Michael Lavipour, Managing Director, Investments at Square Mile Capital Management, LLC, predicts the future of shopping malls and explains why now is a good time to lend on hotel assets.
Q: Tell us about Square Mile Capital. Where are you currently finding opportunities?
A: Square Mile has been around for almost 15 years. We are a private equity firm with approximately $8 billion in regulatory assets under management, focusing on real estate credit and equity investing throughout the United States.
In terms of where we are currently finding opportunities, on the equity side, we anticipate distressed opportunities as a result of COVID-19 and its impact on cash flows and valuations and we will also continue to focus on thematic investing, specifically at the intersection of real estate and technology, including last-mile industrial space and the convergence of media and technology, among other active themes. Over the last couple of years, we have made a big push on the equity side into the production studio space, both in Southern California and in other markets around the country. On the lending side, we are focused on pretty much anything the banks won't do, including value-add lending, either light value-add or more transitional, and development finance, but all for the balance sheet and nothing for securitization or syndication.
This year, we are down approximately 75 percent in loan volume due to the pandemic. However, we are still finding opportunities. We recently closed several significant transactions, among them a large speculative industrial development deal that was subsequently leased to a major credit-rated tenant and some multifamily development finance, including several notable projects in the New York City area. We are also mining our existing portfolio for opportunities.
Q: Let's focus on industrial for a moment. We are witnessing the rapid convergence of retail and logistics as many shopping mall owners turn to logistics companies to relet space traditionally occupied by big-box retailers. In light of this trend, how do you envision the future of shopping malls?
A: I think it will look very different. I believe many malls are dying or will die. Where they can be repurposed (and not all of them can), people will evaluate whether there are excess development rights that could allow tearing down boxes to build multifamily developments, or educational facilities, or, as you described, distribution centers. Some malls certainly will survive. But I think now, there is much uncertainty about how retail will take shape when things return to normal, and as part of that, everyone is starting to look at how they can repurpose malls.
Q: One last point on this topic: where are you seeing the trend towards vertical industrial centers occurring?
A: First, I think in terms of fulfillment centers, for example, the million-square-foot bombers located near airports in traditional industrial markets are going vertical. Some of the new prototypes, are approximately 65 feet in height, which is undoubtedly vertical. And this includes multiple mezzanine levels within the boxes.
Separately, regarding last mile assets in urban areas, we are developing a 1 million square foot center in the Bronx near the Bruckner Expressway. It's a two-story property – although it is more accurate to think of this structure as performing like two first floors stacked on top of each other. We are building it with 30-foot clearance, load-bearing capacity, up and down ramps, and enough turning radius to allow 18-wheelers to access both floors. The property has been designed to accommodate potential uses generating demand for Class A urban distribution space. We're in the equity on this project.
Another project we are involved with is a three-story industrial project in Red Hook, Brooklyn, where we're the lender. We closed the loan in July.
Multistory industrial is coming, as evidenced by the two projects mentioned above, where we're involved in both the equity and the debt side.
Q: How much of your day do you spend on asset management/modifications? What are borrowers asking for, and what are you giving?
A: I split my time between loan origination and asset management; it varies in any given week. Early on in the pandemic, we heavily focused on asset management, and specifically around the asset classes that immediately lost income, such as retail and hotels. Luckily, we don't have much retail in our portfolio. And surprisingly, we don't have many hotels either. I think retail and hotel comprise a modest part of our overall portfolio, much of which is senior in the capital structure.
Keep in mind that when you are a debt fund lender (as opposed to a bank or life insurance company) that levers itself through the warehouse market or selling mortgages, any modification involves two deals: a deal with the borrower and a deal with the person sitting ahead of you in the capital stack. So early on in the pandemic, we were swamped on the asset management side. We are still heavily involved in discussions with borrowers, but a lot of the noise has quieted down. There will probably be a second wave of modifications and restructurings in the fall as forbearance on the early restructurings burns off.
But broadly speaking, the portfolio is doing pretty well. I think we are going to try and focus as much as we can on originations. It's tough because you’ve got to make sure you play defense to protect the house, but this is also one of the best lending environments out there, given the pullback by so many others and the depressed leverage levels available in the market.
Q: You mentioned the warehouse market – how has it been to deal with your warehouse/repo lenders?
A: Some of them are better than others. Overall, it has been pretty good. We have managed to work through issues without being exposed to margin calls in a material way. One of the benefits of not being a public permanent capital vehicle is that we do not have to deal with liquidity management in terms of buying securities on repo that are marked to market daily. Most of our warehouse lines have stable long-term funding, with mark to market for pre-specified credit events. We have not had too much activity in terms of managing those. I think the biggest thing that we have had to do is seek approvals from our warehouse lenders as we have been restructuring transactions with our hotel and retail borrowers. They've generally been playing ball and doing what's best for the overall loan and the project.
Q: For the asset classes you are currently lending on, what structure are you requiring?
A: Broadly speaking, we're lending on industrial, multifamily, and then select office. And I would say that the most significant difference in multifamily and industrial lease-up transactions is that we are underwriting a longer lease-up period. And as a result, we are underwriting larger carry reserves and interest reserves and earlier replenishment tools, like early trigger and warning signs of depletion of reserves and requirements to post, and maybe even some guaranteed obligations to post. I would also add that we are structuring loans at lower leverage points. Beyond that, we are not employing much new technology. If we were to consider writing hotel loans, which we are looking at right now, we would want to have liquidity for cash flow disruption if we are in a deal for around a year, with early warning signs for rebalancing. We are not lending on retail at this point. And on office, we are focusing on cash flow, whereas we have historically done more speculative lease-up deals.
Q: You just mentioned something that I found very interesting. Everyone whom I speak with is avoiding hospitality. Briefly walk me through why you think now is a good time to lend on hotel assets, and what factors are most important in deciding whether or not to lend.
A: We firmly believe that hotels will snap back. It is going to take a couple of years for them to do so. The challenge is that we don't know how long they will be depressed. It is a bit complicated on the equity side to make a huge bet and buy a hotel because if you are off by 6 or 12 months, that cash flow burn will drain your returns. But I think that on the lending side, you can write a good loan with a reset basis. We are working on a loan right now on a newly delivered project in New York with a buyer coming in. The buyer is coming in at a basis 25 percent below pre-COVID levels, and we are coming in at 65 percent of the new basis, which is 10 percent below pre-COVID levels. We have about a year of liquidity management via interest reserves and are getting paid more than we would have been paid pre-COVID. So, the buyer's basis is lower, our loan-to-value on their basis is lower, we have liquidity management for that interim period, and we are getting paid more – that is exciting to us. I think the challenge is that hotels have not cycled through ownership yet, via the debt, partly because many of the loans in this cycle are not highly levered. As a result, there are not that many assets trading hands, but I think we would be an open lender for hotels in major markets with high pre-COVID occupancy levels, good margins, and cash flows.