Q&A with Aleksey Chernobelskiy | Distress in the Real Estate Market

If distress hits the real estate market hard, Aleksey Chernobelskiy of Centrio Capital Partners will be among the first to see it. He spends his time advising real estate investors and sponsors, many of whom are navigating hairy situations—a horror show of expiring rate caps, refinancings, capital calls, and even litigation. (He writes about the lessons he sees in a weekly newsletter here.)

This week we sat down with him to discuss the state of the market and emerging distress, including:

• How he got his start helping LPs;

• The state of the real estate market and where he’s seeing real distress;

• Advice for GPs and LPs facing challenged properties;

• The biggest mistakes real estate investors make.

Tell us a bit about how you got started helping LPs

I come from an institutional background—I ran two teams at STORE Capital, a public REIT that was recently taken private. While there I ran both the underwriting and portfolio management teams, so I got to see both the analysis process and risk-reward decision-making as well as how those decisions drove the work in portfolio management. By the time I left, we owned approximately 2,800 properties across the US.

Over the past decade, retail LPs have sent me many fundraising decks looking for feedback. While the retail LP market is filled with tremendously successful and smart people, many lack investment experience. Between my work advising LPs and STORE, I also spent a short time in an executive role at a syndicator—an eye-opening experience.

With this in mind, I started a new venture to bridge the gap in an otherwise opaque GP/LP marketplace. I never tell people whether they should invest or not invest in anything. Instead, my goal is to ensure they understand what they're getting into—to the best of my ability—before writing a check. Success, for me, is hearing from a client that they invested (or didn't invest) based on a better understanding of the transaction.

You post some wild examples of distress - often in multifamily - in your Twitter feed. Do you think that's representative of what's going on? Or crazy outliers?

I definitely have some sample bias and talk about this fairly often and publicly. Having said that, some of the stories that I share are important because otherwise they wouldn't be seen. For instance, I recently shared a story about an LP who was asked to do a capital call on a deal where, by generous valuations, the property is worth ~30% of the current senior debt balance.

While I definitely don't think that this example represents the population of syndications at large, I do think that (1) this means there are likely more cases like this and (2) LPs should be aware that just because a capital call is issued doesn't mean that the investment makes sense.

How'd owners end up in those positions? How much is simply high price + rate cap expirations? Or is there real operational distress out there too?

A lot of what I see currently is due to a combination of debt issues—rate cap expirations, bridge maturities, or the need for cash in refinances as a result of a senior debt maturity (at the now much higher rates and lower valuations). I've seen a lot of other situations as well, but there's no question that this is the clear majority.

Lots of investors are on the sidelines waiting to take advantage of distress. Do you think we're seeing buying opportunities emerge yet? If so, when and what sectors?

There's no question that some properties are trading at deep discounts, but a deep discount to an overly inflated price doesn't make it a good deal. This is especially true when rates sit where they sit today, and there are some (well based in my opinion) predictions of NOI pressures.

Similarly, are you seeing more pain in some markets over others?

Keep in mind that my sample might be biased since I mostly work with retail LPs, and retail money over the past few years has generally pursued multifamily in hot markets (I haven't seen actual data but would love to see it if someone has it - [email protected]). That said, a lot of the distress I see today falls into two categories:

• Sunbelt owners who bought at the top of the market in 2019-2021 and are now facing the combined pressures of higher interest rates and softening rents.

• Class C building owners in markets with regulatory pressure—for example, rent-stabilized buildings in NYC or lower-end multifamily assets in markets with long eviction moratoria—e.g., California.

For GPs facing distress in deals they control, what should they do?

At a high level, GPs should identify the challenge early, plan well, and communicate thoroughly.

Contrary to the common approach of issuing a capital call or seeking external capital at a higher cost, there are multiple strategies to consider for the benefit of investors. Options include raising equity or alternative forms of capital (loans, mezzanine debt, preferred equity) from existing investors, attracting new investors through mezzanine debt or preferred equity, and utilizing rights for the General Partner (GP) entity to lend money to a deal, showing commitment to Limited Partners (LPs).

Transparency, market terms, and prioritizing LP equity in the repayment structure are vital. Additionally, leveraging the GP's promote in a deal can provide a basis for securing loans. Communication with LPs is key, especially when making significant decisions like capital calls. Explaining the rationale behind decisions can build trust, highlighting the thought process and partnership value. Financial participation in plans by the GP and taking responsibility where necessary are important, alongside avoiding procrastination.

Real estate's illiquid nature requires advance planning, with actions for 3-6 months ahead needing initiation today and strategic planning 9-12 months in advance to avoid appearing unprepared.

On the flip side, how should LPs react to an existing deal facing distress?

First: do you simply have a hunch that there’s trouble, or has the GP communicated that there are challenges and you have to respond?

For the former scenario, the most important thing is realizing that your hunch might be wrong, so approach the situation with grace. At the same time, it's important to know that even though you're an LP and can't directly influence the trajectory of the deal, sending questions in at the right time and engaging in conversation can certainly help right the ship.

Once distress has been communicated, it’s important to understand that the GP’s and LP’s interests begin to diverge. The LP’s goal is to save their investment. Likely underwater, the GP’s goals are more complicated—avoiding a default on the loan, avoiding bad press, and optimizing for staying in business or even avoiding personal bankruptcy might become top priority despite the actions that lead to these outcomes not being optimal for saving the LP investment. Of course, ethics play a role here as well.

LPs should try to understand the GP’s motivations and work with them to achieve the best possible outcome. I’ve written more about this and potential steps forward here.

What are the biggest mistakes you see LPs make?

The biggest mistake is probably not noticing cap rate compression assumptions in decks. In many cases, GPs will make assumptions that they’ll be able to exit a deal in the future at a lower cap rate than what would be available today. These cap rate compression assumptions can be a major driver of projected IRR.

There's nothing wrong with assuming this as part of an investment thesis, but (1) the LP should know it's happening, (2) they should understand what will happen if the macro tailwinds don't come, and (3) they should fundamentally understand that, to a large extent, cap rates aren't in the control of the GP.

There are other things that LPs should watch out for when evaluating deals—they aren’t necessarily deal-killers, but if you see enough of them it might be a red flag:

• Over-reliance on social proof: A deck that focuses on the sponsor’s media appearances or social / newsletter following.

• High or complicated fees: Anything higher than a 3% acquisition fee on purchase price or complex / unclear waterfall structures.

• Low co-GP investment: Anything less than 5% is too low.

There are others, but most retail LPs that get in trouble are missing one of more of those flags. I wrote about more common LP mistakes—and other things to watch out for—in my newsletter here.