Find a Partner with Experience, Agility, and Capital

By Pat Jackson

Several months ago, I penned an article noting that amidst ongoing inflation and a lengthy span of interest rates elevated at a 23-year high, commercial real estate (CRE) valuations had declined, lending had dramatically slowed, and banks were facing heightened bank scrutiny from their primary regulators and the FDIC. Pointing to problematic bank capital positions and the increased likelihood of CRE loan performance issues, I posited that investment opportunities would eventually emerge for investors able to onboard problematic CRE loan assets – either single-asset or portfolio asset transactions – from the banks needing to offload them. Investors with experience in the workout of troubled assets, who could also employ a long-term approach, would be best suited for these investments.

Now, in mid-2024, those investment opportunities have officially arrived.

The U.S. economy and the banking sector continue to face serious headwinds, which have produced an investment opportunity of a caliber not witnessed since the Global Financial Crisis. Interest rates have held steady at their high, and its possible we won’t see any cuts this year. If we do, they won’t be substantial. Community and regional banks, which supply the largest amount of commercial real estate loans (in 2022 they accounted for 27.0% of the total CRE loans issued by all sources) now have balance sheets buckling under the weight of CRE loans due for repayment.

In a shocking statistic, there is a more than $2.2 trillion wall of U.S. commercial real estate debt coming due for repayment by year end 2027. This record amount is boosting the likelihood of defaults. Some of these loans have already been extended. In 2022 and 2023, many borrowers exercised the one- and two-year extensions built into their loans. However, those extensions will reach their end, causing many borrowers to face the higher rate environment, as many also simultaneously grapple with higher vacancies and weak cash flows.[i]

2023 and 2024 Bank Failures

Distress has been rippling through the banking industry since last year. 2023 delivered several high-profile bank failures. By May 2023, we had all witnessed the well-documented second-, third-, and fourth-largest bank failures in all of U.S. history. Those were First Republic Bank, Silicon Valley Bank and Signature Bank, respectively.

This year, New York Community Bancorp dominated the spotlight after having recently become a significantly bigger institution and thus facing increased regulator scrutiny. Moody’s and Fitch both slashed the bank’s credit rating to junk, its stock plunged, and the bank admitted to weakness within its internal control for reviewing loans. With 14% of its rent-regulated loan book at risk of default[ii], the bank has replaced its CEO twice and some shareholders are now calling for punishment of the executives who caused the bank’s decline.

Another institution, Republic First Bancorp was seized by Pennsylvania regulators on April 26, 2024, following a failed deal earlier this year to infuse the bank with new funds as it struggled under the weight of declining deposits and a weakened mortgage lending business.  A regional institution, the bank was substantially smaller than the three failed institutions the year prior, with just $6 billion in assets.[iii]

The year isn’t over, and experts anticipate additional impending bank distress amidst current circumstances.

The Opportunity

Given today’s backdrop, including general bank distress, the drop in commercial real estate valuations and the continued difficulty borrowers face in refinancing properties, high profile loan defaults are now occurring, and banks are being forced to move non-performing assets off their balance sheets.

The valuation drop of the assets isn’t the sole issue when a bank has sufficient capital and loss reserves to weather the storm. However, when banks have a disproportionate exposure to an asset class, in this case commercial real estate, and the overall market value as a class declines, the impact to the bank’s capitalization structure is disproportionately impacted. This leveraged concentration of the bank’s capital raises concerns about the viability of the bank when the “tide goes out”. This high concentration of capital attracts the attention of the regulator and investor community alike.

Thus, three investment opportunities now exist due to these combined factors:

1. FDIC Structured Transactions with Private Sector Partners

The FDIC has begun taking action following the recent bank failures and the probability of additional, impending distress. Similar to what FDIC did during the Global Financial Crisis, it is helping to shift problematic bank assets in bulk, including non-performing commercial real estate loan portfolios, to private partners with the expertise, infrastructure, and proven ability to work out and resolve them.

2. Proprietary, Privately Negotiated Bank Transactions

Even as the FDIC plays a crucial role in resolving bank distress from banks in receivership, the majority of transactions will occur outside of FDIC led portfolio sales. Likely scenarios for these additional transactions include M&A driven transactions where one or both institutions require the other to dispose of problematic real estate loans or portfolios of loans as part of the negotiation for the ultimate merger, as well as banks disposing of assets when seeking an infusion of fresh capital to shore up their capital structure. In either case, a partner offering a holistic approach based in deep banking experience is required to complete a portfolio transaction. This single, complete solution clears the balance sheet and allows the bank to reach its ultimate goal – restored confidence in the institution among investors, regulators, clients and acquisition targets.

3. One-Off Transactions

Lastly, there are many opportunities emerging with single asset transactions comprised of either bank balance sheet loans, loans with shadow banks, or recapitalization needs at the asset level that require a new capital infusion. The pipeline for these single asset deals is expected to increase exponentially over the next couple of years as time runs out with current borrowers/owners and new solutions are needed.

Choosing Your Partner

In the case of all three investment opportunities, choosing your partner is key. Potential partners must be well capitalized, with the ability to move quickly, but also must also be able to demonstrate their past operational successes in resolving distressed bank assets. Those that are well positioned to invest in these transactions can generate a compelling risk/reward profile.

Choose a proven partner with the deep expertise required for success. Sabal Investment Holdings is that trusted partner.

About the Author

Pat Jackson is founder and chief investment officer for Sabal Investment Holdings, the Irvine, California-based investment management firm serving institutional investors across the United States.

[i] The Bill is Coming Due on a Record Amount of Commercial Real Estate Debt, Wall Street Journal, January 16, 2024, https://www.wsj.com/real-estate/commercial/the-bill-is-coming-due-on-a-record-amount-of-commercial-real-estate-debt-451ec8cb

[ii] How to Kill New York’s Rental Housing Market, Wall Street Journal, April 1, 2024, https://www.wsj.com/articles/albany-democrats-good-cause-eviction-new-york-rent-control-kathy-hochul-f4d8125f?page=1

[iii] Here’s what Led to Republic First’s Collapse – And Why It’s Different From 2023 Failures, Forbes, April 27, 2024, https://www.forbes.com/sites/tylerroush/2024/04/27/heres-what-led-to-republic-firsts-collapse-and-why-its-different-from-2023-failures/?sh=5b7cde275878