Private Equity Investors in Commercial Real Estate: Easy Does It Now

“The market is clearly becoming more selective again, in terms of the deal profiles,” said David Bitner, vice president and Americas head of capital markets research for Cushman & Wakefield (CWK). “If I were betting I would say there are going to be more price adjustments.”

In the early part of 2022, private equity investors focused mostly on the hot multifamily and industrial sectors along with core office and retail assets, according to Bitner. While industrial and multifamily remain attractive asset classes, Bitner said investors may be far more cautious about deploying capital for long-term investments, given uncertainty around where rents may land in the future and the potential for higher cap rates.

Ian Ross, founder and principal of real estate development and investment firm SomeraRoad, has aggressively sought distressed opportunities since founding the firm in 2015. Since then, the company has deployed more than $880 million of equity for over $2.2 billion in total transactions across a variety of markets and property sectors.

“There is a lot of equity in the system, but that equity is being highly selective particularly because of the lack of leverage out there,” Ross said. “The availability of leverage in the marketplace has noticeably contracted, causing buyers who rely on bridge financing for acquisitions to have limited options: high-cost unlevered debt fund money, or more traditional bank financing which requires increased equity investment. And, while acquisition financing will be challenging, the bigger land mine may end up being the refinancing of high-leverage real estate debt with near-term maturities.”

A big reason for reduced leverage opportunities for borrowers now is the weakening of the collateralized loan obligation (CLO) market, with CLOs now largely absent as a financing source. Wider credit spreads in the CLO and commercial mortgage-backed securities (CMBS) markets is causing warehouse lenders to become more selective and creating a carryover effect for private equity investors, according to Bert Crouch, head of North America for Invesco Real Estate (IVZ).

“The cost of leverage is up fairly significantly, which lowers borrowers’ ability to pay up for assets, and it stresses debt-service coverage ratios further,” Crouch said. “With financing costs up, and assuming target returns remain unchanged, asset prices should adjust accordingly in the near to medium term.”

Crouch noted that while credit conditions could cause some potential challenges in the CRE market, there is still plenty of dry powder to be unleashed on the private equity side that could offset possible looming distress. 

“You’re still seeing a significant amount of capital that is on the sidelines that needs to be invested in commercial real estate,” Crouch said. “That said, the denominator effect is a looming headwind for institutional investors that should be factored in by year end.”

The denominator effect occurs when an investor’s private equity portfolio value exceeds its target allocation due to the decline in other elements of it. 

Distress in the market is on the uptick and, with it, signs of investor appetite for distressed real estate assets. Debt is also being underscored. Last month, an affiliate of BH Properties acquired a four-story retail complex in Miami Beach at 100 Lincoln Road from Vornado Realty Trust (VNO) for $96.3 million, 29 percent less than the REIT giant paid for the property in 2012. BH, which launched a $200 million distressed real estate fund in July 2020, seized on the opportunity after Vornado defaulted on an $83 million loan in 2021. 

Distress also made headlines with Innovo Property Group’s struggles to acquire the HSBC tower at 452 Fifth Avenue from PBC USA for $855 million, the financing not lined up by the May 16 deadline to close the sale. HSBC, which occupies 63 percent of the tower, has confirmed it won’t renew its lease when it expires in 2025, with plans instead to move its U.S. headquarters to Tishman Speyer’s The Spiral in Hudson Yards. PBC had purchased the building from HSBC for $330 million in 2010, and now has $378 million in debt on the asset.

Ross noted, however, that a distressed CRE market also creates opportunities for basis resets on certain assets like office or retail.

“Those resets can certainly open up optionality for reimagining a property’s use through a creative change in use or can just allow a property to be more competitive in its current use by needing to now achieve lower rents,” Ross said. “There will be opportunities to take assets at a new basis and reinvent them for alternative uses, whether that is office to multifamily or various other conversions.”

Alfonso Munk, chief investment officer for the Americas at Hines, said that in the current volatile market environment investors are mostly seeking opportunities that can withstand an economic downturn, including multifamily, industrial and self-storage. He noted that investments not dependent on aggressive growth assumptions and cap rate compression are important, as well as ones not dependent on financial leverage, given how much debt terms have changed in the past three months. 

Munk cautioned against investors going after distressed assets like office buildings in major gateway cities due to the many unknowns with remote working trends and the lack of actual trading activity that makes pricing discovery more challenging to gauge. He said patience is key because of long lease terms tied up in many of these properties. 

“A lot of investment product is expected to come to the market, so patience and focusing on the best-located, high-quality assets is the right strategy,” Munk said. “Distressed assets are distressed for a reason.” 

Pamela West, senior portfolio manager at Nuveen Real Estate Impact Investing, said investors have begun to place a much higher emphasis on risks associated with individual deals given the higher debt costs amid inflationary pressure. They’re also reassessing the ability to achieve necessary rental and occupancy growth. This has resulted in focusing on high-performing sectors like multifamily and industrial.

West added that geography is taking on a greater importance when deciding what deals to tackle. Bigger markets with strong economic fundamentals take priority. 

“There is also a renewed emphasis being placed on location, as there is an expectation that a wide dispersion of performance will become more evident between the stronger and weaker markets,” West said. “The importance of geography was less pronounced during the post-COVID lockdown period. It will return.” 

Private equity investors are confronting unusual market conditions with concurrent strong headwinds and tailwinds, Bitner said. In typical periods of volatility investors have honed in on cash-flow growth, but Bitner noted that this strategy can also prove treacherous due to the exposure of sectors like multifamily and industrial to risks of higher interest rates. 

“If COVID-19 had been a normal recession, we would be moving right now into prime-time, value-added, opportunistic activity,” Bitner said. “But it wasn’t a normal recovery and it was super-, super-charged by the government, and now we have inflation for a variety of reasons. And now there’s a very significant risk of a recession in the next six quarters, so that’s going to make it harder for investors to move into full thrust.”

Andrew Coen can be reached at acoen@commercialobserver.com.