Distressed funds target commercial mortgage-backed debt securities as part of crisis manual relaunch

“This is an interesting strategy that has proven successful in other asset classes,” said Paul Norris, head of securitized loans investments at asset management firm Conning & Co., which oversees approximately $ 198 billion worldwide. “We expect to see more hedge funds doing this,” he said, noting that he was not pursuing the strategy himself.

Representatives for Axonic and Metamorphosis declined to comment.

But lenders acknowledged the pandemic was likely a temporary setback for most properties, and rather than foreclosure en masse, banks and commercial mortgage bondholders have given homeowners more time to pay off their obligations. As cities shut down last year during the pandemic, thousands of hotels, offices and shopping centers fell behind on mortgage payments. Fund management companies have raised billions of dollars promising investors huge returns from a potentially endless sea of ​​struggling commercial real estate.

With American life showing signs of returning to normal, many properties are expected to start making payments again soon. For Axonic and Metamorphosis, the opportunity belongs to those who cannot.

Loan liquidation

Many troubled borrowers will continue to receive payment deferrals from banks until their sectors are again almost full of strength. But for most commercial mortgage-backed securities, it isn’t possible to wait another year for distressed properties to turn the corner as they have to pay interest to noteholders. There are about 3,100 hotel loans bundled into commercial mortgage bonds, some of which finance multiple properties, according to real estate data company Trepp. About 14% were delinquents in May.

The special services that are called in when commercial mortgage bond-backed loans struggle will face increasing pressure to liquidate debt if a property is unlikely to meet its interest obligations soon.

The Metamorphosis strategy can involve purchasing distressed loans at or near par, often wiping out equity in the process, like a creditor in a conventional bankruptcy, according to someone familiar with the plans.

The private equity fund is focused on hotels that it says will struggle to catch up with their obligations after months of abstention, the person said. This includes properties with large meeting and conference companies and those that cater to business travelers.

A hotel may have a loan equal to about 60% of the property’s value before the pandemic, with equity accounting for the remaining 40%. Metamorphosis could buy that loan at about 100 cents on the dollar, take control and repair the asset before cashing it in about five years.

If the property appreciates only 20% above its pre-pandemic value, investors could double their money. If the joint venture can do this through its fund, in addition to adding leverage, it could generate compound annual growth rates of around 20%. Metamorphosis backers – including investment bank Westwood Capital, hedge fund Jerica Capital Management and a U.S. hotel asset management firm – expect to have up to $ 1 billion to roll out in the months. future.

CMBS 1.0

Axonic is looking for something slightly different.

As Metamorphosis buys loans bundled into CMBSs sold over the past decade, Axonic picks up pieces of pre-2008 commercial mortgage bonds known as CMBS 1.0. The tranches it holds are the first to suffer losses if a property falls behind on interest payments. This “first loss” position gives Axonic the right, under the oldest titles, to sell the bond-backed properties.

By taking control and repairing distressed properties such as hotels, offices, and retail spaces and increasing tenant occupancy over time, the idea is that the business can eventually sell the properties and make a healthy profit. Axonic, which sets up a closed-end fund of $ 250 million to $ 350 million, is aiming for a return of 8% per annum and will offer investors 20% of any additional profit beyond that, according to fund documents seen by Bloomberg.

In the aftermath of the global financial crisis, several companies with stakes in CMBS 1.0 made similar games to wrest control of distressed loans in transactions, sometimes leading to lawsuits over disputes with more senior bondholders. .