Five months into the pandemic, hotel rooms remain largely unreserved, office space sits empty and hardly anyone is venturing into malls. Commercial tenants are struggling to pay their rents, and property owners are struggling to make payments on the loans they took out to finance the buildings.
Some real estate investors, including the hedge funds and private equity firms that hold those loans, have had enough. Unwilling to risk any more missed interest payments, they are taking property owners and developers to court, hoping to foreclose on their interests in the properties and minimize their financial losses.
Already, there are a few high-profile battles, including one involving a retail complex in Times Square that is owned by the family of Jared Kushner, President Trump’s son-in-law. The operators of the Mark Hotel, one of Manhattan’s most luxurious hotels, with Art Deco-inspired rooms and a suite that can cost $10,000 a night, recently beat back a foreclosure attempt in court.
These cases have been initiated by a type of lender that is driven largely by narrow financial interests, but real estate lawyers and lenders expect foreclosure proceedings to become more widespread the longer commercial tenants fail to keep up with the monthly rent checks. Given that a full economic recovery from the pandemic is probably years in the making, things could get much uglier in the commercial real estate market before they improve.
“When this all started in March, the first reaction was this was temporary and let’s just see how this plays out,” said H. Scott Miller, a real estate lawyer with Carlton Fields. “But we’re getting to the point where people are saying, ‘How much longer can this continue?’ This just can’t be open-ended.”
In cities across the United States, commercial hubs are lying silent. In Midtown Manhattan, usually a hive of activity filled with office workers, tourists and vehicles, the pandemic has cut pedestrian traffic in Times Square by 83 percent. Office buildings are all but empty because employees are working from home or have lost their jobs. Restaurants and stores are shuttered or operating at greatly diminished capacity.
The delinquency rate on large commercial loans tied to real estate in the United States has surged to just under 5.78 percent — nearly doubling in just one month, according to Moody’s Investors Service, a credit-rating agency. During the financial crisis that began in 2008, that rate peaked at just over 10 percent, but not until four years into the crisis. The hospitality and retail industries, which have been hit especially hard by the pandemic, account for 82 percent of the most seriously delinquent commercial loans, Moody’s said.
While big banks, which are among the largest real estate lenders, have been generally willing to give property owners time to work things out with tenants, a class of smaller lenders — including hedge funds and private equity firms — is showing impatience. These lenders have provided billions of dollars in so-called mezzanine financing to help owners of hotels, retail complexes and office buildings run their businesses.
Unlike traditional mortgage lenders, whose loans are secured by the real estate, mezzanine lenders make loans that can convert into an equity interest in the business if the owner is unable to pay the mortgage, rather than the property itself. So “mezz” lending, which typically pays high interest rates, is both riskier and more rewarding for investors.
The mezzanine finance market is one of the fastest-growing corners of the commercial real industry, providing a financial lifeline to big property owners who either don’t want to take out a second mortgage or want to reduce the amount of cash they put up. Last year, the 158 most active mezzanine lenders — including well-known investment firms like Apollo, Blackstone, Brookfield and KKR — originated more than $44 billion in loans, according to Commercial Mortgage Alert, an industry newsletter.
A foreclosure is a way for a mezzanine lender to recoup potential losses by arranging for a sale or an auction of a delinquent loan as well as its equity interest in a borrower’s business. If no bidder emerges, the mezzanine lender can oust the borrower and take over as the property owner or developer. Judges have tended to side with mezzanine lenders in foreclosure disputes, but the pandemic has prompted some judges to be more sympathetic to financially stressed borrowers.
In May, after the Mark Hotel missed several payments, a California private equity firm moved to foreclose on its $35 million mezzanine loan to the company that owns and operates it. A New York judge blocked the attempt to foreclose on the Mark, claiming the action was not justified and not “commercially reasonable” during a pandemic.
Just last week, another New York judge delayed a foreclosure action initiated by a hedge fund mezzanine lender on a building in Albany on similar grounds and because of the “severe turmoil in the real estate market.”
But in May, a third judge in New York allowed a foreclosure auction on a nearly completed hotel at 12 East 48th Street in Manhattan to proceed, and said any harm to the developer, Hidrock Properties, could be remedied after foreclosure in a subsequent lawsuit for money damages — which Hidrock is doing.
In the case of Kushner Companies, the lender, Paramount Group, has backed away from its planned foreclosure on a $70 million mezzanine loan to a retail condominium complex owned by Mr. Kushner’s family. The foreclosure action involving Kushner and the building, which once housed The New York Times, was postponed at the last minute to allow for more negotiations, a person briefed on the matter said.
Lenders who move to foreclose on mezzanine loans said they were not being predatory but merely looking to protect their financial interests.
John Bucci, a managing partner of SteepRock Capital, said his firm would appeal the judge’s ruling that stopped the foreclosure auction on SteepRock’s $3.3 million loan to the owners of a 12-story office building in Albany. Mr. Bucci said the financial problems at the office building predated the pandemic. Lenders are willing to work with borrowers, especially in trying economic times, he said, but added: “We have an obligation to our creditors and investors.”
The New York court rulings on whether it is appropriate for mezzanine lenders to foreclose on borrowers during the pandemic are particularly important because New York law is often pivotal in resolving disputes between lenders and borrowers.
“Most mezz loan agreements not only say New York law applies but that you can have a foreclosure in New York,” said Daniel Rubock, senior vice president at Moody’s.
Mezzanine foreclosures in New York and elsewhere take place under procedures outlined in the Uniform Commercial Code, a set of laws that governs many commercial transactions. A U.C.C. foreclosure is much quicker than a traditional mortgage foreclosure, but the risk to a mezzanine lender is that if no other investor buys the delinquent loan at auction, the lender must assume all of the borrower’s financial obligations — including taxes and mortgage payments.
It’s why some mezzanine lenders are exploring alternatives to outright foreclosure, including selling delinquent loans at discounted prices to firms that are more interested in managing properties.
Christopher Smith, whose firm, Ohana Real Estate Investors, had moved to foreclose on the Mark Hotel, said his firm specialized in hotel investing and, if needed, would be ready to step in to manage a facility. But most mezzanine lenders are not willing to make that kind of commitment, he said. Mr. Smith declined to comment on the litigation involving the Mark Hotel.
“For a hedge fund that owns mezz debt on a hotel, the last thing they want to do is own a hotel,” Mr. Smith said. So those funds would be motivated to sell their loans, he added.
And sure enough, some on Wall Street are gearing up for that new reality. Lawyers and lenders said the market for distressed mezzanine debt had sprung to life in recent weeks. A major sponsor of financial investment conferences just announced that it was holding its first Distressed Hotel Investing event in September — a move inspired by the pandemic. Already, more than 800 people from banks, hotels, law firms, investment firms and hedge funds have signed up for the online event.