The tide has shifted in commercial real estate as the compounding effects of inflation, rapidly rising interest rates, and volatility have left many market participants in a tough spot. If you feel things are unsettled in the real estate world, it’s because they are: We’ve entered a new cycle, characterized by stress and distress.
GlobeSt.com reports the amount of distressed assets in the US commercial real estate market has reached nearly $80 billion after climbing for five straight quarters, as per MSCI data. This represents the highest level of distress since 2013 when markets were navigating the effects of the global financial crisis. Notably, the current level is less than half the GFC-era peak.[1]
What do you need to know about today’s real estate investing environment? We share our top insights here, including why you shouldn’t let the term “distress” spike your blood pressure and how you can capitalize on the current opportunity set.
Past vs. present: From development cycle to distressed cycle
Before interest rates started their rapid climb in 2022, we were in a real estate development cycle. For sponsors and investors, it made financial sense to buy raw land and build new, quality projects. The market was extremely hot, and everyone was racing to create supply to meet strong demand. For participants who began developing projects in 2020-2022, however, things haven’t gone according to plan. Many of these folks are now facing serious challenges.
Much of the pain can be attributed to variable-rate bridge loans. As these loans come due, some owners can’t source the additional cash needed to refinance at today’s significantly higher rates. In the face of tightening loan standards, fewer lenders, and higher borrowing costs, finding feasible refinancing can be a problem even for assets that are performing well.
For underperforming assets, the picture is even more problematic: As PwC notes, many assets were purchased pre-pandemic under much more favorable circumstances—but now, tenants are departing, and owners must make significant capital investments to attract and retain tenants, adding to the burden of their financing challenges.[2]
Take heed: Opportunities abound in a distressed cycle
When individual investors hear about distress in the market, they often feel a wave of worry—but for savvy professionals and sponsors, distress can be a good thing. Distress represents pricing inefficiencies; it represents opportunity. In fact, we think we’re seeing the best real estate investment opportunity since the 2008 financial crisis.
After a decade of relentless price appreciation, the distressed cycle will offer favorable entry points to those with strategies designed to provide rescue capital for projects in trouble. Sponsors and investors will have opportunities to buy assets below cost or replacement value, setting the stage for compelling risk-adjusted returns.
Potentially attractive deals include:
- Broken development projects
- Bank-owned properties
- Foreclosures
- Turnarounds
Plus, investors stand to benefit from the limited availability of debt in the current environment. For example, the distressed cycle may offer investors the opportunity to buy a stabilized asset at a meaningful discount vs. past valuations—and they can buy the spread with more equity because there is less debt in the market.
Key question: How do I buy the right properties at a discount due to the disruption in the market?
In the coming year, the real estate sector can be a great place for investors to build long-term wealth; however, you will need to look at real estate investments through a different lens than they would during other cycles. Investors will need to be in the right vintage and the right assets. The right sponsor is also critically important. In our view, dealmaking efforts, relevant experience, and the ability to move quickly will all play critical roles in value creation during the distressed cycle.
[1] Distress figure includes financially troubled and bank owned assets. “Distressed CRE Reaches Ten-Year High”, Erik Sherman, GlobeSt.com, October 19, 2023, https://www.globest.com/2023/10/19/distressed-cre-reaches-ten-year-high/
[2] PwC, “Emerging Trends in Real Estate 2024”, https://www.pwc.com/us/en/industries/financial-services/asset-wealth-management/real-estate/emerging-trends-in-real-estate.html
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