I came across this deal, which is an actual distressed deal, and not just “ooh, the market value went down 5–10%”. This is a class A office high rise in downtown Minneapolis. The sponsor here is buying the note from the the lender at 42% discount to the principal, and the owner is agreeing to a deed in lieu. Prior to covid, office buildings in CBDs typically trade in the 200 PSF range. This deal is being bought at $77 PSF with mid 60’s occupancy, which at face value is about a cap rate of 15.
It took about a month until the details came out. What struck me as odd was how the cap of 15 turned into a CoC of 8.58%. The debt the sponsor wants to place is 8%, which should lever the CoC, only being offset by fees, capex, etc. Still, the CoC should be about mid teens. Upon digging in, it turned out the capex here is significant and detracting from the CoC. What initially confused me was that they wrote in $15M for capex as part of the capital raise, which means they are double counting it incorrectly if it is decreasing the CoC, until I realized they are doing $15M as part of the capital raise, and then also funding continuing capex annually from the cash flow.
What the sponsor here is trying to do is spot on. The general trend is for companies to want top tier office properties with multiple amenities, and they are willing to pay for it. It does not matter to them that they can get a class B office lease for significantly cheaper since office space is abundant post covid. Hence the significant capex as part of the business plan.
The fees were standard, and the promote was not bad on a high risk deal as this. 10% pref, then 90% to 16% IRR, then 80% to 20% IRR, then 70%.
However, the deal killer for me was they decided to include pref equity of 14% IRR, probably to appease some business partners (my guess, otherwise it doesn’t make any sense). So the 1st lien is 8%, the pref equity is 14%, and the common equity is behind that. Initially sold as a low LTV/LTC (73%/53%); however the pref equity should be considered a second position loan, which if reoganized would make the LTV/LTC 92%/67%. This is given the high risk nature of CBD office. Why? Just why? Without the pref equity, I felt the risk/rewards balance on this was right.
Oh well, I believe there will be more distressed CBD office deals in the upcoming 1–2 years, and that this is just the start.
