Commercial Real Estate: Finding Value in Distressed Assets
- Amid sharply rising interest rates and a looming recession, traditional channels of liquidity for commercial real estate have collapsed, providing attractive opportunities for distressed investors.
- In the public markets, we see opportunities in select discounted CMBS and public REITs backed by mortgages with conservative loan-to-value ratios that yield more than we think fundamentals suggest they should.
- In the private markets, as the stress cycle continues we believe real estate owners with upcoming loan maturities will turn to investors with the expertise to innovatively acquire or structure debt and equity deals across both public and private real estate capital structures.
- Published net asset values for open-end core funds have barely moved this year, despite a more than 25% drop in REIT prices. Investors in core funds have begun redeeming fund shares, prompting many core funds to attempt to sell their most liquid assets, like industrial and multifamily assets, which implies a headwind for even the most relatively resilient sectors of CRE today.
The commercial real estate (CRE) market teeters on the precipice of the biggest downturn since the global financial crisis of 2008. High inflation, rising interest rates, and ongoing financial market volatility have launched the real estate sector into a stress cycle marked by major dislocations in asset pricing and paralyzed capital markets activity. As liquidity pressures and uncertainty build, private transaction volume continues to drop precipitously. Heading into 2023, the dislocated CRE transaction market is now characterized by special situations including complicated restructurings, fund unwinds, and lender risk transfers.
While today’s market chaos persists across all parts of the public and private CRE space, we believe this environment also creates attractive opportunities for disciplined and sophisticated investors that can navigate across both public and private CRE, and throughout the capital structure.
Pricing dislocations move from public to private markets
Prices in the more liquid public market – always first to react – have already tumbled: Year to date, real estate investment trust (REIT) prices have fallen over 25%, with some asset sectors down over 35% (see Figure 1). Spreads of BBB (just above the lowest investment grade rating) commercial mortgage-backed securities (CMBS) have widened by over 360 basis points (bps) year to date along with the broader spread widening and volatility in structured credit markets (see Figure 2). In response to this market disruption, new CMBS issuance has evaporated as investment banks that package bank loans and sell them as CMBS stepped back.
Traditional bank lenders, for their part, have curtailed real estate lending. Federal regulators Footnotei mindful of the recent rapid rise in real estate lending volume – have signalled they will more closely scrutinize real estate loans; in response, U.S. banks have curtailed real estate lending. Further, many banks saw limited CRE loan paydowns this year given the dramatic move in rates and credit spreads, and now face over-sized balance sheet exposure to CRE heading into 2023.
This decrease in credit availability and rise in financing costs has in turn restricted real estate transaction volumes, as many new buyers now face borrowing rates that exceed asset level cap rates from just a year ago. This “new math” for buyers, in combination with broader uncertainty, further exacerbates “bid-ask” spreads on traditional transactions, resulting in the decline in transaction volumes. Perversely, as rate pressures indirectly impact transactions and values, credit pressures are only exacerbated, thus starting a vicious cycle of higher financing costs leading to impaired values, leading to higher credit spreads and financing costs, leading back to further value impairment.
Alternative lenders step in to offer liquidity
Amid this market disarray, there remains approximately $2.4 trillion in multifamily and commercial real estate loans scheduled to mature between 2023 and 2027. As the stress cycle continues and traditional liquidity channels continue to dry up, real estate owners with upcoming loan maturities will turn to investors with the flexibility, experience, and creative structuring capabilities to offer bespoke capital solutions.
These capital solutions include high yield bridge capital for real estate owners to refinance an upcoming maturity, or, in other cases, bespoke structured investments for private real estate lenders to manage their balance sheets. Meanwhile, we also see increasing demand for risk-transfer solutions from banks seeking to offload their nonperforming real estate loans to the private market to satisfy increasingly stringent regulatory requirements.
In a scenario where inflation and elevated rates stabilize on a prolonged, above-target path, we think that this demand for nontraditional financing will only persist.
Deeper distress on the horizon
While today’s pressures primarily stem from higher rates and limited liquidity, a global contraction in the coming years has the potential to ultimately push the real estate sector into a deeper stage of distress as real estate operating fundamentals decline and credit deteriorates. These pressures could build slowly, particularly in sectors like office and retail, as growing lease maturities collide with tenant downsizings.
Where are the opportunities today?
With market dislocation comes opportunity for those with the expertise to innovatively acquire or structure debt and equity deals across both public and private real estate capital structures.
In the public markets today, selective CMBS and public REITs have sold off more than we think fundamentals suggest they should. For example, certain discounted BBB rated CMBS securities today are yielding more than 8% despite being collateralized by mortgages that were originated at a conservative 60% loan-to-value ratio. We believe these CMBS positions have ample cushion to mitigate the risk of even large underlying asset impairments and also offer potential appreciation in an improving market. Many REIT equities appear oversold as well, in our view, offering attractive entry points and the potential for stable dividend yields.
In private markets, this period of illiquidity is a great time to be a solutions provider in our view. With banks and CMBS originators retrenching and nonbank lenders like mortgage REITs facing liquidity pressures, the opportunity set for creative lenders has expanded dramatically. A combination of higher rates and credit spreads has pushed yields for CRE lenders 200 bps to 500 bps higher from the start of the year, implying high single-digit unlevered returns for senior positions that should be able to withstand significant value impairments. In addition, the growing need for rescue capital from borrowers creates opportunities to provide bridge capital in the form of junior debt, preferred equity, and/or hybrid participating capital positions that currently offer return potential in the mid-teens and higher. Finally, considering the regulatory and balance sheet pressures facing banks, we see opportunities to provide capital solutions to banks in a variety of structures, including complex risk transfers or discounted loan acquisitions.
Tail risks remain
We are vigilant and selective, however, in choosing investments as we recognize that massive capital shifts like the one happening today can result in additional risks. In CRE, we see a growing tail risk emanating from open-end core “ODCE” fundsFootnoteii that are now experiencing a wave of redemptions. Here, these types of funds face two primary pressures. First, a broader “denominator effect” pressure, where many of the underlying investors in these funds now believe they are over-allocated to CRE after the mark-to-market declines in public fixed income and equities. Secondly, investors are anticipating significant upcoming markdowns in these vehicles. Specifically, despite clear impairment to private real estate values and the fact that REITs are down at least 25%, core fund published net asset values (NAVs) have barely moved this year and in some instances have gone up, as has the ODCE index (see Figure 3). Sensing this disconnect, investors are starting to rush to redeem before the inevitable markdowns. Interestingly, this acute pressure to meet redemptions is now prompting many core funds to attempt to sell their most liquid assets, like industrial and multifamily assets, which implies a headwind for even the most relatively resilient sectors of CRE today.
Turning the corner into 2023
Heading into 2023, we expect the current distress cycle in the U.S. to progress as the Federal Reserve continues its campaign to counter inflation, and the resulting effects of increased unemployment and macroeconomic contraction begin to be reflected in real estate operating fundamentals. Europe has been harder hit amid the Ukraine war, an environment that will continue weighing on CRE fundamentals and valuations, increasing demand for risk-transfer solutions from regulated European lenders.
Risks abound, but so do opportunities.
Investments in residential/commercial mortgage loans and commercial real estate debt are subject to risks that include prepayment, delinquency, foreclosure, risks of loss, servicing risks and adverse regulatory developments, which risks may be heightened in the case of non-performing loans. Investments in distressed loans and bankrupt companies are speculative and the repayment of default obligations contains significant uncertainties. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. Mortgage-related assets and other asset-backed instruments may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee, there is no assurance that private guarantors will meet their obligations. Private Credit will also be subject to real estate-related risks, which include new regulatory or legislative developments, the attractiveness and location of properties, the financial condition of tenants, potential liability under environmental and other laws, as well as natural disasters and other factors beyond the fund’s control. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Structured products such as collateralized debt obligations are also highly complex instruments, typically involving a high degree of risk; use of these instruments may involve derivative instruments that could lose more than the principal amount invested.
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