How Private Equity Plans to Capitalize on Commercial Real Estate Distress
There’s blood in the water, as hundreds of billions of proverbial dry powder sits poised to enter the financing market. Here’s how and where.
During a May 3 appearance on Bloomberg TV, Blackstone (BX) President and COO Jonathan Gray appeared sunny, despite his surname, as he touted his private equity firm’s recent global real estate investment fund, BREP X, which closed a $30.4 billion fundraising round in mid-April.
“We think there’s a real opportunity to deploy more capital,” Gray said. “I think the private credit area is really at a golden moment because we do see tightening out there.”
For the illiquid world of private credit — which provides debt for commercial real estate projects -– and that of private equity, the recent upheaval in the U.S. regional banking sector and issues plaguing downtown office space has sparked questions surrounding the type of returns CRE can generate for investors.
The primary question being: Is a golden moment possible in the darkest of times?
“We’re in a meaningful period of dislocation,” said Lauren Hochfelder, co-chief executive officer of Morgan Stanley (MS) Real Estate Investments and head of MSREI Americas, during a Commercial Observer forum in late April. “We’re seeing risk and asset values repriced before our eyes, and I think that’s true across the entire investable universe and certainly across all of private real estate, every sector, virtually every global market.”
The dislocation across markets and asset classes has been driven by numerous external factors, including the secular shift in office usage since COVID-19, but the largest reason for the distress has been the historically rapid interest rate hikes by the Federal Reserve. Those have caused asset values to decline as borrowing costs have spiked. The increased leverage ratios on existing loans have put pressure on borrowers, and, in some circumstances, made it impossible to keep loans current or to refinance maturing loans without an infusion of equity. Moreover, the cost of financing acquisitions or new developments has also skyrocketed, creating a pause in equity markets as they assess the fractured landscape.
The shifting of the tide and subsequent distress has been plain to see: Brookfield (BN) defaulted on $784 million in loans tied to two Los Angeles skyscrapers in February; Blackstone sent a $270 million CMBS loan on a Manhattan multifamily portfolio to special servicing in February; GFP Real Estate defaulted on a $130 million mortgage-backed securities loan for 515 Madison Avenue in December; and just last month RXR defaulted on a $260 million loan on 61 Broadway.
“The backdrop is setting up for a likely scenario where we see more distress than we’ve seen since the Great Recession, and maybe even more distress than in 2008, 2009 and 2010,” said Warren de Haan, founder and managing partner at Acore Capital, one of the largest lenders in commercial real estate. “We have a supply and demand imbalance between the demand for commercial real estate debt and the supply of CRE debt.”
An estimated $1.5 trillion in CRE debt comes due by the end of 2025, according to a report by Morgan Stanley. This maturity wave arrives just as capital markets have seen a vast reduction of liquidity driven by a retrenchment of the U.S. banking system, which has experienced the second-, third- and fourth-largest commercial bank failures in American history since March and is gearing up for potentially more in the months ahead.
Given that regional banks (those with $10 billion to $160 billion in assets) represent nearly 14 percent of commercial real estate lending, the pullback in debt capital from the system at a time when that money is needed to pay down billions in maturities is not exactly an appetizing mix for either investors or property owners.
“If all of that plays out together, you’ll have significantly lower liquidity in debt markets, a huge wall of maturities coming due, a higher interest rate environment, meaning values decline, and you have a banking crisis at the same time, meaning that the amount of distress we expect to see in the system will be exponentially higher than what we’ve seen in the last decade,” de Haan told CO.
“That is the big opportunity for the $400 billion of private equity sitting on the sidelines,” he added.
Ah, yes, the $400 billion in private equity capital. It’s commercial real estate’s caped crusader; an underwater sponsor’s proverbial knight in shining armor; the missing layer in an empty capital stack’s billion-dollar sandwich.
The numbers differ rather widely, depending on sources – Ernst & Young counts $1.2 trillion in dry powder; 1,520 funds raised $727.3 billion in 2022, according to Private Equity International; private equity fundraising exceeded $259 billion in the first nine months of 2022, according to Pitchbook — but there’s no denying that at least hundreds of billions of dollars is ready and waiting to enter capital stacks and distressed portfolios across the country from all parts of the private equity universe.
All told, private credit investors account for 12 percent of the $6.3 trillion U.S. commercial credit market, while regional banks account for 40 percent of the total, according to Reuters.
Aside from Blackstone’s $30.4 billion fundraise in April, other heavy hitters have made headlines in recent months: Brookfield Asset Management’s flagship real estate fund, Brookfield Strategic Real Estate Partners IV, raised $17 billion in late 2022; Invesco Real Estate (IVZ)’s U.S. Fund VI closed above its $1.75 billion hard cap in May; and Nuveen Real Estate’s CASA Partners IV fund raised $410 million in October to renovate and reposition multifamily units.
The money appeared because capital markets, like nature, abhor a vacuum.
“De-levering has created opportunities, lack of capital has created opportunities,” said Josh Zegen, founder and managing director of Madison Realty Capital, a private real estate investment firm with more than $10 billion AUM. As for the banking sector shift, “people say it’s over. It’s absolutely not over. We’re seeing every other day a deal fall apart because a bank pulled out,” Zegen said.
As banks retreat, private equity players are prepping their well-timed pounce, sizing up debt and equity environments equally as market duress runs formerly well-capitalized sponsors to exhaustion and eventual submission.
On the credit side, Zegen noted that there’s less appetite available to re-lever positions through A notes, loan-on-loan financing and credit lines, while the debt side is beset by problems associated with the higher cost of capital and increasingly expensive short-term debt, floating-rate debt, and fixed-rate debt from single-asset single-borrower loans and collateralized loan obligations.
“There’s a perception that there’s so much liquidity, but I don’t share that opinion,” Zegen said. “This is a major opportunity for someone like us right now, particularly in the private credit area. But, really, at the end of the day, there’s a lack of supply of capital relative to the demand.”
He added that one fundamental difference between now and the 2008 Global Financial Crisis is that previous downturns carried the perception that, so long as investors or sponsors didn’t lever themselves too badly, they could hold out and wait for the cycle to invariably turn back — but now that offices have entered a structural shift in the way people work and businesses utilize space, all bets are off.
“The problem is in one very important sector of the five major food groups of commercial real estate,” Zegen said, referring to office. “And it’s something that opportunity funds, debt funds, mortgage REITs, collateralized loan obligations – just a huge section of these guys – had a 10 percent to 40 percent exposure to.”
While some sponsors may recoil at the thought of onboarding new investment partners who’ll provide either mezzanine financing or preferred equity stakes in vulnerable capital stacks, the practice will be unavoidable over the next six to 12 months as more loans mature and interest rates remain high: Over $500 billion of CRE debt comes due this year alone, according to the Mortgage Bankers Association.
“Anytime you see this level in asset value repricing and this level of capital retreating, both for structural reasons and, frankly, concern around the environment, that creates opportunities for those of us who have capital and have conviction of where we want to invest it,” Hochfelder said.
Thus, under the pall of 5 percent interest rates, significant portions of that $500 billion debt avalanche will struggle to maintain their covenants, whether that’s debt-service-coverage ratios or loan-to-value ratios, while even those loans that aren’t maturing this year carry interest rate caps that are set to double upon expiration, potentially ballooning expenses, according to David Bitner, executive managing director of global research at Newmark (NMRK). All this will create “distress and distress adjacency” for sponsors who need to pay down at least a portion of their maturing loans to maintain ownership of their properties, or generate new capital altogether for assets sunk underwater, he said.
“You’ll have to go through a loan modification, even if that is splitting into an A-B structure, where there’s still upside for incremental equity,” Bitner explained. “These are all very sensitive negotiations, they’re going to be one by one, and they’re going to create opportunities for opportunistic capital to come into assets, but you have to have the reckoning first.”
The entrance of private capital into this world of distress is expected to take on two different guises in the months ahead, according to CEOs and analysts.
One route private equity can take is buying distressed loans – loans that are in default or foreclosure – at a significant discount and taking control of a property and riding it out into a high rate of return. Another route is buying performing loans from distressed sellers, who sell loans backed by performing commercial properties at a significant enough discount that private equity firms step into the position with the ability to generate high rates of return, usually in the 15 to 20 percent range. The first avenue offers the chance to buy debt notes on the cheap and foreclose on the entire capital structure once payments are missed. The other allows investors to purchase good properties from desperate sellers willing to sell for 80 cents on the dollar.
“The question is: What price or cost of capital will people look for to step into the fulcrum of distress?” said Ronald Dickerman, president and founder of Madison International Realty, a real estate private equity firm with over $8 billion in capital commitments. “Make no mistake, the equity investors are licking their wounds from their office exposure and, generally speaking, have written down other parts of their office portfolio. There isn’t as much exuberance to dive into the market as quickly as one might think and people are super cautious, especially about the office sector.”
To be fair, there’s a less rapacious side to private equity. That’s specifically found in the preferred equity space, which has seen opportunity funds at Cerberus and Rockpoint, among others, help sponsors deliver loan payments upon maturity through recapitalizations, refinancings, or mezzanine funding on assets that were initially financed at lower rates and higher values.
“A lot of people have thrown their hands up, they don’t have the money, and then XYZ fund comes in,” explained Zegen. “There’s a perception that that’s more secure than buying a piece of real estate today, that it’s more secure in the capital stack, so a lot of private equity firms are doing that.”
Dickerman added that private equity firms will pick their spots in the capital stack at risk-mitigated entry points, avoiding deep distress, and focus more on viable paths into reliable returns, like providing mezzanine loans or preferred equity financing to help roll over construction loans on attractive projects into permanent financing.
“There will be lots of counterparties that struggle to raise money because raising money in this market is really hard to do and everyone is focused on lack of equity capital,” Dickerman said. “So just being a conventional equity provider across the spectrum is also a business opportunity.”
There are several avenues for that money to follow. Different funds cater to different types of CRE investment levels, which vary by asset class, debt funding ratios, and projected rate of return. Open-ended fund vehicles will gravitate toward core and core-plus investments, while closed-end fund vehicles will risk more in the value-add and opportunistic spaces.
Core investments provide stable income with little risk and typically achieve lower annualized returns — think an apartment building in a well-populated town. Core-plus investments carry opportunities for increased returns but only so long as more leverage is used to enhance property improvements, like an occupied multifamily building that needs a new common area.
Value-add investments usually provide no cash-flow upon investment, but carry the opportunity for ample returns once debt has been used to “add value” into the property – as seen in many older, Class A office properties undergoing changes. Finally, opportunistic investments carry the most risk, require the most leverage, and generate the greatest rewards – ground-up developments, empty buildings, and land deals fall under this category.
“You look at equity funds, opportunity funds, core funds, value-add funds, all of that is dealing with struggles that are defensive in nature,” Zegen explained, emphasizing that most funds are currently paying down existing leverage. “Lots of money raised is being used from a defensive standpoint, and the question is: How do I get new money going into 2023 and 2024, and how will that money be capitalized?”
The direction that money goes upon capitalization is the next element of the equation.
With more than $57 billion in global investment capital, Morgan Stanley’s Hochfelder said that her firm is looking to buy “high-quality assets at below replacement cost” and at substantial discounts to their prices from the first quarter of 2022.
“We’re not chasing value traps,” Hochfelder said at the conference. “We’re much more focused — rather than trying to buy a Downtown L.A. office at X percent off peak values, we want to buy the highest-quality assets that we believe have the longest-term demand drivers”
To this end, Morgan Stanley is bullish on acquiring repriced core industrial assets and endorsing its “tremendous long-term conviction” around the multifamily sector, she said.
Zegen said firms should keep an eye on the hospitality space, as many hotel companies took private money during the pandemic because they were over-levered and had no cash flow. Now that the industry has rebounded, hotel companies are replacing that debt with cheaper financing or are being forced to sell assets that took on too much debt.
“It’s a time to play offense, but also have your defense hat on, as well,” he said.
Acore’s de Haan said his focus is on top 25 markets, specifically cities like Miami where assets can be had at deep discounts in an environment poised for future growth.
“I follow migration patterns, states and cities where we’ve got strong governance, business-friendly environments, lower cost of housing and lower taxation,” he said. “Those are migration ponds that I think are deep and broad.”
Avi Feinberg, a real estate partner at Fried Frank in New York, said that many of his private equity clients are using the distress to invest in alternative asset classes: marinas, RV parks with amenities, corporate-branded RV parks, and logistics centers.
“Anytime there’s distress, it breathes opportunities. Every cloud has a silver lining for somebody,” Feinberg said. “Some people are unfortunately scarred by the downturn, but there’s others who will find opportunities in that situation.
“As a general matter, there will be opportunity in real estate because real estate hasn’t died,” he added. “That’s what we learned from prior cycles.”
Brian Pascus can be reached at email@example.com