The pressure of rising interest rates is giving some commercial real estate owners and operators sleepless nights these days, while a lot of capital is rushing in eager to take advantage of the market turmoil.
Large managers such as Blackstone, Brookfield Asset Management, Ares and Starwood have either completed launches or are actively raising funds for megafunds targeting opportunistic strategies. Brookfield, for example, is actively fundraising for its fifth vintage global opportunistic real estate fund, Brookfield Strategic Real Estate Partners V, which is reportedly targeting $15 billion. Office REIT SL Green Realty has also entered the fray, announcing recently that it plans to begin raising funds for a $1 billion opportunistic debt fund focused on New York City.
“The amount of capital raised and sitting around ready to be deployed is near all-time highs,” says Aaron Giocca, director of U.S. capital markets research at Colliers. There is currently about $260 billion in capital targeted at North American real estate, according to Preqin. That level is down from a 2022 high of $283 billion, but still a significant amount by historical standards. “At the end of the day, there's still a huge amount of investable capital, and the majority of it is concentrated in debt, value-add and opportunistic strategies,” he says.
There is currently about $260 billion in capital targeted at North American real estate, according to Preqin, down from a 2022 high of $283 billion but still significant by historical standards.
About $109 billion of the funds raised are targeted at opportunistic strategies, according to Preqin, and that number nearly doubles to $200 billion when global strategies are considered. “This is not a repeat of the global financial crisis,” Giocca stressed. But opportunistic capital raised through both debt and equity investments provides a good backstop for some of the distressed and distressed real estate that exists, he added.
Desire for higher returns
Investors are hoping to capture attractive investment opportunities created primarily by the high interest rate environment. Investors are also looking to boost risk-adjusted returns, with many core strategies generating returns just above the risk-free rate on Treasury bonds. “The appetite for higher-return strategies has certainly shifted as we expect market turmoil and dislocation, which has led to increased interest in value-add and opportunistic multi-sector focused funds,” said Douglas M. Weill, founder and co-managing partner at Hodes Weill & Associates.
Bernie McNamara, head of client solutions at CBRE Investment Management, agrees that investors have shown significant interest in yield-enhancing strategies over the past 12 to 18 months, with opportunistic strategies being the favored strategy for the third consecutive year, according to CBRE's 2024 Investor Intentions Survey.
“Investors naturally want to be rewarded with a reasonable spread over the base rate,” he says. Moreover, he says, many investors (both managers and LP clients) are seeing opportunities to take advantage of the bankruptcy to buy high-quality assets at discounted prices. Most of the interest has been in closed-end investment vehicles that offer higher returns, while open-end investment products have been plagued by redemptions and declining net asset values (NAVs).
Bernie McNamara, Head of Client Solutions, CBRE Investment Management
It's also important to note that fundraising hasn't always been smooth sailing. The fundraising environment has become tough for all types of real estate investment vehicles, including opportunistic and value-add funds. While investors are interested in opportunistic strategies, they are reluctant to commit capital, as evidenced by the longer lead times for funds to reach their fundraising targets. According to Preqin, the average time it takes for a fund to reach its final fundraising target is now around 24 months, up from 16 months in 2020.
“Last year was a tough one for fundraising in general, but there was some optimism early in the year,” McNamara said. The first half of the year may be quiet as investors wait for more clarity on the macroeconomic picture. But investors are preparing to “go from defense to offense,” and are seeing increased interest in higher-yielding opportunistic, value-add and core-plus strategies, he added.
Maturing loans will require capital
There are many opportunity funds on the market (over 500 worldwide) with a variety of strategies, from globally diversified funds to funds focused on specific real estate sectors or regions. Of course, these funds are not solely focused on distressed: some pursue other high-return strategies, such as emerging market development.
But its plight has drawn attention amid hopes that an estimated $1.5 trillion in commercial real estate loans maturing will create investment opportunities in a market where interest rates are higher and lending is more conservative.
Capital markets are not freezing and many borrowers and lenders will be able to make it through to maturities, but distressed situations will inevitably arise that create investment opportunities for funds to inject new equity and debt.
“Banks aren't going to make a lot of new loans until they've paid off maturing debt, so capital sources are historically low and they're having to fill a pretty big gap with either debt or equity,” said John Berg, managing director of portfolio management at Principal Real Estate Investors Inc. “So there's going to be ample opportunity to deploy capital going forward.”
One high-profile example was the FDIC's sale of Signature Bank's commercial real estate loan portfolio, which was reportedly valued at more than $30 billion, though such large portfolio transactions are rare and funds are taking a more focused approach to deploying capital.
There has been a lot of discussion between borrowers and lenders over loan modifications and extensions, but the market appears set for a prolonged high interest rate environment, even if the Fed enacts its expected gradual rate cuts in 2024.
“Until we see a change in policy from the Fed, I think the opportunities will continue to grow,” Berg says. For example, if an owner had a loan maturing 10 years ago at 75% LTV, refinancing that loan might be at 60% today. “That creates an opportunity to work out the capital stack by incorporating debt in addition to the first mortgage or by incorporating capital as preferred stock.”
That said, he added that the size of the upcoming opportunity is difficult to predict at this point as it depends on the cost and availability of borrowing.
Capital looks beyond the office
While much of the talk about real estate distress has focused on offices, there are opportunities across the real estate sector: Estimates of distress in the U.S. commercial real estate market have risen to $85.8 billion as of the end of 2023, according to MSCI Real Assets’ Distress Tracker.
Offices accounted for the largest share at 41%, followed by retail at 25%, hotels at 17% and apartments at 11%. Moreover, the value of assets classified as potentially troubled was $234.6 billion as of December, nearly three times the current total value of distressed assets.
CMBS delinquencies and special administration data also point to growing office distress: Trepp said the percentage of CMBS office loans in special administration has jumped from 4% to nearly 10% in the past 12 months.
For offices in particular, prices have repriced, and in some cases come down quite substantially, making this an opportunity for intergenerational buying, Giocca said.
Capital is also taking aim at cracks emerging in the multifamily sector, where loans were underwritten at historically low interest rates in hopes of a short-term hold period. “At the end of the day, some of these deals were done very carefully and are going to need some form of support,” he said.
Another potential crunch point in the early stages of rollout is logistics. Despite strong demand for logistics space, McNamara notes that the market is showing signs of polarization and stratification of performance. “Logistics, in some ways, is similar to what's happened in offices over the past decade-plus, where there's a separation between older facilities that can accommodate today's key occupiers and newer facilities,” he says.
Modern logistics users such as Amazon, FedEx, and Walmart often have building specifications that are incompatible with traditional logistics buildings, such as needing high clear heights and roof load-bearing capacity to support solar power, floor slabs that can support robotics and automation equipment, and EV charging stations with battery storage.
Opportunistic funds are looking to buy older properties in good locations, demolish them and build new, modern facilities. “So it's not just about buying cheap, it's about building the next generation of logistics,” McNamara says.
Is there too much capital to deploy?
Stories of capital lining up to jump on “generational buying opportunities” are not new, and the amount of capital raised raises the question of whether too much capital is chasing too few deals.
“You can argue there's plenty of capital, but the market is pretty deep,” Weil said, noting that there is about $400 billion in unredeemed cash in closed-end funds. When leveraged twice, that gives buying power approaching $1.2 trillion.
In theory, that level of capital would be enough to cover a year's worth of global real estate transactions. “But what we often see in times of crisis is not just asset sales; we also see recapitalizations and distressed loans, which means there are far more opportunities to allocate capital than just investing directly in real estate,” he adds.
“They have a lot of freedom to move between sectors and up and down the capital structure. By definition, that's what they do. That's how they generate alpha.”
Douglas M. Weil, Founder and Co-Managing Partner, Hawes, Weil & Associates
Opportunity funds also have a very broad mandate based on target risk and return, giving them the flexibility to invest throughout cycles and pivot where they find investment opportunities that are consistent with their return objectives.
“They have a lot of freedom to move between sectors and up and down the capital hierarchy. By definition, that's how they do it, and that's how they generate alpha,” Weil says. Ares, for example, has partnered with RXR to pool capital to invest in New York City offices. Ares also has a logistics strategy focused on growth. “So I think we're going to see a mix of strategies going forward,” he says.
So far, many funds have delayed deploying capital because there is still a buying-selling price gap and managers are waiting for a bottom in prices. “We expect activity to pick up in the first half of the year, but it will be a slow start as the clouds start to clear and certainty increases,” McNamara said. And capital may need to be patient, as systemic problems often take years to resolve.