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'We've seen this movie before,' says Waterfall Asset co-founder on trouble in commercial real estate

By Joy Wiltermuth

Capasse's Waterfall Asset closes a new $485 million Atlas Fund to invest in commercial real estate, distressed loans and bonds

Tom Capasse, a veteran of distressed property investing, won't say the sky is falling when it comes to a credit crunch bearing down on the estimated $21 trillion U.S. commercial real-estate market.

But Capasse does see a wave of distress unfolding in the coming months as more borrowers buckle under the weight of higher interest rates, tighter credit and other pandemic aftershocks.

"You are going to see strategic defaults," said Capasse, CEO of Ready Capital Corp. (RC) and co-founder of Waterfall Asset Management, of landlords walking away from properties or handing the keys back to lenders. "You are going to see a lot more of that in the office sector."

After an era of easy credit and low interest rates, property values are expected to fall, eroding the equity that borrowers have in properties and likely leading to climbing defaults. "The Fed is getting its way. It is going to have a traditional cyclical decline in real estate," he said.

See:Fed needs to keep raising interest rates, Waller says

Ready Capital is externally managed by Waterfall Asset Management, an alternative investment manager with $11.6 billion in assets. Waterfall closed a new $485 million Atlas Fund this week to invest in commercial real estate, distressed loans and bonds.

Capasse had a front-row seat to four decades of past commercial real estate boom and bust cycles. Back in the 1980s, he was helping Merrill Lynch navigate the Resolution Trust Corporation (RTC), a sweeping federal program that purged problem assets from failed banks, but also built the early fortunes of real estate titans Barry Sternlicht and Thomas Barrack.

"People who say this is the new RTC, they are like Chicken Little," Capasse told MarketWatch "That's not going to happen."

Instead, Capasse sees an more orderly process of loan sales from lenders able to better absorb some level of loss, rather than the flood of bank failures that led to the RTC and fire sale prices. But he also anticipates enough distress coming down the way to gear up Waterfall, and its small-balance loan affiliate Ready Capital, to seize the moment.

"We've seen this movie before," Capasse said. "Our trading desk is definitely hearing more inquiries from potential sellers of select, target portfolios from smaller and midsize banks," he said, adding that this activity picked up since the collapse of Silicon Valley Bank and Signature Bank in March.

Ready Capital has been one of the biggest buyers of distressed small-balance property loans, with some $5 billion of total purchases in past down cycles. It also is a lender in the sector, where banks have recently retrenched.

Concerns in this cycle have been centered on smaller banks will less than $250 billion in assets, which account for three-quarters of commercial-real estate bank lending. It's an area the International Monetary Fund pointed to earlier this week as a potential source if financial instability.

"For now, it's more of a fact-finding mission at this point," Capasse said of buyers and sellers who aren't yet agreeing on price. "That impasse is only going to be broken by distressed sales," he said, pegging office properties as the first shoe to drop. "They are just starting to happen."

U.S. stocks have rallied to start 2023, but REITs have yet to catch a break. The Dow Jones Equity REIT Index XX: DJDBK was down almost 22% from a year ago, while other REITs were down closer to 25%, according to FactSet. The Dow Jones Industrial Average was less than 2% lower from a year ago, while the S&P 500 was off by about 6%, through Friday.

While headwinds continue to gather for commercial real estate, banks' balance sheets remain awash in "safe," but underwater assets as the Federal Reserve has quickly jacked up rates to fight inflation, making older, lower coupon bonds worth less.

The Fed in March created an emergency program for banks to avoid forced sales of "safe" but rate-sensitive assets. Banks can pledge Treasurys and agency mortgage bonds, in exchange for liquidity, but not commercial real-estate loans.

"That's part of where we will get our supply," Capasse said.

Related: As cities push to turn offices into homes, a key New York developer says a significant factor is being ignored

-Joy Wiltermuth

This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.


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04-14-23 1211ET

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