might be able to access? And Nick, perhaps we can get your thoughts on timing as well in just a minute?
Alex Cuppage
That’s a good question Omega. It’s… timing’s everything right? Look, I think when Covid first hit and we are you know we are significant investors and businesses that generate ABS debt you know, we really felt kind of March/April that Q2 was going to be a very important moment in this crisis and there could be potential liquidity issues from the capital markets. That’s not played out. I can see things staying pretty stable until early next year. If we look at the US there’s an election coming in November. The Government is going to maintain a stimulus into the market you know, unprecedented stimulus announced yesterday by the Chancellor into the UK. So, ultimately until you start whilst I think the challenge has always been for the Governments to make sure that the main street could be propped up and they’re doing that with abundance. Whilst that’s happening, I see very little distress kind of coming into the capital markets which is ultimately going to drive the asset opportunities. We’re… so we kind of think look, you’ve just got to get in, you’ve got to spend the next six months as Nick says, building relationships, pounding the streets, finding opportunities, you know driving solutions and it’s just a wait and see game. No-one has a crystal ball when it’s going to come but I don’t expect any sort of major distress to occur before kind of Q1 of next year. What we are seeing at the moment is distress on paper particularly in the student accommodation sector but when we look at the fundamentals of student accommodation in terms of whether overseas students will come back, you’ve seen Stanford and Harvard, MIT put courses online. You’ve seen the impact of foreign students not being allowed back into the country in the US. I think that has much longer-term structural changes that are nearly impossible to underwrite today and your entry price is just not going to be low enough to enter. So, the distress on paper is not necessarily the best investment. I would just use the time wisely now to build your relationships and get into the deal flow.
Omega Poole
Thanks Alex. So, now is the time to be doing your thinking around the strategy and building up as you say, building up those connections so that you can look to take advantage when distress comes more into the market. Nick, what are you seeing? Or perhaps maybe reflect back to the audience what we’re seeing in terms of for example, rental collection and how we think that might impact on the distress side.
Nick Strutt
It’s a good question. Obviously, the rental collection in the last quarter date was perhaps slightly better than the previous quarter date in terms of, in some sectors. I don’t foresee there being that much difference in the next quarter date. I don’t see that much difference in terms of how the banks react to that in terms of what they’re being told to do by the PRA which regulates them in terms of taking enforcement action. So, I don’t see as Alex said, I don’t see any real distress coming to market in terms of the last quarter this year. I think once a new year starts and you’ve had three quarter dates of non-performance and three quarter dates of non-financial Government compliance and maybe sort of interest breaches, I think the pressure for the banks will become too much to bear in terms of their own stakeholders and also some of the debt holders and their stakeholders as well and I think that’s when we’ll, as Alex said in the Q1 next year we’ll start to see some of this distress start to grow.
Alex Cuppage
One thing maybe just building on what Nick said there. So, you know, we’re significant investors in consumer finance. What we have seen there is main street is held up pretty well and actually consumer finances has paid down in a lot of cases but the data coming through certainly in the US, less so the data’s as clear in the UK, on mortgages you’re roughly about 30% of the book is in forbearance. Nick also talked about rental collections you know, quarter on quarter kind of down and whether that’s extended past Q3 on the commercial side and both the personal mortgage side is going to be a real kind of sticking point in this. What our experience is in terms of main street consumer finance is when people go over three payments due, they very rarely catch up. So, we are spending a lot of time kind of looking at ABS, RBS and CBS and looking at those kind of payment trends. If they continue I think it’s going to be very hard for a lot of the payments to come current. If you play that through that’s going to create liquidity issues in capital markets. That could eventually lead to pulling back of minds and debt funds, pulling back on lines on key sponsors which could result in distress. So, that’s something to definitely keep an eye on. The other side of things is you know, we really don’t know what jobs are going to come back in terms of the furloughed employees so the numbers are just incredibly scary. A lot of the businesses that we have talked to have been using the last four months to actually get lean and they’re realising now that some functions you know, technology has replaced those jobs and they won’t be coming back. Others are going to use the furlough scheme to actually get rid of head count that they wanted to get rid of pre-Covid anyway. And I think so looking at those as the furlough scheme winds down, looking at what jobs do come back… If I’m just looking in the States we’re a little bit closer to this but I think anywhere from kind of 30-50% of those jobs may never come back and that is driven by a weaker economy coming out on the other side or predicted to come out the other side, it’s leading to technology and automation change and ultimately if you’ve got starkly high levels of unemployment coming out into a weaker environment then capital markets are going to see more distress.
Omega Poole
We’ve had a question actually around hospitality and that’s probably a good sector in terms of jobs because as we all know hospitality has been one of the industries that has been worst hit by the crisis and the Covid shutdown and in terms of raising finance for that space. So, one of a number of the opportunities that we’ve been looking at recently with clients has been to source those kind of traditional one-way capital that Alex was talking about. But we have seen some hospitality deals happen in the market although they seem to be bucking the trend so for example, there was a 230 million I think financing for Sheva Hotels development by Cale Street Partners that came out recently. In fact, some lenders that we speak to although hospitality has been hugely hit, obviously, lots of hotels have been shut down entirely, most staff have been put on furlough. In some ways some of the lenders are telling us it’s actually easier to underwrite because you can effectively write-off 2020 and then you apply an income profile to build up the income looking at comparisons from, say, China and Europe. But they think there’ll be some runway so, for those hotels that are open it may not be until 2023/24 until things get back to the profile that they would have been in 2018 from an income perspective. Although, that said, hopefully the announcement around VAT yesterday, the reduction twenty to five percent will be a bit of a shot in the arm for the hospitality industry and may also provide confidence to some of the lenders in that space as they look to underwrite new opportunities. So, we do see, it’s one of those, like retail was actually pre-Covid, it’s one of those asset classes where lenders are incredibly cautious for obvious reasons but there is still some activity. Perhaps, I don’t know if we have any other questions from the audience but perhaps Nick this might be a good time to talk about any guidance that you would give to people if they find in fact they’ve got distress in their own portfolios and what they might do about managing that?
Nick Strutt
Yeah, sure. So, if there is sort of, if you do encounter distress or you think there may be distress in terms of some of your own loan positions, I would suggest two things really. I think you need to know your rights and know your exits. In terms of knowing your rights, I recommend that proper DD is done on your finance documents to know what your obligations are. If they have any weak spots or potential hair triggers that may be a problem. Equally there may be some weak spots on the lenders side as well which might be to your advantage. Obviously, I would say this but I would thoroughly recommend getting a lawyer involved sooner rather than later. In particular, there are, there’s a fair amount of case law as to how certain clauses can be interpreted which tend to be favourable to the borrower which you may not be aware of and it’s good to have that knowledge in the back of your mind when you’re discussing things with lenders because it just gives you a sort of competitive edge. I would also recommend just having a plan for the asset in terms of you know, a capex plan or a re-letting plan or repositioning, something that you can buy into and sell to a particular creditor because they will then pass that positive message on up the chain internally and it will get to their credit committee and hopefully you’ll be put in a sort of different basket to sort of other more favourable basket let’s say. In terms of knowing your exits, I think this sort of in terms of you know, a refinancing strategy for the asset or a sale of the asset. This helps for three reasons. It gives you peace of mind. It helps you market test any new terms that your current lender is imposing on you, so, as a part of restructuring they’re trying to sort of increase fees or margin by x amount. If you’ve tested the market and can see that actually the asset doesn’t merit that level of interest then you can, it sort of helps your negotiation. It also just puts you on a surer footing with the lender who would otherwise as a secure creditor if you default would hold the cards but if you know you’ve got a route out of this it just gives a certain confidence for discussions.
Omega Poole
Thanks Nick. I suppose maybe lets cover off one final point and that’s really around valuations at the moment. So interested Alex in your observation because obviously there’s a lack of transactional data at the moment of whether there’s likely to be a correction across the board, so not just in the, so to say distressed space. And when we might see a mismatch between vendor and buyer pricing be reduced to the extent we can start seeing some deal flow?
Alex Cuppage
Again, I would come back to the timing element of this Omega. It’s very difficult to predict. You know, I think every investor is going to have their own cost of capital which is going to drive their entry points. But I would go back to one of the original points that I made, I just think with the amount of dry powder in the market, below interest rate environments, the fact that rental growth for most asset classes is going to be pretty minimal over the next couple of years, I would expect returns are going to be lower relative to other cycles. I hope I’m wrong as an opportunistic investor but that’s just my gut feel. And you know, it’s hard to say whether you’re going to see a massive fall in values, I go back to offices you know, with the exception of some very, very core buildings, I’m looking at office transactions at the moment and I feel that the value needs to fall anywhere between 10 and 60% depending on the underlying asset. Will the market allow it to fall in the near term by that much? I don’t think so.
Omega Poole
I know you’re one of the most barish people I know Alex when it comes to office and I suppose following on from that, so office is one area and hospitality we’ve touched on, is also a challenging sector. Another question we’ve had is which sectors are there then than say that and retail do you think will be hardest hit? And perhaps which sectors do you think will thrive in the sort of post-Covid getting back to normal regime? Nick, I don’t know what your thoughts are on that?
Nick Strutt
Well I think as Alex said, I think obviously you know, everyone knows that leisure is going to take a hit but in terms of sort of long-term sort of structural changes, students accommodation has got potential problems ahead if there is a long-term shift towards remote/distance learning so yeah I think that is an area where you may see not a short-term amount of distress but in the longer-term there are potential problems to be had there.
Omega Poole
Alex?
Alex Cuppage
Maybe just to not be so barish but I think what a brilliant opportunity this is. I think we are you know, we’ve had 10 years of very strong asset growth but I think going back there are going to be structural changes to hit every asset class here. I think if you can be smart and find your entry points I think you can deliver some fantastic value for your shareholders or your investors and I think you can deliver some phenomenal buildings that will be driven by technological change, behavioural change both on the consumer and the working side and you know, ultimately people that get that right understand the structural changes, come up with the solutions and deliver buildings that kind of meet the ESG standards of the larger institutional investors I think will do phenomenally well out of this. But patience is going to be key.
Omega Poole
So, if I were trying to summarise the last 50 minutes or so, I think it’s a question of investors looking at the markets, trying to analyse the structural versus the short-term trends. Looking to identify and build up their contacts, particularly it seems, our panel think that joint ventures and bilateral arrangements where you may be able to provide solutions other than just purely capital. So, Alex gave that great example of filling floor space in a building as a way to look to unlock opportunities, perhaps working with the debt funds maybe more than the banks although maybe we’ll see some loan sales as the banks get pushed towards that rather than work out solutions as a way to really create value for your investors and your family offices going forward. I don’t know if you guys have any final comments to make for our audience in terms of what they should be thinking about? Otherwise I think that’s a good time to wrap up just before our 9.55 required time so, everyone can dash off to their 10.00 calls and Zooms. Thank you so much for your attention. Thanks also to Alex and Nick for your thoughts and great to see everybody. Thanks so much.