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Unprecedented San Francisco Real Estate Default Shakes Investors to the Core


Lauren Miller

March 11, 2024 - 14:24 pm


San Francisco Property Loan Default Delivers a Shockwave through Investment Circles

Buildings in downtown San Francisco.

In a turn of events that rattled prominent investors, January brought unexpected surprises and a substantial financial blow to firms that had vested interests in one of the United States' most expensive real estate markets. The unassuming bond deal organized by Goldman Sachs Group Inc. in 2021—initially perceived as a lucrative investment—suddenly defaulted, culminating in an unprecedented financial debacle.

This misfortune befell on investors including TPG, Angelo Gordon, LibreMax Capital, and Lord Abbett & Co., who were stunned to discover the borrowers had failed to meet their obligations, leading to a substantial loss and distribution holdbacks that could echo through the financial markets.

Financial Crisis in The Making: The San Francisco Default Story

Investors who purchased bonds tied to the acquisition of numerous apartment complexes in San Francisco were in for a bleak revelation as the end of 2022 approached. The companies that borrowed money for these properties defaulted on their loans, resulting in a significant markdown on their backing securities.

A Protracted Pause on Payouts

Further complications arose when Midland Loan Services Inc., the intermediary for bondholders, announced that the significant sum of $164 million due to investors would be withheld. While temporary holdbacks are not an anomaly in commercial mortgage bonds, the scale of this particular one stood out, bringing to light a vulnerability in the market that could translate to unexpected losses even for grades deemed investment-worthy by the Kroll Bond Rating Agency.

The Domino Effect of an Unexpected Setback

This holdback didn’t just shock affected investors; it has since rippled across Wall Street, inciting concerns that this might be indicative of a looming X-factor risk in the vastly interconnected $1 trillion market for commercial mortgage-backed securities. With the real estate market already reeling from an historic downturn, the added worries of unanticipated servicer decisions add another layer of complexity for investors, who fear these choices could drastically diminish their returns.

Stav Gaon, a strategist at Academy Securities Inc., has suggested that the magnitude of the holdback in the Midland case may very well be the largest on record for the U.S. securities market. This incident underlines a concerning outlook for investors, prompting them to brace for potential obstructions as defaults escalate.

The Triggering Transaction

Probing the cause of such financial disarray leads us to the commercial mortgage bond backed by a hefty loan. This loan was taken out by Veritas Investments and Baupost Group in 2020 for over 60 apartment complexes in the heart of San Francisco. The following year saw Goldman Sachs transforming this loan into commercial mortgage-backed securities.

However, as we navigated through 2022 and into 2023, many apartment landlords across the nation experienced severe financial outflows. The Federal Reserve's dramatic rate hikes have escalated financing costs, squeezing profits out of property owners despite a rise in rents in various regions.

Financial Fractures and Frustrations

Veritas, alongside Baupost, succumbed to these formidable economic pressures and defaulted on their $675 million loan. Midland was subsequently brought in to manage this floundering debt starting November 2022. In essence, their charge was to ensure maximum recovery from the loan, a task that inherently involves tough decisions such as direct sales or renegotiations, ultimately benefitting bondholders.

The servicer's proposal suggested a minimum sale price of around $515 million. However, this figure didn't sit well with Angelo Gordon, LibreMax, and Lord Abbett, who believed it grossly undervalued the properties. A comprehensive assessment, perhaps limited by the fluctuating real estate market conditions, didn't bring clarity on whether selling the loans at prevailing market rates or pursuing alternative recovery strategies was the most advantageous course of action.

The Resolution and Resulting Repercussions

Despite the pushback from concerned investors, Midland proceeded with the sale, offloading the loan to Brookfield, with net proceeds circling around $513 million. This sale marked an approximate 25% markdown from the loan's original value, consequently subjecting two classes of bondholders—holders of the class G note and some within the class F note—to losses.

The holdback imposed by Midland Loan Services inadvertently exposed additional bondholders to potential losses. This included classes E and D, and a portion of class C notes, which had credit ratings ranging from BB- to A- assigned by Kroll. This action has only added to the uncertainties surrounding the future steps taken by servicers in similar default situations.

The Fickle Fate of Commercial Mortgage-backed Securities

Despite the Fed's aggressive interest rate hikes, the credit markets have largely remained intact, avoiding the anticipated cascade of defaults that had loomed with the tapering of an era marked by easy financial accessibility. Instances like the collapse of Silicon Valley Bank sparked brief anxiety over a potential credit squeeze, but the overall resilience of the economy has somewhat allayed these fears. Recent shifts in investor expectations, with predictions of the Fed lowering interest rates, have started to shrink the required yield premiums on some commercial mortgage-backed bonds.

However, distress is quietly accumulating within the real estate industry. As the normalization of remote work persists, landlords are disposing of office spaces at severe discounts.

A Prelude to Potential Problems

Yet, the greatest concern is emerging within the multifamily apartment sector. The potential for financial strain here has surpassed that of the office sector, with troubling signs pointing toward a troubling sum of $67 billion in distress, according to MSCI's recent findings. This growing mountain of distress has left Wall Street on edge, wary of conflicts such as the one unfolding with the San Francisco apartment debt.

If high-interest rates persist and more deals falter, it's likely that special servicers will be thrust into the spotlight, acting as arbitrators over an increasing number of financial disputes.

Investor Sentiment and Risk Perception

JPMorgan strategist Chong Sin pointed out in a note that the disclosure of the Midland situation, especially the substantial holdback without detailed explanation, could dent the confidence of investors in these securities. It is still unclear how servicers may be incentivized to resolve deals in the future, which adds to the market's anxieties.

"This reminds investors that they don’t have as much control as they think they do," stated Liza Crawford, co-head of securitized research at TCW. "It opens the door to a new level of risk that could materially disrupt investors’ expected returns."

This sentiment lays bare the new spectrum of risks that investment-grade commercial mortgage-backed securities might embody, upending traditional conceptions of risk and reward within the sector.

Final Thoughts

As the dust settles on this unforeseen financial fiasco, one fact becomes clear: the intricate dance of debt and investment in the commercial real estate arena has become even more precarious. The domino effect of what began as a single loan default in San Francisco has now rippled through the halls of Wall Street, prompting a reevaluation of risk and a cautious eye on the ever-changing tapestry of the American real estate market.

As this saga unfolds, many wait with bated breath for further explanations or insights from Midland, yet the company is under no obligation to elaborate on their decisions. Spokespeople for the affected investment firms and Goldman Sachs have either maintained silence or declined to provide their perspective. Meanwhile, the wheels of finance continue to turn, with the real estate sector and its investors navigating the undulating terrain that lies ahead.

Sources and Additional Information:

For more information on this evolving story, please reference the Bloomberg article available at: Bloomberg.

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